FIN 3330 Ch 6-7

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return. $ 796.04 $1,000.00 $1,126.42 $ 536.38 $ 791.00

$ 536.38 N= 20 I = 14% PV = ? PMT = 70 (1000 x .07 x 1) FV = 1000 P/Y and C/Y= 1

Delta Corporation has a bond issue outstanding with a 7% coupon, semiannual payments, and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return. $ 796.04 $1,000.00 $1,126.42 $ 536.38 $ 791.00

$ 791.00 N=8 (4 x 2) I= 14% PV =? PMT = 70 (1000 x 7% x .5 (2 annual payments) FV= 1000 P/Y and C/Y =2 PV = $ 791.00

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 4 years remaining until maturity. The par value of the bond is $1,000. Determine the current value of the bond if present market conditions justify a 14% nominal annual required rate of return. $ 796.04 $1,000.00 $1,126.42 $ 536.38 $ 791.00

$ 796.04 N = 4 I = 14 PV = ? PMT = 70 (1000 x .07) FV = 1000 P/Y and C/Y =1

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. Its' yield to maturity is 6.53%. Assume that the yield to maturity remains constant for the next two years. What will be the price of the bond two years from today? $ 988.89 $ 975.25 $ 964.61 $1,250.00 $1,000.00

$ 964.61 N=4 (6-2) I = 6.53 PV = ? PMT = 55 (1000 x .055) FV = 1000 P/Y and C/Y = 1 PV = $ 964.61

Moerdyk Corporation's bonds have a 15-year maturity, a 7.25% semiannual coupon, and a par value of $1,000. The going interest rate (rd) is 6.20%, based on semiannual compounding. What is the bond's price? $1,101.58 $1,074.05 $1,047.19 $1,157.35 $1,129.12

$1,101.58 N= 30 (15 x 2) I= 6.2 PV = ? PMT = 36.25 (1000 x .0725 x .5) FV= 1000 P/Y and C/Y = 2 PV = $1,101.58

Grossnickle Corporation issued 20-year, noncallable, 7.5% annual coupon bonds at their par value of $1,000 one year ago. Today, the market interest rate on these bonds is 5.5%. What is the current price of the bonds, given that they now have 19 years to maturity? $1,171.32 $1,142.03 $1,113.48 $1,232.15 $1,201.35

$1,232.15 N= 19 I = 5.5 PV = ? PMT = 75 (1000 x .075) FV = 1000 P/Y and C/Y =1

Assume that Steed & Associates' bonds have a par value of $1,000, mature in 8 years, and make an annual coupon interest payment of $65. If the market requires an interest rate of 8.2% on these bonds, what is the bond's price? $996.79 $948.76 $903.04 $972.48 $925.62

$903.04 N= 8 I = 8.2 PV = ? PMT = 65 FV = 1000 P/Y and C/Y =1

Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 8.4% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? $1,161.67 $1,133.34 $1,105.69 $1,220.48 $1,190.71

*$1,105.69* FV = $1,000 PMT = $47.50 ($1,000 X 9.5% / 2) N = 40 (20 X 2) Rate = 8.4% P/Y and C/Y = 2 PV= 1105.69

View each of the below-listed provisions that are often contained in bond indentures alone. Which of these provisions would tend to REDUCE the yield to maturity that investors would otherwise require on a newly issued bond? 1. Fixed assets are used as security for a bond. 2. A given bond is subordinated to other classes of debt. 3. The bond can be converted into the firm's common stock. 4. The bond has a sinking fund. 5. The bond has a call provision. 6. The indenture contains covenants that restrict the use of additional debt. 1, 2, 3, 4, 6 1, 4, 6 1, 3, 4, 6 1, 3, 4, 5, 6 1, 2, 3, 4, 5, 6

1, 3, 4, 6 Fixed assets used as security, having the ability to convert into common stock, having a sinking fund, and including covenants that restrict the use of additional debt would all tend to reduce the yield to maturity.

What are the two ways sinking funds can be handled? Which alternative will be used if interest rates have risen? If interest rates have fallen?

1. call in bonds for redemption at par value. Those called in are determined by a lottery administered by the trustee. 2. The company can buy the required number of bonds on the open market.

