Fixed Income Basics (Series 65)
In a situation where the yield curve is sloping downward and to the right: I less funds are available to short term borrowers II greater funds are available to short term borrowers III there is a high demand for short term funds IV there is a high demand for long term funds A. I and III B. I and IV C. II and III D. II and IV
The best answer is A. An "inverted" yield curve is one that is downward sloping from left to right, with yields decreasing with lengthening maturities. Thus, shorter maturities have higher yields and longer maturities have lower yields. From an economic standpoint, this question can be looked at on the basis of supply and demand. In Choice I, there are less funds available (lower supply) to short term borrowers. This will drive up the "price" of short term funds, which is the interest rate charged to borrow those short term funds. In Choice II, there are greater funds available (higher supply) to short term borrowers. This will drive down the "price" of short term funds, which is the interest rate charged to borrow those short term funds. In Choice III, there is a high demand for short term funds from borrowers. This will drive up the "price" of short term funds, which is the interest rate charged to borrow those short term funds. In Choice IV, there is a high demand for long term funds from borrowers. This will drive up the "price" of long term funds, which is the interest rate charged to borrow those long term funds. When the yield curve is inverted, short term rates are higher than long term rates. The choices that drive short term rates higher are I and III.
When a recession is expected: I investors will increase purchases of corporate bonds II investors will increase purchases of government bonds III yields on corporate bonds will decrease IV yields on government bonds will decrease A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. When a recession is expected, investors sell corporate bonds (increasing their yields) and buy government bonds (decreasing their yields). Thus, the spread between corporate and government bond yields will widen.
Years ago, a bond was issued at par with a 7% coupon. This year, new issue bonds of similar credit quality are being issued at 10%. Which statement is TRUE? A. The new bonds will be issued at a premium to the current price of the 7% bonds B. The new bonds will be issued at a discount to the current price of the 7% bonds C. The new bonds will be issued at the same price as the current price of the 7% bonds D. There is no relationship between the prices of the 2 bond issues
The best answer is A. Because interest rates have risen from 7% to 10%, any new issue bonds will come out at par with a 10% coupon; while the prices of outstanding bonds with lower coupons will drop in the market. Thus, new bonds will be selling at a premium to the current price of existing bonds that have lower coupons.
Industrial development bonds are issued by municipalities to build facilities that are leased to: A. corporations B. government agencies C. municipalities D. sovereign governments
The best answer is A. Industrial development bonds are issued by municipalities to build facilities that are leased to corporations. These are a type of revenue bond where the lease payments made by the corporate lessee are the source of funds to pay debt service on the issue.
In 2015, a customer buys 1 GE 10%, $1,000 par debenture, M '40, at 120. The interest payment dates are Jan 1st and Jul 1st. The bond is callable in 3 years at an 8% call premium. The yield to call on the bond is: A. 5.26% B. 8.00% C. 8.37% D. 10.23%
The best answer is A. The formula for yield to call for a premium bond is: annual income - annual capital loss to call date --------------------------------------------------------- (purchase price + call price)/2 $100 - ($120 premium / 3 years to call) ------------------------------------------------ ($1200 + $1080) / 2 = $100 - $40 ------------- $1140 = $60 --------- $1140 = 5.26% Note that because there is an 8 point ($80) call premium paid if the bond is called in 3 years, $1,080 the redemption price at that date. Also note that because of the 8 point call premium (8%) paid at early redemption, the full 20 point premium is not lost; rather, only 12 points ($120) is lost when the bond is called at 108.
Yield curve analysis is useful for an investor in debt securities for all of the following reasons EXCEPT: A. the yield curve is used to compare the marketability risk of one issue to that of another B. investors can compare rates of return relative to changing maturities C. the yield of a specific security can be compared to the market expectation for similar securities D. the curve shows market expectations for interest rates
The best answer is A. The yield curve is not used to compare the marketability risk of different issuers. This is the risk that the security will be difficult to sell. The yield curve shows market expectations for interest rates - depending on the shape of the curve. An ascending curve indicates that interest rates are likely to rise in the future; a descending curve indicates that interest rates are likely to fall in the future. Because the yield curve shows all the market interest rates for all maturities, investors can compare rates against differing maturities. The yield curve is an average for securities of a given risk class. An investor can compare the yield on a specific security to the curve for the risk class to evaluate the attractiveness of that investment. If there is a great demand for a specific maturity, the price will be pushed up and the yield lowered. One can pick this out in a yield curve since the curve would drop for that specific maturity.
