Unit 12 Determine Their Value

One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that A) agency issues typically carry higher returns than Treasury issues because of the lack of direct government backing B) agency issues are more likely to be issued in larger amounts C) agency issues frequently trade on the NYSE while Treasuries never do D) agency issues are taxable on the federal level while Treasury issues are not

A. Agencies, with only a very few exceptions, GNMA being one, do not carry the direct backing of the U.S. Treasury. While they are quite safe, that lack of direct backing causes their yields to be somewhat higher. Agencies are never traded on the stock exchanges and their float is almost always smaller than Treasuries. Both are taxable on the federal level. U13LO1

Which of the following are NOT considered money market instruments? American depositary receipts Commercial paper Corporate bonds Jumbo (negotiable) certificates of deposit A) II and IV B) I and II C) I and III D) III and IV

C. A money market instrument is a high-quality, short-term debt security with maturity of 1 year or less. American depositary receipts (ADRs) are equity, and corporate bonds are long-term debt instruments. U13LO13

The price of which of the following will fluctuate most with fluctuating interest rates? A) Money market instruments B) Common stock C) Long-term bonds D) Short-term bonds

C. Because of its longer duration, long-term debt prices will fluctuate more than short-term debt prices as interest rates rise and fall. When buying a debt instrument, one is really buying the interest payments and final principal payment. Money has a time value: the longer it takes to receive the money, the less it is worth today. U13LO11

Which of the following statements regarding the properties of duration is NOT true? A) Duration is a weighted-average term to maturity of a bond's cash flows. B) Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. C) Duration measures the holding period return on a bond. D) Duration measures the effect of an interest rate change on the price of a bond or bond portfolio.

C. Duration does not measure the holding period return on a bond; it measures the effect of an interest rate change on the price of a bond or bond portfolio. Duration measures a bond's price volatility by weighting the length of time it takes for a bond to pay for itself. Duration is also a weighted-average term to maturity of a bond's cash flows. U13LO11

All of the following are true of negotiable, jumbo certificates of deposit EXCEPT A) they are readily marketable B) they usually have maturities of 1 year or less C) they are secured obligations of the issuing bank D) they are usually issued in denominations of $100,000 to $1 million

C. Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan. U13LO13

A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? Bought it at a discount Bought it at a premium Sold it at a discount Sold it at a premium A) II and III B) I and III C) I and IV D) II and IV

C. The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain. U13LO10

Municipal bonds are often called tax-exempts. This refers to the exemption of their income from A) state income taxes B) state, federal, and inheritance taxes C) federal estate taxes D) federal income taxes

D. Although municipal bonds are sometimes exempt from state income tax (if issued in the state of residence of the taxpayer), all references to tax exemption refer to their exemption from federal income taxes. U13LO5

When referring to municipal bonds, the formula of (1 − tax bracket) is found in the computation of A) return on investment B) yield to maturity C) current yield D) tax-equivalent yield

D. The computation for the tax-equivalent yield of a municipal bond is performed by dividing the bond's coupon rate by (1 − the investor's tax bracket). If the bond has a coupon of 4% and the investor is in the 20% bracket, the tax-equivalent yield is 4% divided by (1 − 0.20) or 4% divided by 0.80 = 5% U13LO6

Duration

Duration is simply the weighted average of the cash flows an investor will receive over time, discounted to the bond's present value.

Which of the following is TRUE of GNMA securities? Interest is subject to federal income tax. Interest is exempt from federal income tax. They are backed by farm mortgages. They are backed by residential mortgages. A) II and III B) I and III C) I and IV D) II and IV

Income received by investors in Government National Mortgage Association (GNMA) securities is subject to both state and federal income tax, and the asset backing them is residential mortgages. U13LO1

current Yield

The current yield is the annual interest (in dollars) divided by the bond's market price (in dollars).

A respected analyst reports that last week's T-bill rate at 6% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is TRUE? A) The general level of interest rates is increasing. B) The yield curve is inverted. C) Investors are paying more for T-bills. D) Investors are paying less for T-bills.

C. When the rate is lower, the price has gone up; this means investors are paying more as interest rates are going down. U13LO1

One would look at the average maturities when doing a cash flow analysis for A) subordinated debentures B) revenue bonds C) Brady bonds D) mortgage-backed pass-through securities

D. Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature. U13LO12

Which of the following are regulated under the Securities Exchange Act of 1934? New issues Broker-dealers Transfer agents A) I and III B) II and III C) I only D) I, II, and III

B. The Securities Exchange Act of 1934 was designed to regulate securities transactions, securities markets, and the securities firms who do the trading. While the Securities Act of 1933 covers requirements relating to new issues, the Securities Exchange Act of 1934 covers almost everything else in the securities industry. Its greatest impact is on the securities firms and the people who sell securities (i.e., broker-dealers and their agents) in the secondary market. Of the choices listed, new issues would be regulated by the Securities Act of 1933. U12LO2

Your client with $100,000 to invest is looking for maximum current income. Which of the following would offer the highest current return? A) $200,000 of utility common stock paying a current dividend of 3.5% B) $100,000 of zero-coupon bonds with a yield to maturity of 6% C) $100,000 market value of corporate bonds selling at a premium and yielding 6% to maturity D) $100,000 AA-rated corporate bonds trading at par with a 6% coupon rate

C. Bonds selling at a premium have higher coupons than those selling at par. Therefore, the current yield on those bonds is higher than the ones at par, even though they would have the same yield to maturity. The zero-coupon bonds offer no current income and the investor only has $100,000 to invest, so the utility stock is not a viable option. U13LO10

A bond's yield to maturity is A) determined by dividing the coupon rate by the bond's current market price B) set at issuance and printed on the face of the bond C) the annualized return of a bond if it is held to maturity D) the annualized return of a bond if it is held to call date

C. The yield to maturity is the annualized return of a bond if it is held to maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the YTC. U13LO10

When doing cash flow analysis on a mortgage-backed pass-through security, you would want to know A) size of the tranche being analyzed B) whether there is a real estate "bubble" C) the quality of the mortgages D) the average maturities

D. Mortgage-backed pass-through securities pass through interest and principal payments to their investors. The rate at which the cash flows are generated depends, among other things, on the rate at which the mortgages mature. U13LO12

A TIPS bond with a par value of $1,000 has a coupon rate of 4%. During years 1 and 2, the inflation rate has been 6%. What effect will this have on the TIPS 2½ years later? A) The next interest payment will be $20.00. B) The principal value will be $1,080. C) The next interest payment will be $23.19. D) The next interest payment will be $46.37.

On a semiannual basis, the principal value of a TIPS is increased by that year's inflation rate. A TIPS bond adjusts principal every 6 months based on the inflation rate. With an annual inflation rate of 6%, each 6 months the principal will increase by 3% compounded. Because the question is asking about 2½ years later, there will be 5 periods (2 each year plus the first half of the 3rd year). Using the calculator at the testing center, you would enter the $1,000 initial par value and then multiply that times 103% five times to arrive at $1,159.27. Then, multiply that times the semiannual coupon rate (2%) and the result is $23.19. In almost every case, the "shortcut" will work. That is, if it was not a TIPS bond, then the interest would simply be 2% of $1,000, or $20. That will always be one of the choices—you look for the one that is a bit higher. U13LO1