Assume that the real risk-free rate, r*, is 4% and that inflation is expected to be 7% in Year 1, 4% in Year 2, and 3% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 11%, what is the difference in the maturity risk premiums (MRPs) on the two bonds; that is, what is MRP5 - MRP2? 0.5% 2.3% 1.3% 1.0% 1.5%

1.5% IP5= (7% + 4% + (3% x 3))/5 = 20%/5= 4% IP 2 = (7% + 4%)/2 = 5.5% rT = r* + IP + MRP rT2= 4% + 5.5% + MRP2 = 11% rT5= 4% + 4% + MRP5 = 11% MRP5= 11% - 8% = 3% MRP2= 11% - 9.5% = 1.5% Difference = 3% - 1.5% = 1.5%

You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%. What is the nominal risk-free rate, rRF? 10% 12% 14% 11% 13%

11% rRF = r* + IP = 3% + 8% = 11%.

Delta Corporation has a bond issue outstanding with an annual coupon rate of 7% and 20 years remaining until maturity. The par value of the bond is $1,000 and present market conditions justify a 14% nominal annual required rate of return. What is the bond's current yield? 13.75% 13.05% 12.20% 14.50% 14.00%

13.05% Step 1: N= 20 I = 14% PV = ? PMT = 70 (1000 x .07 x 1) FV = 1000 P/Y and C/Y= 1 PV = 536.38 70/536.38 = *13.05%*

Acme Products has a bond issue outstanding with 8 years remaining to maturity, a coupon rate of 10% with interest paid annually, and a par value of $1,000. If the current market price of the bond issue is $814.45, what is the yield to maturity, rd? 14% 13% 12% 16% 15%

14% N= 8 I = ? PV = -814.45 PMT = 100 (1000 x .1) P/Y and C/Y=1

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. 1.81% 2.00% 2.21% 1.90% 2.10%

2.00% r10 - r* -MRP 5.05 - 2.15 - .9 = 2.00%

A Treasury bond that matures in 20 years has a yield of 8%. A 20-year corporate bond has a yield of 11%. Assume that the liquidity premium on the corporate bond is 1.0%. What is the default risk premium on the corporate bond? 0.50% 1.50% 2.00% 1.00% 1.75%

2.00% rt= IPt +DRPt + LPt +MRPt

McCue Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a 25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. What is the difference between this bond's YTM and its YTC? (Subtract the YTC from the YTM) 3.17% 2.88% 2.62% 3.83% 3.48%

2.62% Step 1: N= 25 I = ? PV = -1250 PMT = 90 FV = 1000 *I= YTM = 6.88%* Step 2: N = 5 I= ? PV = -1250 PMT = 90 FV = 1050 *I = YTC = 4.26%* *Difference = 2.62%*

If all interest rates in the economy fall by 1%, which of the following bonds would have the greatest percentage increase in value? 20-year, zero coupon bond. 20-year, 10% coupon bond. 10-year, zero coupon bond. 1-year, 10% coupon bond. 20-year, 5% coupon bond.

20-year, zero coupon bond.

Taussig Corp.'s bonds currently sell for $1,150. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. Under these conditions, what rate of return should an investor expect to earn if he or she purchases these bonds? 3.79% 3.60% 3.42% 4.20% 3.99%

4.20% N= 5 I = ? PV = -1150 PMT = 63.50 (1000 x .0635) FV = 1067.50 P/Y and C/Y =1 I = 4.20%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 3-year Treasury securities? 5.2% 6.0% 6.5% 5.7% 6.2%

5.7% IP3 = (3% + 3% + 5%)/3 = 3.67% rT3 = 2% + 3.67% = 5.7%

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's current yield? 5.79% 6.00% 5.50% 6.50% 6.25%

5.79% Current Yield of bond = Annual coupon/Current price of bond 1) Current Yield = (5.5% * $1000)/950 = 5.7895% Hence, answer is option a, 5.79%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 5-year Treasury securities? 5.2% 6.0% 6.5% 5.7% 6.2%

6.2% rT5 = r* + IP5IP5 = (3% + 3% + 5% + 5%)/5 = 4.2% rt5 = 2% + 4.2% = 6.2%

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now? 5.32% 5.89% 6.51% 5.60% 6.20%

6.20% 1 year rate today: 5% 2 year rate today: 6% MRP on 2 year bond: 0.40% Expected annualized return on a series of 1 year bonds: 2 year rate - MRP = 6%-0.4% = 5.6% Compounded return on series of 1 year bonds at above rate: = (1.056)(1.056)= 1.115136 Compounded rate on series of 1 year bonds= (1.05)(1 + x)= 1.1151 x = 6.20%

A bond that matures in 6 years sells for $950. The bond has a face value of $1,000 and a 5.5% annual coupon. What is the bond's yield to maturity, rd? 6.33% 5.79% 5.50% 7.00% 6.53%