A 4% coupon bond is being offered on a 3% basis. If interest rates for similar bonds rise above 3%, the basis for this bond will: A. increase B. decrease C. be unaffected D. be volatile
The best answer is A. This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
Which statements are TRUE when a bond sells at a discount? I The nominal yield is less than the yield to maturity II The nominal yield is more than the yield to maturity III The current yield is less than the yield to maturity IV The current yield is more than the yield to maturity A. I and III B. I and IV C. II and III D. II and IV
The best answer is A. This one is worded in a tricky manner. For discount bonds, the relationship of yields from highest to lowest is: Yield to Maturity (Highest) Current Yield Nominal Yield (Lowest) Therefore, nominal yield is lower than current yield (choice I) and current yield is lower than yield to maturity (choice III). Yield to maturity is highest for a discount bond because it reflects both the fact that the bond was purchased for less than par and that the discount will be earned over the life of the bond. Current yield only reflects the fact that the bond was purchased for less than par; it does not include the annual earning of the discount. Finally, nominal yield is the yield based on purchasing the bond at its original par value - it is the lowest yield of the choices offered because it neither reflects the discount price nor the annual accretion of that discount.
A customer has won $1,000,000 in a lottery. The customer has the choice of taking $1,000,000 today or $65,000 per year for the next 20 years. To evaluate the best option, the customer would use: A. Net Present Value B. Total Return C. Rule of 72 D. Expected Rate of Return
The best answer is A. This person has the choice of taking $1,000,000 now or can take $65,000 a year for the next 20 years. To find the best choice, each $65,000 payment over each of the next 20 years must be discounted back to today's net present value, using the risk-free interest rate as the discount factor. If the net present value of these payments is more than $1,000,000, then the 20 payments of $65,000 would be the better choice.
For bonds trading at a discount, rank the yield measures from lowest to highest? A. Nominal; Current; Yield to Maturity; Yield to Call B. Yield to Call; Yield to Maturity; Current; Nominal C. Yield to Maturity; Nominal; Yield to Call; Current D. Current; Nominal; Yield to Call; Yield to Maturity
The best answer is A. When bonds are trading at a discount, the stated (nominal) yield will be lowest. The current yield will be higher, since it is based on the discounted market price - not par value. The yield to maturity will be the next highest, since it includes the portion of the discount earned annually as part of the annual return in addition to the interest received. Finally, yield to call will be highest, since the discount would be earned over a shorter period of time, increasing the annual yield on the security.
When the price of a bond increases, which of the following statements regarding yields are TRUE? I Yield to call increases II Yield to call decreases III Yield to maturity increases IV Yield to maturity decreases A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. When the price of a bond increases, yield to maturity drops. Similarly, because the bond is more expensive, yield to call will also fall.
During a period when the yield curve is flat: A. short term rates are more volatile than long term rates B. long term rates are more volatile than short term rates C. short term and long term rates are equally volatile D. no relationship exists between short term and long term rate volatility
The best answer is A. Whether the yield curve is ascending (normal), flat or descending, the true statement always is that short term rates are more volatile than long term rates. Short term rates are susceptible to Federal Reserve influence, and move much faster than do long term rates. Long term rates respond more slowly; and reflect longer term expectations for inflation and economic growth, among other factors.
During a period when the yield curve is normal: A. short term rates are more volatile than long term rates B. long term rates are more volatile than short term rates C. short term and long term rates are equally volatile D. no relationship exists between short term and long term rate volatility
The best answer is A. Whether the yield curve is ascending (normal), flat or descending, the true statement always is that short term rates are more volatile than long term rates. Short term rates are susceptible to Federal Reserve influence, and move much faster than do long term rates. Long term rates respond more slowly; and reflect longer term expectations for inflation and economic growth, among other factors. Please note that if the question referred to bond price movements, long term bond prices always move faster than short term bond prices, as interest rates change. This is due to the compounding effect on the bond's price that occurs, which increases with longer maturities.
What represents business risk? A. The risk that a company presents fraudulent financial statements B. The risk of buying a single stock C. The risk of investing in an enterprise that does not have a government backing D. The risk is making an investment commitment when prices are peaking
The best answer is B. Business risk is simply making an investment in a business that runs into problems, such as falling sales, bad management, bad market environment, bad product line, that cause business results to deteriorate. On this one, we are down to a 50/50 choice - either Choice A or Choice B. Since business risk really does not take "fraud" into account. Choice B is the best answer. As more stocks are added to a portfolio, diversification reduces business risk. A single stock portfolio will have a high level of business risk.
A customer who is retired wants to select an investment that is liquid, marketable, and that provides regular income. The BEST choice would be to recommend: A. Treasury Bills B. Treasury Notes C. Preferred Stock D. Certificates of Deposit
The best answer is B. Certificates of Deposit are non-negotiable - they are non-marketable, so this does not meet the client's needs. Preferred stock is marketable, but not as marketable as Treasury securities, making Treasury securities the better choice. So we are left with either a T-Bill or a T-Note. Treasury notes pay interest semi-annually; while Treasury Bills do not provide a regular income stream, so a T-Note is the better choice. (One could argue that buying T-Bills at a discount and letting them mature at par and then rolling over the original investment amount into a new T-Bill purchase will also provide an income stream, but this requires continuous reinvestment on the part of the customer. Buying a T-Note is a completely passive investment in terms of the customer's needs.)
