Finance 3000 Exam 2 Mizzou
Asset-Backed Securities
Repayment based on a pool of securities
DRP
nominal interest of non treasury issuer - nominal interest of treasury issuer
Arbitrage Opportunity
Investors can earn more on one year bonds than they would with one single 4 year bond
PMT
(Coupon/2) x Face Value
How is a primary market defined?
A primary market is a market in which corporations and other fund demanders obtain funds by issuing new securities.
The Main Thrust for Market Segmentation
Investors do not consider securities with different maturities as perfect substitutes
How much did the DOW Jones average fall?
54%
What is an IPO?
An IPO is the first offering of financial securities by a firm to the general public.
Which one of these is the best description of a 5-year zero coupon bond?
A bond with a current value equal to its discounted par value
Bid-Ask-Spread
A cost of actively trading bonds where a dealer is compensated for taking risks by buying low and selling high
Curves
A downward-sloping curve indicates short-term bonds have the highest rates. An upward-sloping curve indicates long-term bonds have the highest rates.
Indenture Agreement
A legal contract describing the bond characteristics and the bondholder and issuer rights
What is the definition of a money market?
A market that trades securities that mature in one year or less.
What is a subprime mortgage?
A mortgage given to those with lower credit ratings that have a significantly higher interest rate.
Increasing Discount Rate
A rise in the prevailing i rates that reduces all bond values
1R4
A security in period one with a 4 year life to maturity
Zero Coupon Bond
A zero coupon bond is sold at a steep discount and pays no semiannual interest payments.
Which of the following will increase the nominal rate of interest on a security?
Addition of a call provision Decrease in liquidity Increase in the real rate of interest
What is included in the nominal rate?
All risk premiums
Unbiased Expectations Theory
At any point in time the yield curve will reflect the markets current expectations for future short term rates
You manage a trust fund and have a fiduciary responsibility to only purchase investment grade bonds. Which bond rating indicates a bond you could not purchase?
BB bonds are below investment grade so you could not purchase them while complying with your fiduciary responsibilities.
Which of these Standard & Poor's bond ratings is the lowest investment grade rating?
BBB
What are examples of financial institutions
Banks, Mutual Funds, Thrifts, Insurance Companies, Pensions
nominal interest rate (i) =
expected IP + RFR
Selling Price =
Bid price x 1000
1 year or less...
Bill
10+ years
Bond
Agency bonds
Bonds issued by the federal government to support a sector of the US economy
What is the key premise of the market segmentation theory?
Investors do not consider securities with different maturities as perfect substitutes.
What is the primary function of financial institutions?
Channeling the funds of those with excess to those in need of funds
What does a bond rating measure?
Credit Quality or Default RIsk
The market rate of interest that is used to compute the present value of a bond is affected by?
Credit quality of the bond Tax status of the bond
Which of the following yields or rates are inversely related to a bond's market price?
Current Yield and Yield to maturity only
What factors affect the nominal interest rate
Date to maturity Default risk Liquidity risk
Bonds
Debt obligations that corps, governments, and agencies issue to fund its operations with fixed interest and principle payments outlined by an indenture agreement.
What affects the coupon rate a firm must set on its bonds if the bonds are to be sold at par?
Default Risk Market rates of interest Bond Term
DRPj
Default Risk Premium on the "jth" date
What is the yield spread?
Difference between the yields to maturity on bonds with differing levels of credit risk
What determines the i rate under Market Segmentation Theory
Distinct supply and demand conditions within a particular market segment
Forward Rate
Expected or implied rate on a short term security that is to be originated at some point in the future derived from existing or actual rates traded in the spot market
Which money market security is defined as short-term funds transferred between financial institutions, often for no more than one day?
Federal funds.
What is exchanged in a foreign market?
Foreign currency.
When US interest rates on financial securities are higher than the foreign sector...
Foreign investors increase their supply in the US
According to the unbiased expectations theory....
Four one year bonds = One four year bond
If you fear foreign exchange risk you should enter into a....
Futures contract
Junk Bonds
Have a high credit quality risk that they combat with highly discounted bonds with high yields to maturity
As compared to money market securities, capital market securities differ in that they...
Have wider price fluctuations due to their longer maturities.