6.53%

Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,120. What is the bond's nominal yield to call? 6.85% 6.53% 6.20% 7.55% 7.20%

6.53% Current Bond Price: Nper = 15 x 2 = 30 (indicates the period) FV = 1000 (indicates the face value of bonds) Rate = 6.50% PMT = 1000 x 8.25% x 1/2 = 41.25 (indicates semi-annual interest payment) PV = ? (indicates current bond price) P/Y and C/Y =2 PV= 1166.09 --- Step 2: Nominal Yield to Call: Nper = 6 x 2 = 12 (indicates the period) FV = 1120 (indicates the face value of bonds) PMT = 1000 x 8.25% x 1/2 = 41.25 (indicates semi-annual interest payment) PV = 1166.09 (indicates current bond price) I = ? (indicates nominal Yield to Call) I= 6.53%.

A bond that matures in 8 years has a 10% coupon rate, semiannual payments, a face value of $1,000, and an 8.5% current yield. What is the bond's nominal yield to maturity (YTM)? 7.7% 7.1% 6.9% 10.0% 8.5%

7.1% Step 1: N= 16 (8x2) I= ? PV= ? PMT = 50 (0.1/2 x 1000) FV = 1000 P/Y and C/Y =2 Step 2: Current yield = annual interest payment /current bond price 8.5% = 100/Vb Vb= 100/0.085 Vb= 1176.47 Step 3: N= 16 (8x2) I= ? PV= -1176.47 PMT = 50 (0.1/2 x 1000) FV = 1000 P/Y and C/Y =2 *I = 7.1%*

Interest rates on 4-year Treasury securities are currently 6.5%, while 6-year Treasury securities yield 6.8%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? Use the geometric average to arrive at your answer. 7.4% 7.0% 6.5% 7.2% 6.8%

7.4% (1.065)^4(1+r)^2=(1.068)^6 solve for r

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. 6.60% 7.32% 8.09% 6.95% 7.70%

7.70% Risk free rate + inflation + MRP + (r* +mrpt + IPt) 4.20% + 3.10% + (.10 x 4) = 7.70%

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now? 7.36% 8.16% 9.04% 7.75% 8.59%

9.04%

Which is riskier to an investor, other things held constant—a callable bond or a putable bond? Explain.

A callable bond is riskier to an investor A callable bond is the one that can be called back by the issuing company. A putable bond is the one that can be returned back to the company by the investor. The callable bond is usually called back when the interest rates go down and the company believes that they can call back these shares and issue new ones at a lower interest cost. These possess a threat to the investor as he will have to find a new investment at that time to put his money.

Call provision

A provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date.

Sinking fund provision

A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year.

Component and symbol: Over the past several years, Germany, Japan, and Switzerland have had lower interest rates than the United States due to lower values of this premium.

Inflation premium IP

Which factor determines how much will be saved at different interest rates?

Consumers Time Preferences

Component and symbol: This is the premium added as a compensation for the risk that an investor will not get paid in full.

Default risk premium DRP

What are the two items whose sum is the cost of equity?

Dividends and Capital Gains

True or False: Actions that lower short-term interest rates will always lower long-term interest rates.

False

A zero coupon bond pays no interest. It is offered at par value, which is where it sells initially. These bonds provide compensation to investors in the form of capital appreciation. True False

False A zero coupon bond pays no interest and is sold at a discount below par value.

We should expect to see interest rates decline if the federal deficit increased sharply from one year to the next, the Federal Reserve kept the money supply constant, and all other things held constant. True False

False An increase in the deficit and a constant money supply will cause interest rates to increase, all else being equal.

True or False: If the Fed injects a huge amount of money into the markets, inflation is expected to decline, and long-term interest rates are expected to rise.

False If the Fed increases the money supply by making more money available in the markets, inflation is expected to increase; because inflation dilutes their returns, investors expect higher returns in the future. Thus, long-term interest rates increase with an increase in the money supply.

Of the many factors that affect the cost of money, one of the four most fundamental factors is the expected rate of inflation. A predictable correlation between inflation and interest rates is this: If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant. True False

False Inflation is one of the fundamental factors that affect interest rates, the cost of money in the economy. If inflation is high, rates will be, too.

If the appropriate rate of interest on a bond is greater than its coupon rate, the market value of that bond will be above par value. True False

False It will sell at a discount, so its market value will be less than its par value.