Which statements are TRUE when comparing options contracts to futures contracts? I A futures contract requires future delivery of the underlying physical asset II A futures contract does not require future delivery of the underlying physical asset III An options contract requires future delivery of the underlying physical asset IV A options contract does not require future delivery of the underlying physical asset A. I and III B. I and IV C. II and III D. II and IV
The best answer is B. Futures contracts are standardized, exchange traded contracts that require future delivery of an asset at a fixed price and date in the future. In contrast, options contracts are standardized, exchange traded contracts that only require delivery if the option is exercised.
Two 20-year corporate bonds are issued at par, with stated interest rates of 10%. One issue is callable at par in 5 years, while the other is callable at par in 10 years. If interest rates drop by 200 basis points shortly after issuance, which statement is TRUE? A. The bond callable in 5 years will appreciate more than the bond callable in 10 years B. The bond callable in 10 years will appreciate more than the bond callable in 5 years C. Both bonds will appreciate by equal amounts D. The rate of appreciation depends on the credit rating of the bonds
The best answer is B. If a bond is callable at par in the near future, any price rise due to falling interest rates will be suppressed since the issuer is likely to call in the debt and refund at lower interest rates. Thus, the bond callable in 10 years will appreciate more than the bond callable in 5 years if interest rates fall.
The Net Present Value of an investment is lower than "0." This means that the: A. rate of return from the investment is greater than the discount rate used in the computation B. rate of return from the investment is lower than the discount rate used in the computation C. investment will produce a return that is greater than the rate of inflation D. investment will produce a return that is lower than the rate of inflation
The best answer is B. Net Present Value takes all the cash flows that will be generated by an investment and discounts them back to their "present value." The rate of interest used to discount the cash flows to be received is the current market rate of interest. If the computation results in an NPV of "0," then the rate of return of the investment equals the discount rate used. If the computation results in an NPV of more than "0," then the rate of return of the investment exceeds the discount rate used. If the computation results in an NPV of less than "0," then the rate of return of the investment is lower than the discount rate used. The computation has nothing to do with the inflation rate.
The quantitative method of evaluating investments that uses periodic cash inflows and outflows is: A. inflation-adjusted return B. net present value C. total return D. expected return
The best answer is B. Net present value uses compound interest to discount future cash inflows and outflows to their "net present value" - that is, their value in today's dollars. The rate of interest used to discount the cash flows to be received is the current market rate of interest.
Which security's price would fluctuate the MOST due to a change in interest rates? A. 10 year GNMA with an 8% coupon and a 9% yield to maturity B. 10 year zero-coupon Treasury Note with a 7% yield to maturity C. 10 year AA rated corporate bond with an 8.5% coupon and a 9.3% yield to maturity D. 10 year junk-rated corporate bond with a 9% coupon and a 10% yield to maturity
The best answer is B. Since all of these securities have the same time to maturity, this is not a factor in deciding which would have the greatest duration (duration is price volatility for a given change in market interest rates). Generally speaking, the longer the maturity, the greater the duration; and the lower the coupon, the greater the duration. The zero-coupon bond is the lowest coupon and would exhibit the most volatile price changes as market interest rates move.
A customer buys a 2-year maturity, 10% coupon bond at par. If market interest rates rise to 12%, then the bond's price will fall by approximately: A. 1.7% B. 3.4% C. 8.8% D. 9.7%
The best answer is B. The customer bought this 2-year bond at par with a coupon rate of 10%. If market interest rates rise to 12%, then the present value of the bond's cash flows will fall as follows (rounded): Year 1: $100 / 1.12 = $89.29 Year 2: $1100 / (1.12)2 (squared) = $876.91 Total Net Present Value = $89.29 + $876.91 = $966.20 The bond will fall in price by $33.80 from $1,000 par, for a fall of 3.4%.
A customer buys a 3-year maturity, 6% coupon bond at par. If market interest rates rise to 8%, then the bond's price will fall by: A. 2% B. 5% C. 10% D. 25%
The best answer is B. The customer bought this 3-year bond at par with a coupon rate of 6%. If market interest rates rise to 8%, then the present value of the bond's cash flows will fall as follows: Year 1: $60 / 1.08 = $55.55 Year 2: $60 / (1.08)2 = $51.435 Year 3: $1060 / (1.08)3 = $841.64 Total Net Present Value = $55.55 + $51.435 + $841.64 = $948.625 The bond will fall in price by $51.375 from $1,000 par, for a fall of 5.1375%.
To find the equivalent tax-free yield, one would: A. multiply the taxable yield by the tax bracket B. multiply the taxable yield by (100% minus the tax bracket) C. divide the taxable yield by the tax bracket D. divide the taxable yield by (100% minus the tax bracket)
The best answer is B. The equivalent tax free yield computes the amount of the taxable yield that is kept after taxes are paid. This is the same as the amount of a tax-free yield that would be kept, since no taxes are due. The formula for the Equivalent Tax Free Yield is: Taxable Yield (100% - Tax Bracket %) Also remember that the equivalent tax-free yield must always be lower than the taxable yield.