The impact of more inflation on the basket of goods
Higher price for the same basket
Default or Credit Risk
Higher risk higher interest
What is the cause of the housing crisis?
Housing values decreased and delinquent mortgages and derivative securities increased.
Annual Payment
I x Principal
Liquidity Risk
If a security is illiquid investors add liquidity risk premiums to the i of the security
When is RFR negative
If the T-bill is < CPI
Where are bonds mostly traded today?
In a decentralized OTC market between bond dealers and large institutions
When is the issuer of a security involved?
In the primary marketplace.
Who is exempt from federal taxes?
Income on state and local (municipal) securities
IP
Inflation Premium
What influences all financial securities?
Inflation Premium Real Risk-free rate
If the nominal rate is less than the real rate...
Inflation must be negative
Fisher Effect depends on...
Inflation related to reduction in purchasing power Additional premium over the expected rate of inflation for forgoing present consumption
Current Yield Formula
Interest Rate (or annual coupon) /Market Price or Current Value
True or false: Interest rate risk is only a concern when market interest rates decline.
Interest rate risk is a concern when market rates increase since increasing interest rates cause bond prices to decline.
How will an expected increase in the rate of inflation affect interest rates?
Interest rates will rise.
What relation do i rates and bond prices have?
Inverse
Types of Financial Institutions
Investment banks Commercial banks Financial services corporations Credit unions Pension funds Life insurance companies Mutual funds Exchange traded funds Hedge funds Private equity companies
What key role does an investment bank play?
Investment banks arrange primary market transactions for business entities.
General Obligation Bonds
Investments secured by the taxing power of the jurisdiction that issues them
Time to Maturity
Issue - Current
Corporate Bonds
Issue debt, equity (stocks), or both to minimize its capital costs often issuing bonds with low i rates
Speculative Bonds are often referred to as
Junk Bonds
Liquidity Formula
L3 < L4 < L5
LRPj
Liquidity Risk Premium on the "jth" date
If the curve is upward sloping in the Liquidity Premium theory...
Liquidity premiums increase with maturity premiums
The Fisher effect is based on the theory that investors must be compensated for which two of the following factors? Select two.
Lost purchasing power on loaned funds Premium for forgoing present consumption
MPj
Maturity Premium on the "jth" date
What is a capital market instrument that represents a pool of loans and is collateralized by principal and interest cash flows?
Mortgage backed securities.
Why do municipal bonds pay the lowest rate?
Municipal bond interest is exempt from federal taxation but Treasury bond interest is not.
Fisher Effect
Nominal interest rates (i) in each country equal the required real rate of interest (r) and the expected rate of inflation over the period of time for which the funds are to be lent (I). That is, i = r + I.
In the default risk premium formula, the symbol Ijt represents which interest rate?
Nominal rate on a non-Treasury security.
What is the difference between real rates and nominal rates?
Nominal rates include interest
1-10 years
Note
When are T-bonds taxed
ONLY at the federal level
Discount Bond
Occurs when a par value is greater than the SP where an investor reaps a capital gain
Secondary Securities...
Often provide funds on demand due to their increased liquidity making them more attractive to investors
How many IPO's can a company issue?
One.
For a typical corporate bond, which one of these applies to the calculation of the bond's yield to maturity?
PV = -(Current bond price) because cash flow is going in the opposite direction
If cash flows are moving in the same direction...
PV and PMT must have the same sign
The current price of a bond
PV of future cash flows discounted at the market price
Call Price
Par value + call premium
If a bond is selling at a premium which one of these rates will be the highest?
Premium bond: Coupon rate > Current yield > Yield to maturity
What are the key factors that limit direct investment in financial claims?
Price risk, Monitoring cost, Liquidity risk.
What is the market segmentation theory focused on?
Primarily focused on investor's maturity preferences.
Yield to Call Definition
Rate earned by buying a bond at today's price and holding it until the first call date
RFR
Real Risk-Free Rate
Municipal Bonds that benefit individuals...
Repaid with revenue bonds and user fees
Municipal Bonds that benefit the community...
Repaid with tax revenues
Which money market security involves a sale, generally at a discounted price, that includes a promise to reverse the sale at a specified price on a specified date?