There is a direct relationship between bond ratings and the required rate of return on bonds; that is, the higher the rating, the higher is the required rate of return. True False

False The relationship is inverse. The higher a bond's rating, the lower are its default risk and its required rate of return.

In July 2009, Hungary successfully issued 1 billion euros in bonds. The transaction was managed by Citigroup. What type of bonds are these? Municipal bonds Corporate bonds Government bonds

Government bonds

Impact on yield and Cost of Borrowing Money from Bond Markets: A start-up company is struggling with finances for its projects.

Impact on yield: *Increase* Cost of Borrowing Money from Bond Markets: *More expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: ABC Real Estate is a commercial real estate firm that primarily uses short-term financing, while its competitors primarily use long-term financing. Interest rates have recently increased dramatically.

Impact on yield: *Increase* Cost of Borrowing Money from Bond Markets: *More expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: Ziffy Corp.'s credit rating was downgraded from AAA to A.

Impact on yield: *Increase* Cost of Borrowing Money from Bond Markets: *More expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: A car manufacturing company loses 40% of its market share and has a declining investment in new product development.

Impact on yield: *Increase* Cost of Borrowing Money from Bond Markets: *more expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: A company's credit rating was upgraded from AA to AAA.

Impact on yield: *decrease* Cost of Borrowing Money from Bond Markets: *less expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: A company's interest coverage ratio improves.

Impact on yield: *decrease* Cost of Borrowing Money from Bond Markets: *less expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: Bellgotts Inc. has increased its market share from 15% to 37% over the last year while maintaining a profit margin greater than the industry average.

Impact on yield: *decrease* Cost of Borrowing Money from Bond Markets: *less expensive*

Impact on yield and Cost of Borrowing Money from Bond Markets: Previously, Ferro Co. had only used short-term debt financing. The company now finances its current assets such as inventories and receivables with short-term debt, and it finances its fixed assets such as buildings and equipment with long-term debt.

Impact on yield: *decrease* Cost of Borrowing Money from Bond Markets: *less expensive*

What is the price paid to borrow debt capital called?

Interest Rate

Component and symbol: It is based on the bond's marketability and trading frequency; the less frequently the security is traded, the higher the premium added, thus increasing the interest rate.

Liquidity risk premium LP

Component and symbol: As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty

Maturity risk premium MRP

Does the Fed have complete control over U.S. interest rates? That is, can it set rates at any level it chooses? Why or why not?

No. They need to promote economic growth while keeping inflation at bay. Delicate balancing act.

Component and symbol: This is the rate for a riskless security that is exposed to changes in inflation

Nominal risk-free rate rRF

Differentiate between price risk and reinvestment risk.

Price Risk: Current market value of the bond portfolio -LT Bonds significant risk (value declines and interest rates rise) -ST Bonds less risk Reinvestment Risk: Income the portfolio produces -LT Bonds stable because income is stable -ST Bonds significant risk

Which factor sets an upper limit on how much can be paid for savings?

Producers Expected Returns

What four fundamental factors affect the cost of money?

Production Opportunities, Time Preferences for Consumption, Risk, Inflation

Component and symbol: It changes over time, depending on the expected rate of return on productive assets exchanged among market participants and people's time preferences for consumption.

Real risk-free rate r*

If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt?

ST: Reinvestment Risk If interest rates in economy increase over time it would be very risky LT: Steady rate, doesn't change as economy rate changes.

In July 2009, Hungary successfully issued 1 billion euros in bonds. The transaction was managed by Citigroup. Who is the issuer of the bonds? Hungary Bank Citigroup The Hungarian government

The Hungarian government

What key assumption underlies the pure expectations theory?

The shape of the yield curve depends on investors' expectations about future interest rates.Assumes: Bond traders establish bond prices and interest rates strictly on the basis of expectations for future interest rates and that they are indifferent to maturity because they do not view long-term bonds as being riskier than short-term bonds.

Which of the following types of bonds have the least default risk? Treasury bonds Corporate bonds Municipal bonds

Treasury bonds

A 20-year, annual coupon bond with one year left to maturity has the same price risk as a 10-year, annual coupon bond with one year left to maturity. Both bonds are of equal risk, have the same coupon rate, and the prices of the two bonds are equal. True False

True

A common provision in a bond indenture is a sinking fund. Sinking funds require companies to retire bonds on a scheduled basis prior to their final maturity. Many indentures allow the company to acquire bonds for sinking fund purposes by either (1) purchasing bonds on the open market at the going market price or (2) selecting the bonds to be called by a lottery administered by the trustee, in which case the price paid is the bond's face value. True False

True

True or False: Countries with strong balance sheets and declining budget deficits tend to have lower interest rates.