Given the formula: ( Corporate Yield %) x (1 - Tax Bracket %) = X X is equal to the: A. Taxable Equivalent Yield B. Tax-Free Equivalent Yield C. Discount Yield D. Yield to Maturity
The best answer is B. The formula for the Tax-Free Equivalent Yield is: Tax-Free Yield = Taxable Yield x (100% - Tax Bracket %) For example, if a customer is in the 30% tax bracket, and can purchase a corporate taxable bond yielding 10%, this is the same as earning 7% on a tax-free investment. Tax-Free Yield = 10% x (100% - 30%) = 10% x .7 = 7% Because the 30% of the 10% earned on a taxable investment will go to pay taxes, there is 7% left "after-tax." A non-taxable municipal bond yielding 7% gives the equivalent return.
A municipal dealer quotes a 9 year, 6% term revenue bond at 109. The bond is callable in 3 years at a 3% call premium. The yield to call is: A. 3.57 B. 3.77 C. 5.50 D. 6.00%
The best answer is B. The formula for yield to call for a premium bond is: annual income - annual capital loss to call date ———————————————————————— (purchase price + call price) /2 $60 - ($60 premium / 3 years to call) -------------------------------------------- ($1090 + $1030) / 2 = $60 - $20 —————— $1060 = $40 ———— $1060 = 3.77% Note that because there is a 3 point ($30) call premium paid if the bond is called in 3 years, $1,030 the redemption price at that date. Also note that because of the 3 point call premium (3%) paid at early redemption, the full 9 point premium is not lost; rather, only 6 points ($60) is lost when the bond is called at 103.
A customer, age 25, is looking to invest in securities with the objective of growth to protect against the effect of long term inflation on his portfolio's value. The customer believes that active asset management, along with its higher fees, is not worthwhile. Which recommendation is MOST suitable for this customer? A. Long-Term U.S. Government Bond Fund B. S & P 500 Index Fund C. High Technology Growth Fund D. Special Situations Fund
The best answer is B. This customer is looking for long term growth, so common equities are an appropriate investment rather than long term bonds. Since the customer does not believe in active asset management, a passive approach is best - that is, an index fund that has very low ongoing fees.
A 5% coupon bond is being offered on a 6% basis. If interest rates for similar bonds fall below 6%, the basis for this bond will: A. increase B. decrease C. be unaffected D. be volatile
The best answer is B. This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
A 7% coupon bond is being offered on an 8% basis. If interest rates for similar bonds fall below 8%, the basis for this bond will: A. increase B. decrease C. be unaffected D. be volatile
The best answer is B. This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
Which statements are TRUE regarding Treasury Inflation Protection securities? I In periods of deflation, the amount of each interest payment will decline II In periods of deflation, the amount of each interest payment is unchanged III In periods of deflation, the principal amount received at maturity will decline below par IV In periods of deflation, the principal amount received at maturity is unchanged at par A. I and III B. I and IV C. II and III D. II and IV
The best answer is B. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. In periods of deflation, the principal amount is adjusted downwards. Even though the interest rate is fixed, the holder receives a lower interest payment, due to the decreased principal amount. In this case, when the bond matures, the holder receives par - not the decreased principal amount.
What happens to the rate of return calculation on a non-callable bond if the rate of interest stays the same and the time intervals lengthen? A. The rate of return increases B. The rate of return declines C. The rate of return is unchanged D. The effect on the rate of return cannot be determined
The best answer is B. When the question is stating that the "time intervals lengthen," this means that the time period between each interest payment received lengthens. For example, assume that a 10% bond will pay interest annually, instead of semi-annually. At the end of each year, $100 of interest will be received, instead of receiving $50 every 6 months. Because the first $50 interest payment received can immediately be reinvested over the next 6 months until the second $50 payment is received, this will produce a higher rate of return than receiving the $100 payment at the end of the year. Thus, the actual rate of return will decline if time intervals lengthen, because the interest is actually being received more slowly, and thus cannot be reinvested as quickly to maintain the investment's rate of return.
Which investment offers the BEST protection against inflation risk? A. Common stocks B. Tangible assets C. Long-Term Corporate Bonds D. Treasury Bonds
The best answer is B. When there is a lot of inflation, market interest rates rise, causing long-term bond prices to drop steeply. This is purchasing power risk and high credit quality (e.g., Treasury bonds) does not protect a bond issue from this. When inflation rates and interest rates rise, corporate earnings suffer greatly, causing common stock prices to fall. When there is steep inflation, the best investments are money market instruments and tangible assets (e.g., precious metals, real estate). Money market instruments do not suffer inflation risk and because interest rates are high when there is inflation, they give a nice rate of return. However, this is not offered as a choice! Tangible assets tend to hold their value (or increase in value) when there is inflation, usually because investors are afraid to put their money into stocks or bonds!!!
During a period when the yield curve is inverted: A. short term bond prices are more volatile than long term bond prices B. long term bond prices are more volatile than short term bond prices C. short term and long term bond prices are equally volatile D. no relationship exists between short term and long term bond price changes
The best answer is B. Whether the yield curve is ascending (normal), flat or inverted, long term bond prices always move faster than short term bond prices, as interest rates change. This is due to the compounding effect on the bond's price that occurs, which increases with longer maturities.