Repo
Generally, the quantity of loanable funds increases as interest rates....
Rise
Coupon Bond
SP is less than face value Coupon rate is below the market value
Which one of these is a public offering?
Sale of newly-issued securities to investors with the assistance of an investment bank.
Treasury Bonds
Selling treasury securities through public auctions to finance the federal deficit with a larger deficit bringing more bonds
If both the real rate of interest and the expected rate of inflation are positive, then which of these is correct?
Since the nominal rate is the sum of the real rate and the inflation premium, the nominal rate will exceed both the real rate and the inflation premium.
SCPj
Special Covenant Premium on the "jth" date
Which set of characteristics best applies to a derivative security agreement?
Standardized quantity, predetermined price of exchanged asset, specified exchange date, high degree of leverage
Municipal Bonds
State and local governments borrow money to rebuild community systems
By approximately what percentage did stock prices rise in value between March 2009 and April 2010?
Stock prices rose by approximately 71.1 percent for the period. However, this did not offset the 53.8 percent decline in the prior year and a half. Ex: $100 × (1 - 0.538) × (1 + 0.711) = $79
Which category of mortgages presented the most problems during the financial crisis of the late 2000s?
Subprime Mortgages
Special Provisions
Taxability, Convertibility, and Callability
Yield to Maturity
Tells bond investors what the total rate of return is if they expect the bond were bought at a particular price and held to maturity
Increased liquidity with financial institutions
Tends to lower standards, or decrease credit quality of loans.
Real Risk Free Rate
The rate if no inflation were expected over the inflation period
What is the nominal interest rate?
The rate observed in financial markets including inflation premium.
Term to Maturity
The yield curve from TVM principles comparing similar i rates, most commonly a positive yield rate.
Which is larger and higher in value- the stock or bond market?
The bond market
Current Yield
The bonds annual coupon rate / The bonds current market price
If short-term market supply decreases and increases long-term...
The curve steepens
Coupon Rate
The dollar amount of interest paid to bondholders set at the market i rate
The longer the term and the lower the coupon rate...
The greater the risk
Inflation
The higher level of actual or expected interest, the higher the interest rate.
The higher the demand for securities...
The higher the yield
Interest Rate RIsk
The inverse relationship between market interest rates and bond prices.
The unbiased expectations theory assumes...
The long term rate is a geometric average for each year rate
Which Theory is different from the rest?
The market segmentation theory
Maturity Premium
The more time to maturity, the higher the i rate
What is i in the Fisher formula?
The nominal interest rate
What does the DRPj rate describe?
The non-Treasury security j pays investors a premium as compared to a comparable Treasury security to compensate for default risk.
What is default risk?
The possibility that an issuer may pay late or miss an interest or principal payment.
Current Value of a Bond
The present value of the bond's expected future cash flows discounted at the market rate of interest.
Equivalent Taxable Yield
The pretax rate needed on a taxable bond to produce the same after-tax rate as a muni bond
How is risk measured?
The probability of threat against risk free Treasury securities
Assume you computed an inflation premium, IP, of 2.3 percent based on the PPI. How do you interpret this value?
The producer price index raised 2.3% for the period.
Yield to Maturity is defined as
The rate that will be earned if a bond is purchased today and held until maturity
What is the real interest rate?
The rate that would exist on a default-free security if no inflation were expected.
Fair Interest Rate "i"
The rate to compensate investors of all risks
Current Yield is defined as
The return provided by the annual interest payments if the bond is purchased at the current price
Which of these defines a secondary market? Select all that apply.
The secondary market involves the resale of a stock by a shareholder. A secondary market is a market where previously issued securities are traded.
As the supply of loanable funds increases...
The supply curve shifts down and to the right and equilibrium interest rate falls
You are in the 3rd year of a 10-year corporate bond has a 6% coupon, a call premium of $60, and a first call date in year 4. Market interest rates are 5.75% and are expected to drop dramatically for an extended period. If you plan to hold the bond, which yield should you most consider before buying the bond?
The yield to call as the bond will most likely be called
Why do short-term securities provide greater marketability?
Their role in secondary markets.
If the curve is upward sloping in the unbiased expectations theory...