True

True or False: During the credit crisis of 2008, investors around the world were fearful about the collapse of real estate markets, shaky stock markets, and illiquidity of several securities in the United States and several other nations. The demand for US Treasury bonds increased, which led to a rise in their price and a decline in their yields.

True

True or False: Long-term interest rates are not as sensitive to booms and recessions as are short-term interest rates.

True

True or False: The Federal Reserve Board has a significant influence over the level of economic activity, inflation, interest rates in the United States.

True

True or False: When the Fed increases the money supply, short-term interest rates tend to decline.

True

True or False: When the economy is weakening, the Fed is likely to decrease short-term interest rates.

True

"Interest rate risk," also known as "price risk," is the risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds. True False

True An increase in rates reduces prices, which is known as "interest rate risk" or "price risk."

A predictable correlation between the demand curve for funds and the supply curve is this: If the demand curve for funds increases but the supply curve remains constant, then the total amount of funds supplied and demanded increase and interest rates in general also increase. True False

True If demand increases relative to supply, then the price goes up and so does the amount supplied.

When the U.S. economy is very strong, the Federal Reserve tends to take action to increase interest rates, but when the U.S. economy is weak, the Federal Reserve tends to decrease interest rates. True False

True In a weak economy, the Federal Reserve will lower the interest rates to help increase business investment and stimulate the economy.

Of the many factors that affect the cost of money, one of the four most fundamental factors is the availability of production opportunities and their expected rates of return. A predictable correlation between production opportunities and interest rates is this: If opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant. True False

True Production opportunities are one of the fundamental factors that affect interest rates, the cost of money in the economy.

Of the many factors that affect the cost of money, one of the four most fundamental factors is the risk inherent in a given security. A predictable correlation between risk and required return is this: The higher the risk, the higher the security's required return, other things held constant. True False

True Risk is one of the fundamental factors that affect interest rates, the cost of money in the economy.

If management is sure that the economy is at the peak of a boom and is about to enter a recession, a firm that needs to borrow money should probably use short-term rather than long-term debt. True False

True The firm should borrow short-term until interest rates drop due to the recession, then go long-term. Predicting interest rates is extremely difficult because managers can rarely be sure about what is going to happen to the economy.

Suppose the Fed takes actions that lower expectations for inflation this year by 1 percentage point, but these same actions raise expectations for inflation in Years 2 and thereafter by 2 percentage points. Other things held constant, the yield curve becomes steeper. True False

True The yield curve becomes steeper. Although interest rates in Year 1 decrease by 1%, interest rates in the following years increase by 2%, making the yield curve steeper.

All else being equal, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par? a) Adding a call provision b) Adding additional restrictive covenants that limit management's actions c) Adding a sinking fund d) Making the bond a first mortgage bond rather than a debenture e) The rating agencies changing the bond's rating from Baa to Aaa

a) Adding a call provision Restrictive covenants, mortgages, ratings improvements, and sinking funds reduce a bond's coupon rate. A call provision increases risk to the investor and calls for a higher rate.

Family Traditions Home Fashions would call its outstanding callable bonds if: a) Market interest rates decline sharply. b) The company's bonds are downgraded. c) Market interest rates rise sharply. d) Inflation increases significantly. e) Family Traditions Home Fashions' financial situation deteriorates significantly.

a) Market interest rates decline sharply. A company is most likely to call a bond if the coupon is higher than the market rate of interest. A downgrade, increase in interest rates, increase in inflation, or deterioration of finances would make the market rate higher than the coupon

Eagle Enterprises Inc. can issue a 20-year bond with a 6% annual coupon at par. This bond is not convertible, not callable, and has no sinking fund. On the other hand, Eagle Enterprises could issue a 20-year bond that is convertible into common equity, may be called, and has a sinking fund. Which of the following most accurately describes the coupon rate that Eagle Enterprises would have to pay on the second bond, the convertible, callable bond with the sinking fund, to have it sell initially at par? a) The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%. b) The coupon rate should be over 7%. c) The coupon rate should be exactly equal to 6%. d) The coupon rate should be over 8%. e) The coupon rate should be slightly greater than 6%.

a) The coupon rate could be less than, equal to, or greater than 6%, depending on the specific terms set, but in the real world the convertible feature would probably cause the coupon rate to be less than 6%. The second bond's convertible feature and sinking fund would tend to lower its required rate of return, but the call feature would raise its rate. Given these opposing forces, the second bond's required coupon rate could be above or below that of the first bond. However, the convertible feature generally dominates in the real world, so convertibles' coupon rates are generally less than comparable nonconvertible issues' rates.