A bond is rated BBB by Standard and Poor's. The bond is: A. Highest Quality Investment Grade B. High Quality Investment Grade C. Lowest Quality Investment Grade D. Highest Level Speculative Grade
The best answer is C. A BBB rating is the lowest investment grade rating for a bond. The investment grade ratings are AAA, AA, A, and BBB.
The primary risk associated with holding a long-term U.S. Government STRIP is: A. liquidity B. deflation C. purchasing power D. credit
The best answer is C. A STRIP is a long-term U.S. Government zero-coupon bond (a bond that has been "stripped" of coupons). Such a bond has no credit risk and is easily traded so there is no liquidity risk. If there is deflation and market interest rates fall, this bond will increase in value. If there is inflation, market interest rates will rise, and the bond will decrease in value. This is the primary risk associated with holding STRIPS - inflation or purchasing power risk.
An investment adviser manages the portfolio of a client on a discretionary basis. The customer's objective is conservation of principal and income. Under prudent investor standards, which statement is TRUE about the use of options in the portfolio? A. The use of options strategies is unsuitable for this client based on her investment objective B. The use of options strategies is only suitable if the customer has previous investment experience with options C. The use of options strategies is only suitable if the strategies are limited to the sale of covered options D. The use of options strategies is only suitable is the strategies are limited to the purchase of options
The best answer is C. Covered call writing is the most popular retail income strategy in a flat market, and is appropriate for conservative investors that are looking for extra income. The customer sells calls against stock that is already owned, getting premium income. If the stock stays flat, the calls expire and the customer keeps the premium. If the stock rises, the calls are exercised and the stock is called away at no loss to the customer. If the market falls, the calls expire and the customer loses on the stock (which he would have lost on anyway!).
The yield to maturity on a bond is lower than the current yield. This bond is trading: A. at par B. at a discount C. at a premium D. in the money
The best answer is C. Current yield only takes into account the income from an investment, whereas yield to maturity also factors in the additional return earned when a bond is purchased at a discount and held to maturity; or the loss that will be suffered when a bond is purchased at a premium and held to maturity. If a bond is purchased at a discount, the yield to maturity will be more than the current yield because of the earning of the discount in addition to interest received. If a bond is purchased at a premium, the yield to maturity will be less than the current yield because of the loss of the premium offsetting interest received.
Which of the following are TRUE regarding Eurodollar deposits? I Eurodollar deposits are in European currency II Eurodollar deposits are in U.S. currency III The interest paid on these deposits is based on LIBOR IV The interest paid on these deposits is based on the Federal Funds rate A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. Eurodollar deposits are U.S. currency held in banks in foreign countries, mainly in Europe. The Eurodollar market is centered in London - and the interest rate paid on these deposits is "LIBOR" = London Interbank Offered Rate.
Which of the following items is NOT true about Jumbo Certificates of Deposit? A. Jumbo CDs are traded in the secondary market B. Jumbo CDs are backed by the issuing financial institution C. Jumbo CDs are fully insured by the Federal Deposit Insurance Corporation D. Jumbo CDs are considered to be negotiable instruments
The best answer is C. Jumbo Certificates of Deposit are issued in minimum $100,000 amounts and many banks only offer them in $1,000,000 minimums. Any amount in excess of $250,000 does not get FDIC insurance ($250,000 is the FDIC coverage limit). They are backed solely by the faith and credit of the issuing bank. Jumbo CDs are negotiable securities - they can be traded in the secondary market prior to maturity. However, most Jumbo CDs are simply held as an investment until maturity - the trading market in these instruments is thin.
The definition of Net Present Value of an investment is: A. The sum of annual cash flows discounted by the cost of capital B. The sum of annual cash flows compounded by the cost of capital C. The sum of annual cash flows discounted by the cost of capital minus initial investment D. The sum of annual cash flows compounded by the cost of capital minus initial investment
The best answer is C. Net Present Value takes each annual cash flow projected to be received from an investment and discounts it back to today's present value, typically using the risk-free rate of return as the discount factor and adds them up. This computes the aggregate present value of those cash flows. Then, the initial cash outflow (the investment) is subtracted. If the net result (as in net present value) is positive, then the investment should be made. If it is negative, there would be a loss on the investment. Assume that an investor makes a $1,000 investment that will return $100 in the first year; $100 in the second year; and $1,100 in the third year. (Basically, this investment is returning 10% per year over 3 years.) A $100 cash flow to be received 1 year from now would have a present value of: $100 ------- 1.05 = $95.24 A $100 cash flow to be received 2 years from now would have a present value of: $100 -------- (1.05)2 = $90.70 A $1,100 cash flow to be received 3 years from now would have a present value of: $1100 -------- (1.05)3 = $950.22 The sum of the present values is: $95.24 + $90.70 + $950.22 = $1,136.16. If we subtract the initial investment of $1,000, we get a net present value of +$136.16. (Also note that, logically, since the rate of return on the investment of 10% is more than the discount factor of 5%, the net present value would have to be positive.)