Then the markets expectation of persistently rising one-year interest rates over the future is accurate
How does the yield to call differ from the yield to maturity for the same bond? Select all that apply.
There are fewer time periods in the yield to call. The call price used in the yield to call usually exceeds the face value used in the yield to maturity.
Society's Preference for "today"
There is a higher RFR because there is more of a demand for having money "today"
Where are treasury securities taxed?
They are exempt from state and local taxes but are taxed at the federal level.
Why do FI's have an incentive to monitor?
They have far more stake than the small individual supplier would have and they use delegated monitors
The term structure of interest rates compares similar bonds based on which variable?
Time to maturity
What is the role of investment banks?
To arrange primary market transactions for business entities.
When are US treasury bonds used?
To implement monetary growth
Independent Bond Ranking Agencies role
To monitor credit quality risks
When are US treasury bills used?
To rebuild schools, road, public works
Bond Price
Trade Value x Principal
Types of securities
Treasury Bills & Treasury Bonds Municipal Bonds Corporate Bonds Preferred Stocks Common Stocks
what is NOT a capital instrument? -US treasury notes and bonds -US treasury bills -US government agency bonds -corporate stocks and bonds
US treasury bills
Debenature
Unsecured bond
Premium Bond
When a bond is selling a premium to par because its coupon rate is higher than its current market price
Who is involved in the direct transfer of funds?
When a corporation is selling its securities directly to investors it does not need to go through a financial institution, or underwriter.
Reinvestment Rate Risk
When i rates increase so bondholders cash flows are discounted at a higher rate decreasing the bond value
What is a primary market transaction?
When the issuer is the seller.
A 10-year corporate bond has a 6 percent coupon, a call premium of $60, and a first call date in year 4. Market interest rates are 6.5 percent and are expected to rise for an extended period. If you plan to hold the bond, which yield should you most consider before buying the bond?
With market interest rates exceed the coupon rate and are rising, a bond is unlikely to be called. The yield to maturity.
Is cost of holding cash attractive to investors?
Yes
Which one of these formulas will compute the expected 1-year rate for year 4?
[(1 + 1R4)4/(1 + 1R3)3] - 1
Interest Premium Equation
[(CPt+1 - CPt)/ CPt] x 100
An investor buys bonds at the ___ price and sells them at the ___ price.
ask, bid
RFR Equation
average - nominal interest
what is NOT a money market instrument? -treasury bills -commercial paper -corporate bonds -bankers acceptances
corporate bonds
What is the risk premium when one party breaches agreement with another
default risk
What formalizes an agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future?
derivative security
The rate to compensate for all risks ij
f(IP+RFR+DRPj+LRPj+SCP+MPj)
If interest rates rise...
individuals and corporations result in a loss of wealth
Primary market financial instruments include stock issues from firms allowing their equity shares to be publicly traded on the stock market for the first time. We usually refer to these first-time issues as which of the following?
initial public offerings (IPOs)
In the US, what financial institutions arrange most primary market transactions for businesses?
investment banks
Market Segmentation Theory
investors do not consider securities with different maturities as perfect substitutes; have specific maturity preferences
Liquidity Premium Theory
investors will hold long-term maturities only if these securities with longer term maturities are offered at a premium to compensate for future uncertainty in the security's value
What refers to the ease with which an asset can be converted into cash?
liquidity
Liquidity Premium Theory is the same as the Unbiased Expectations Theory plus...
liquidity premiums and increasing maturity
Spot Market
market in which a transaction is made immediately at the prevailing price
What feature debt securities or instruments with maturities of one year or less?
money markets
formula for equivalent taxable yield
municipal yield / (1-tax rate)
What provides a forum in which demanders of funds raise funds by issuing new financial instruments such as stocks and bonds?
primary markets
Once firms issue financial instruments in primary markets, these same stocks and bonds are then traded in what?
secondary markets
Why would you want to use the yield to maturity when comparing bonds
the annual return that will be earned if a bond is purchased at the current price and held until maturity.
Present value of a payment made forever (perpetuity)
the payment / interest rate
If you expect interest rates to increase significantly within the next two years, which one of these bonds would you prefer to own?
you would prefer the bonds with the least interest rate risk as they would decrease the least in price. Short term, high coupon.