Assume that the rate on a 1-year bond is now 6%. Investors expect 1-year rates to be 7% one year from now and then 8% two years from now. If the pure expectations theory holds, so that the maturity risk premium equals zero, which of the following statements would be CORRECT? a) The interest rate today on a 3-year bond should be approximately 7%. b) The interest rate today on a 2-year bond should be approximately 6%. c) The interest rate today on a 3-year bond should be approximately 8%. d) The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. e) The interest rate today on a 2-year bond should be approximately 7%.

a) The interest rate today on a 3-year bond should be approximately 7%. Under the pure expectations theory, forward rates represent expected future rates. Thus, the three year rate today would be the average of 6%, 7%, and 8%.

Hooper Printing, Inc. has a bond issue outstanding with 14 years left to maturity. The bond issue has a 7% annual coupon rate and a par value of $1,000, but due to changes in interest rates, each bond's value has fallen to $749.04. The capital gains yield earned by investors over the last year was 25.10%. What is the expected current yield for the next year on this bond issue? a) 10.00% b) 9.35% c) 8.24% d) 8.75% e) 10.50%

b) 9.35% The current yield is defined as the annual coupon payment divided by the current price. CY = $70/$749.04 = 9.35%.

Of the following, identify the CORRECT statement. a) Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. b) A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. c) If a bond sells at par, then its current yield will be less than its yield to maturity. d) A discount bond's price declines each year until it matures, when its value equals its par value. e) A discount bond's price increases each year until it matures, when its value equals its par value

b) A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate.

If interest rates on 20-year Treasury and corporate bonds are as follows: T-Bond: 6.27% AAA= 9.72% A= 10.34% BBB= 11.42% Then differences in these rates were probably caused primarily by: a) Inflation differences. b) Default and liquidity risk differences. c) Real risk-free rate differences. d) Tax effects. e) Maturity risk differences.

b) Default and liquidity risk differences. Treasury and corporate bonds face similar tax structures, maturity risk, inflation risk, and real rate of interest.

Which of the following statements about bond price risk is CORRECT, assuming that all else is equal? a) Long-term bonds have less price risk than short-term bonds. b) Long-term bonds have less reinvestment risk than short-term bonds. c) High-coupon bonds have less reinvestment risk than low-coupon bonds. d) Short-term bonds have less reinvestment risk than long-term bonds. e) Low-coupon bonds have less price risk than high-coupon bonds.

b) Long-term bonds have less reinvestment risk than short-term bonds.

Suppose that a firm is facing an upward-sloping yield curve and needs to borrow money to invest in production. Does this mean that the firm should consider borrowing only at short-term rates? a) No, an upward-sloping yield curve means that the firm will get a lower interest rate if it uses long-term financing. b) No, the firm needs to take the volatility of short-term rates into account. c) Yes, using short-term financing will give the firm the lowest possible interest rate over the life of the project.

b) No, the firm needs to take the volatility of short-term rates into account.

Which of the following best explains why a firm that needs to borrow money would borrow at long-term rates when short-terms rates are lower than long-term rates? a) The firm's interest payments will be the same whether it uses short-term or long-term financing, so it is essentially indifferent to which type of financing it uses. b) The use of short-term financing over long-term financing for a long-term project will increase the risk of the firm. c) A firm will only borrow at short-term rates when the yield curve is downward-sloping.

b) The use of short-term financing over long-term financing for a long-term project will increase the risk of the firm.

Suppose that a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, the real risk-free rate is expected to remain constant at 3% in the future, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT? a) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope. b) The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond. c) The conditions in the problem cannot all be true—they are internally inconsistent. d) The yield on a 2-year T-bond must exceed that of a 5-year T-bond. e) The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.

b) The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond. The information given covers six years, so we cannot make estimates about 7-year maturities. We do know that inflation will be greater in 5 years than in 2 years, which means that 2-year yields will be lower than the 5-year yields.

The "penalty" for having a low bond rating is less severe when the Security Market Line is relatively steep than when it is not so steep. True False

b. false A steeper SML implies a higher risk premium on risky securities and thus a greater "penalty" on lower-rated bonds.