Which investment offers the greatest protection against purchasing power risk? A. Long term U.S. government bonds B. Long term zero-coupon bonds C. Real estate investments D. Investment grade preferred stock
The best answer is C. Of the choices given, real estate offers the best protection against purchasing power risk (inflation risk). When there is inflation, the prices of real assets tend to inflate as well, hence they give inflation protection. In contrast, long term bonds and preferred stocks are lousy investments in times of inflation. These securities give a fixed income stream, that becomes worth less and less each year as prices inflate. Because of this, their prices drop as inflation rates rise. The actual cause of their price drop is simple - as inflation rates rise, market interest rates rise in tandem. As market interest rates rise, the prices of fixed income securities drop, with longer maturities and lower coupon rate issues being most susceptible to interest rate risk.
The IRR (Internal Rate of Return) of an investment assumes that: A. cash flows generated by the investment are not reinvested B. cash flows generated by the investment are reinvested at the risk-free rate of return C. cash flows generated by the investment are reinvested at the internal rate of return D. cash flows generated by the investment are reinvested at the total rate of return
The best answer is C. The Internal Rate of Return is the true yield maturity of an investment. It finds the yield that will discount the investment's cash flows to "0." Inherent in the IRR calculation is that any cash flows generated by the investment are reinvested at this same IRR.
In 2015, a customer buys 5 ABCD 10% debentures, M '45, at 85. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2020 at 103. The current yield on the bonds is: A. 10% B. 10.81% C. 11.76% D. 12.43%
The best answer is C. The formula for current yield is: annual interest ----------------------- = current yield bond market price $100 ------- $850 = 11.76%
A municipal investor is considering the purchase of a 10 year, 6% G.O. bond with a 6 1/4% yield to maturity. The investor is in the 28% tax bracket. The equivalent taxable yield is: A. 6.25% B. 8.33% C. 8.68% D. 8.99%
The best answer is C. The formula for the equivalent taxable yield is: *Tax free yield/100-tax bracket *6.25/100-28
In 2015, a customer buys 1 GE 10%, $1,000 par debenture, M '30, at 115. The interest payment dates are Jan 1st and Jul 1st. The yield to maturity on the bond is: A. 6.96% B. 8.00% C. 8.37% D. 10.23%
The best answer is C. The formula for yield to maturity for a premium bond is: annual interest - annual capital loss ——————————————————— = yield to maturity (bond cost + redemption price)/2 for premium bond $100 - ($150 premium / 15 years to maturity) ——————————————————————— ($1,150 + $1,000) / 2 = $100 - $10 —————— $1,075 = $90 ———— $1,075 = 8.37%
Which of the following investments has a known long-term internal rate of return? A. Low grade 7% corporate bond B. Investment grade 5% municipal bond C. Treasury STRIP D. GNMA Pass-Through Certificate
The best answer is C. The internal rate of return is the implicit yield to maturity that an investment returns. Securities that have a fixed coupon rate make periodic payments to the holder. These must be reinvested at the same yield as the investment is returning over its life, in order for the yield not to be affected by "reinvestment risk." For example, if a person buys a 10% 20-year bond at par, and over the life of the investment, interest rates are declining, then the rate of return earned on the reinvested interest payments will decline below the 10% that the security is yielding. The compounded rate of return on the investment will fall below 10% in such a case. If one buys a 20-year zero-coupon bond (a Treasury STRIP is "stripped" of coupons and is a zero-coupon obligation), the implicit yield of the investment is "locked in" at purchase and is not affected by reinvestment risk since periodic interest payments are not being made. The interest rate that discounts the redemption price (Par) to the discounted purchase price is the implicit yield of the investment; and is the same as the internal rate of return of the investment. For example, assume that a 3-year $1,000 par zero-coupon bond can be purchased for $751.31 today. The internal rate of return on this investment is 10%, and will not change over the 3-years that the bond is held. After the first year, the bond will be worth $751.31 (1.1) = $826.44. After the second year, the bond will be worth $826.44 (1.1) = $909.09. After the third year, the bond will be worth $909.09 (1.1) = $1,000.
The lowest investment grade rating is: A. B B. BB C. BBB D. CCC
The best answer is C. The lowest investment grade rating is BBB. BB and B ratings are considered to be medium grade while CCC, CC, and C are all speculative with C rating being the most speculative.
During periods when a normal yield curve exists, which of the following statements are TRUE? I Long term bond prices are less volatile than short term bond prices II Long term bond prices are more volatile than short term bond prices III Yields on long term maturities are greater than yields on short term maturities IV Yields on short term maturities are greater than yields on long term maturities A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. When a normal yield curve exists (an ascending curve), long term bond prices are more volatile than short term bond prices in response to market interest rate movements. As a general statement, yields increase as maturities lengthen because investors demand a premium for the extra risk associated with longer term maturities (both interest rate risk and purchasing power risk).