Which of the following situations would be most likely to lead to an increase in interest rates in the economy? a) Households start saving a larger percentage of their income. b) The economy moves from a boom to a recession. c) Corporations step up their expansion plans and thus increase their demand for capital. d) The level of inflation begins to decline. e) The Federal Reserve decides to try to stimulate the economy.

c) Corporations step up their expansion plans and thus increase their demand for capital. Interest rates increase with an increase in demand for money from such things as good investment opportunities, inflation, and riskiness. They go down with an increase in supply of funds from an increased savings rate. The Fed reduces interest rates to stimulate the economy.

Which of the following statements is false? In all of the statements, assume that "other things are held constant." a) For any given maturity, a given percentage point increase in the interest rate causes a smaller dollar capital loss than the capital gain stemming from an identical decrease in the interest rate. c) For a given bond of any maturity, a given percentage point increase in the going interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate. c) Price sensitivity—that is, the change in price due to a given change in the required rate of return—increases as a bond's maturity increases. d) A 20-year zero-coupon bond has less reinvestment risk than a 20-year coupon bond. e) From a borrower's point of view, interest paid on bonds is tax deductible.

c) For a given bond of any maturity, a given percentage point increase in the going interest rate (rd) causes a larger dollar capital loss than the capital gain stemming from an identical decrease in the interest rate.

A noncallable 10-year T-bond has a 12% annual coupon, the yield curve is flat, and it has a10% yield to maturity. A 15-year noncallable T-bond has an 8% annual coupon, the yield curve is flat, and is has a 10% yield to maturity. Which of the following statements is CORRECT? a) If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase, but the price of the 15-year bond would fall. b) The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium. c) If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price. d) The 10-year bond would sell at a premium, while the 15-year bond would sell at par. e) If interest rates decline, the prices of both bonds would increase, but the 10-year bond would have a larger percentage increase in price.

c) If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price.

A bond's ______________ refers to the interest payment or payments paid by a bond.

coupon payment

In general, how is the rate on a floating-rate bond determined?

coupon rate is set for initial period(such as 6 months) and then adjusted with each passing period based on some open market rate

Which of the following would be most likely to lead to increases in nominal interest rates? a) There is a decrease in expected inflation. b) Households reduce their consumption and increase their savings. c) The Federal Reserve decides to try to stimulate the economy by increasing investment opportunities. d) A new technology such as the Internet has just been introduced, and it increases investment opportunities. e) The economy falls into a recession.

d) A new technology such as the Internet has just been introduced, and it increases investment opportunities. If the new technology were so efficient that it takes an underdeveloped economy from a subsistence level, where savings are necessarily low and rates high, to a level where people can afford to save, this might cause interest rates to decline. However, it would take time for this to occur.

Assume interest rates on 30-year government and corporate bonds were as follows: T-bond = 7.72%; AAA = 8.72%; A = 9.64%; BBB = 10.18%. The differences in rates among these issues are caused primarily by: a) Tax effects. b) Maturity risk differences. c) Both default risk differences and inflation differences. d) Default risk differences. e) Inflation differences.

d) Default risk differences. The tax obligation, maturity risk, and inflation differences affect these four bonds differently. The only difference is the default risk.

Which of the following statements about interest rates is CORRECT, all other things held constant? a) If companies increase their savings rate, interest rates are likely to increase. b) Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. c) If individuals have fewer good investment opportunities, interest rates are likely to increase. d) If expected inflation increases, interest rates are likely to increase. e) Interest rates on long-term bonds are more volatile than rates on short-term debt securities such as T-bills.

d) If expected inflation increases, interest rates are likely to increase. Interest rates increase with an increase in demand for money from such things as good investment opportunities, inflation, and riskiness. They go down with an increase in supply of funds from an increased savings rate. Treasury securities have no bankruptcy risk, and short-term rates are more volatile than long-term rates.

A bond issuer is said to be in ____________ if it does not pay the interest or the principal in accordance with the terms of the indenture agreement or if it violates one or more of the issue's restrictive covenants.

default

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond? a) 5.840% b) 6.471% c) 7.152% d) 6.148% e) 6.812%

e) 6.812% (1+Risk Free Rate)(1+inflation) -1

Bond market data show the following information: -The Treasury yield curve is downward sloping. -Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. -Empirical data also indicate that there is no liquidity premium for -Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information, which of the following statements is most CORRECT? a) The corporate yield curve must be flat. b) A 10-year Treasury bond must have a higher yield than a 10-year corporate bond. c) Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping. d) A 10-year corporate bond must have a higher yield than a 5-year Treasury bond. e) A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

e) A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. If a short-term maturity has a higher yield than a longer-term maturity, the yield curve must be downward sloping.