During periods when the yield curve is inverted, which statements are TRUE? I Debt defaults are probably at historically high levels II Issuers are likely to sell non-callable bonds III Debt investors expect that interest rates will fall in the future IV Debt investors expect that economic activity will decline A. II, III, IV B. I, II, III C. I, III, IV D. I, II, III, IV
The best answer is C. When the yield curve is inverted, short term rates are higher than long term rates. This typically occurs when the Federal Reserve pursues a "tight money" policy to slow the economy. The tightening of credit raises interest rates overall, slows economic activity, and thus business defaults increase. Long term rates remain lower than short term rates since investors do not expect the tightening to last far into the future. During periods when the yield curve is inverted, interest rates on all maturities tend to shift upwards, with short term rates rising the most. During these periods of high interest rates, issuers are likely to sell callable issues (not non-callable ones). If interest rates decrease in the future (as expected), the issuer can call in the old debt and refinance at lower current interest rates.
Which of the following statements concerning a universal life insurance policy are TRUE? I The policy owner has a choice of investments for the cash value II The policy owner can change the amounts of premium payments III The policy owner can change the amount of the death benefit IV The policy owner receives a guaranteed, fixed rate of return on cash value A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. With a universal life policy, the policy owner can change the premium payments and the death benefit. The cash value is invested in the insurer's general account, so the policy owner does not have a choice of investments and the rate of return is not fixed - it will vary with the return of the general account.
In a situation where the yield curve is sloping upward and to the right: I less funds are available to short term borrowers II greater funds are available to short term borrowers III there is a high demand for short term funds IV there is a high demand for long term funds A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. A "normal" yield curve is one that is upward sloping from left to right, with yields increasing with lengthening maturities. Thus, shorter maturities have lower yields and longer maturities have higher yields. From an economic standpoint, this question can be looked at on the basis of supply and demand. In Choice I, there are less funds available (lower supply) to short term borrowers. This will drive up the "price" of short term funds, which is the interest rate charged to borrow those short term funds. In Choice II, there are greater funds available (higher supply) to short term borrowers. This will drive down the "price" of short term funds, which is the interest rate charged to borrow those short term funds. In Choice III, there is a high demand for short term funds from borrowers. This will drive up the "price" of short term funds, which is the interest rate charged to borrow those short term funds. In Choice IV, there is a high demand for long term funds from borrowers. This will drive up the "price" of long term funds, which is the interest rate charged to borrow those long term funds. When the yield curve is normal, short term rates are lower than long term rates, caused by either short term rates being driven down; or long term rates being driven up. The only choice that drives short term rates lower is Choice II. The only choice that drives long term rates higher is Choice IV.
Which of the following is NOT a derivative? A. Warrant B. Option C. Convertible Preferred Stock D. Unit Investment Trust
The best answer is D. A Unit Investment Trust is a directly proportional ownership in an underlying portfolio of investments. It is not a derivative. A derivative security has its value "derived" from a reference security. The value of warrants and options is based on the price of the reference common stock. Similarly, the price of convertible preferred stock, if the market price of the common exceeds the conversion price, will be based on the price of the common stock. For example, if $100 par preferred stock is convertible into common at $20 per common share, 1 share of preferred can be converted into 5 shares of common. If the common stock price moves up to $30 per share, the preferred will now trade for 5 x $30 = $150.
Which statements are TRUE about duration? I The lower a bond's coupon rate, the lower the bond's duration II The higher a bond's coupon rate, the lower the bond's duration III The longer a bond's maturity, the lower the bond's duration IV The shorter a bond's maturity, the lower the bond's duration A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. Duration is a measure of bond price volatility. Bonds with low coupons have large duration numbers; as do bonds with long maturities. These bonds have the most volatile price movements in response to changes in market interest rates. Bonds with high coupons have small duration numbers; as do bonds with short maturities. These bonds do not move much in price as market interest rates move.
Which security would be expected to have the greatest duration? A. 5 year; 5% coupon bond B. 5 year; zero-coupon bond C. 20 year; 6% coupon bond D. 20 year; zero-coupon bond
The best answer is D. Duration is a measure of price volatility of a fixed income security. As maturity lengthens or the coupon rate drops, duration increases. These are the securities which are most greatly affected by interest rate risk. Of the choices given, the security that would have the greatest duration is the 20 year, zero-coupon bond - it has the longest maturity and lowest coupon rate.
When the yield spread between U.S. Government and lower grade corporate bonds is widening, which of the following statements are TRUE? I Yields on lower grade corporate bonds are lower than average relative to yields on U.S. Government bonds II Yields on lower grade corporate bonds are higher than average relative to yields on U.S. Government bonds III Investors are increasing their purchases of corporate issues IV Investors are increasing their purchases of U.S. Government issues A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. If the yield "spread" between Government bonds and lower medium quality corporate bonds is widening, this means that yields on lower grade corporate bonds are higher than normal relative to yields on Government bonds. This occurs because an excess of investors are buying Governments, pushing their yields down; or an excess of investors are selling lower grade corporate bonds, pushing their yields up. This behavior is typical when investors expect a recession. When a recession is expected, there is a "flight to quality." Investors liquidate holdings that are vulnerable in a recession (low grade corporate bonds) and put the money into safe havens such as government bonds.