Which of the following statements about the yield curve is CORRECT? a) Yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds because long-term bonds are riskier than short-term bonds. b) If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat. c) If the expectations theory holds, the Treasury bond yield curve will never be downward sloping. d) If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. e) If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.

e) If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. The Treasury yield curve will slope upward if inflation is expected to increase and the maturity risk premium is greater than zero. Both factors must be in place.

Imagine that you see a yield curve for a current corporate bond that is upward sloping. What can you determine from this information? a) Long-term bonds are a better buy than short-term bonds. b) Inflation is expected to decline in the future. c) Long-term interest rates are more volatile than short-term rates. d) The economy is not in a recession. e) Maturity risk premiums could help to explain the yield curve's upward slope.

e) Maturity risk premiums could help to explain the yield curve's upward slope. Maturity risk premiums, an increase in inflation, and a growing economy cause an upward slope. The slope says nothing about investment prospects or volatility.

If the U.S. Treasury were to issue $50 billion of short-term securities and sell them to the public, what would be the most likely effect on short-term securities' prices and interest rates? Assume that other factors are held constant. a) Interest rates would decline and prices would rise. b) Interest rates and prices would both decline. c) There is no reason to expect a change in either prices or interest rates. d) Interest rates and prices would both rise. e) Prices would decline and interest rates would rise.

e) Prices would decline and interest rates would rise. Selling securities takes money out of the economy. This reduces the supply of funds and raises rates. An increase in rates reduces prices.

Which of the following statements about sinking funds is CORRECT? a) Sinking fund provisions only establish "targets" for the company to reduce its debt over time, not to retire their debt entirely. b) A sinking fund provision makes a bond more risky to investors at the time of issuance. c) Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. d) If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price. e) Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued.

e) Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued.

Apply the pure expectations theory to the following: Assume that the real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future but that inflation is expected to increase steadily over the next 30 years, giving the Treasury yield curve an upward slope. You are considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity, both of which have the same default and liquidity risks. Again, assuming the pure expectations theory holds, which of these statements is CORRECT? a) Because the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds. b) The 10-year Treasury bond must have a higher yield than the 5-year corporate bond. c) Because the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond. d) Because the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds. e) The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

e) The 10-year corporate bond must have a higher yield than the 5-year corporate bond. Under the pure expectations theory, forward rates represent expected future rates. Expected future rates will increase due to inflation.

Which of the following statements about bond markets is CORRECT? a) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. b) The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. c) The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity. d) The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year, AAA-rated corporate bond. e) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

e) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. A corporate bond will have more default risk than a Treasury bond, and thus have a higher yield. The other relationships vary with market conditions.

Of the following statements about default risk, which one is CORRECT? a) A company's bond rating is affected by its financial ratios but not by provisions in its indenture. b) Senior debt has more default risk than subordinated debt, all else being equal. c) Under Chapter 13 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act. d) Secured debt is more risky than unsecured debt, all else being equal. e) Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act.

e) Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Bankruptcy Act.

What are the four main issuers of bonds?

federal government, local government, corporations, foreign governments

Define floating-rate bonds, zero coupon bonds, callable bonds, putable bonds, income bonds, convertible bonds, and inflation-indexed bonds (TIPS).

floating rate bonds = a bond in which interest rate is adjusted for the general level of interest rates callable bonds = bond contract giving issuer the right to redeem the bonds under specified terms prior to normal maturity date putable bonds = allow investors to sell bond back to company before maturity date income bonds = bond that pays interest only if it is issuer has earned enough money to pay it convertible bonds = bonds exchangeable into common stock shares at fixed price, choice of bondholder inflation-indexed bonds = interest rate is based on inflation index - interest paid rises when inflation rises

How do risk and inflation impact interest rates in the economy?

higher risk and inflation = higher interest rates

Distinguish among the shapes of a "normal" yield curve, an "abnormal" curve, and a "humped" curve.

normal- upward sloping yield curve/abnormal- downward or inverted yield curve\humped- medium term rates were higher than short/long term rates. flat

In addition to default risk, what key risk do investors in foreign bonds face? Explain.

the value of the currency may fall relative to the dollar and so the bond holder will receive less dollars in return

Why are U.S. Treasury bonds not completely riskless?

their prices may decline when interest rates rise

How does risk affect interest rates?

when risk is higher, interest rate is higher.