Which of the following is an example of purchasing power risk? A. The balance of payments deficit increases, and the value of the U.S. dollar declines as a result B. The market value of all equity securities listed on an exchange declines due to worries about increasing interest rates C. The financial statements that a company has issued are not reflective of the company's actual financial status D. Inflation increases at a greater rate than expected, causing bond yields to rise and stock prices to fall
The best answer is D. Purchasing power risk is the risk of inflation (Choice D). Business risk (Choice C) is "company specific" risk, and would include the risk that the company's products are not competitive; that market demand for the company's products shifts; that management of the company is not qualified; etc. Market risk is the risk that general market prices fall, taking all securities along for the downward slide (Choice B). Currency exchange risk is the risk that the local currency (U.S. Dollars) declines, making the cost of imports more expensive (Choice A).
During periods when interest rates are rising, which of the following fixed income securities offers the greatest protection from "interest rate risk"? A. zero coupon bonds with long maturities B. low coupon bonds with long maturities C. current coupon bonds with long maturities D. high coupon bonds with long maturities
The best answer is D. The basic truths regarding bond price volatility and interest rate movements are: The longer the maturity, the greater the bond's price volatility in response to interest rate movements. The lower the coupon rate, the greater the bond's price volatility in response to interest rate movements. The farther away from par that the bond is priced, the greater the bond's price volatility in response to interest rate movements. This question only examines the second factor, since the maturities are equivalent for all choices, and no mention is made of whether the bonds are trading at a discount or a premium. The bond with the lowest price volatility will be the one with the highest coupon rate. Bonds with low coupon rates exhibit greater price volatility. Thus, to minimize price volatility due to interest rate movements ("interest rate risk"), high coupon bonds are appropriate.
To find the equivalent tax-free yield, one would: A. multiply the taxable yield by the tax bracket B. multiply the taxable yield by (100% minus the tax bracket) C. divide the taxable yield by the tax bracket D. divide the taxable yield by (100% minus the tax bracket)
The best answer is D. The equivalent tax free yield computes the amount of the taxable yield that is kept after taxes are paid. This is the same as the amount of a tax-free yield that would be kept, since no taxes are due. The formula for the Equivalent Tax Free Yield is: Taxable Yield (100% - Tax Bracket %) Also remember that the equivalent tax-free yield must always be lower than the taxable yield.
A municipal dealer quotes a 9 year, 6% term revenue bond at 92. The yield to maturity is: A. 6.50% B. 6.92% C. 7.12% D. 7.18%
The best answer is D. The formula for yield to maturity is: annual income + annual capital gain (discount bond) --------------------------------------------------------------- average bond value This bond has a coupon rate of 6% = 6% of $1,000 par = $60 of annual income. The bond is purchased at 92% of $1,000 par = $920; and will mature at $1,000 in 9 years, Thus, the $80 capital gain is earned over 9 years for an annual gain of $80 / 9 = $8.88 per year. The bond is purchased at $920 and matures at $1,000, for an average value of $920 + $1,000 / 2 = $960. The YTM is: $60 + $8.88 ---------------- $960 = 7.175% = 7.18%
The sale of an "at the money" put is a: A. bull strategy B. bear strategy C. neutral strategy D. bull/neutral strategy
The best answer is D. The seller (writer) of a put has the obligation to buy stock at a fixed price in a falling market, in return for which the writer collects a premium. If the market stays the same, or rises, the put expires and the writer keeps the collected premium. This is a bull/neutral market strategy.
Which statements are TRUE when a bond sells at a premium? I The nominal yield is less than the yield to maturity II The nominal yield is more than the yield to maturity III The current yield is less than the yield to maturity IV The current yield is more than the yield to maturity A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. This one is worded in a tricky manner. For premium bonds, the relationship of yields from highest to lowest is: Nominal (Highest) Current Yield Yield To Maturity (Lowest) Therefore, nominal yield is higher than current yield (Choice II) and current yield is higher than yield to maturity (Choice IV). Yield to maturity is lowest for a premium bond because it reflects both the fact that the bond was purchased for more than par and that the premium will be lost over the life of the bond. Current yield only reflects the fact that the bond was purchased for more than par; it does not include the annual loss of the premium. Finally, nominal yield is the yield based on purchasing the bond at its original par value - it is the highest yield of the choices offered because it neither reflects the premium price nor the annual amortization of that premium.
An investment in Treasury Bills has: A. interest rate risk B. purchasing power risk C. credit risk D. no risk
The best answer is D. Treasury Bills are considered to be free of credit risk (Treasury debt is rated AAA). They do not have purchasing power risk because they are short term and they have virtually no interest rate risk because they are short term. The best choice is that they have "no risk." It could be argued that they have a small amount of interest rate risk, but "no risk" is the best choice offered.
