Finance Chapter 7

Interest Rate Risk is the risk that arises for bond owners from fluctuating interest rates. All other things being equal, the _______ the time to maturity, the _________ the interest rate risk.

longer, greater

Interest Rate Risk is the risk that arises for bond owners from fluctuating interest rates. All other things being equal, the _______ the coupon rate, the _________ the interest rate risk.

lower, greater

Warren Corporation is interested in a three-year, 11% annual coupon bond. A broker quotes a price of $930.35. What is the yield to Maturity? 10% 11% 12% 13% 14%

14% N = 3 I = ? PV = -$930.35 PMT = 110 ($1,000 x 11%) FV = $1,000

Rao Investments has 6.5 percent coupon bonds outstanding with a current market price of $548. The yield to maturity is 13.2 percent and the face value is $1,000. Interest is paid annually. How many years is it until these bonds mature? 17.84 years 14.19 years 17.41 years 16.16 years 18.32 years

17.84 years

Which one of the following bonds is the least sensitive to interest rate risk? 3-year; 4 percent coupon 3-year; 6 percent coupon 5-year; 6 percent coupon 7-year; 6 percent coupon 7-year; 4 percent coupon

3-year; 6 percent coupon

A $10,000 face value Treasury bond is quoted at a price of 101.6533 with a current yield of 4.87 percent. What is the coupon rate? 5.20% 4.48% 5.41% 4.95% 4.27%

4.95% .0487*101.6533

Franklin Corporation has an opportunity to purchase bonds at a rate of 11%. They are in the 34% tax bracket. What is the after tax yield on these bonds? 3.74% 5.93% 7.26% 9.62% 11%

7.26% After tax yield = taxable × (1− tax rate)After tax yield = 11% × (1 − .34) After tax yield = 7.26%

Lampson bonds have a face value of $1,000 and are currently quoted at 867.25. The bonds have coupon rate of 6.5 percent. What is the current yield on these bonds? 7.45% 7.67% 7.49% 8.03% 8.47%

7.49% (1000*.065)/867.25

Assume the nominal rate was 11.50% and the inflation rate was 3%. Using the Fisher Effect, what was the real rate? 8.1% 8.25% 9.10% 9.90% 11.50%

8.25% 1+R = (1+r) x (1+h)

Bonds issued by the U.S. government: are considered to be free of interest rate risk. generally have higher coupons than comparable bonds issued by a corporation. are considered to be free of default risk. pay interest that is exempt from federal income taxes. are called "munis."

are considered to be free of default risk.

Rollins, Incorporated, has a 15-year bond issue with a coupon rate of 4.5 percent that matures in 11.5 years. The bonds have a par value of $1,000 and a market price of $1,105.50. Interest is paid semiannually. What is the yield to maturity? 1.69% 1.79% 4.07% 3.38% 2.52%

3.38%

The 30-year, 5.5 percent bonds issued by Modern Kitchens pay interest semiannually, mature in four years, and have a $1,000 face value. Currently, the bonds sell for $1,020.66. What is the yield to maturity? 4.92% 4.41% 2.46% 2.68% 5.39%

4.92%

When short-term rates are higher than long-term rates, we say it is __________________.

Downward sloping.

Lochmere Corporation is evaluating a taxable bond at 7% and a municipal bond at 5.75%. What is the break-even tax rate? 88% 82% 44% 18% 12%

Taxable bond x (1 − tax rate) = Municipal bond .07 × (1 − tax rate) = .0575 (18%) is the − breakeven tax rate.

A $1,000 par value corporate bond that pays $45 annually in interest was issued last year. Which one of these would apply to this bond today if the current price of the bond is $989.42? The bond is currently selling at a premium. The current yield exceeds the coupon rate. The bond is selling at par value. The current yield exceeds the yield to maturity. The coupon rate has increased to 7 percent.

The current yield exceeds the coupon rate.

When comparing a 10-year bond versus a 1-year bond, the 10-year bond has a much greater interest rate risk.

True

The Fisher effect primarily emphasizes the effects of ________ on an investor's rate of return. default market movements interest rate changes inflation the time to maturity

inflation

Municipal bonds: are totally risk free. generally have higher coupon rates than corporate bonds. pay interest that is free from federal taxation. are rarely callable. are free of default risk.

pay interest that is free from federal taxation.

Municipal bonds are taxable for federal, state and local taxes.

False

Werden Drilling offers 5.5 percent coupon bonds with semiannual payments and a yield to maturity of 7 percent. The bonds mature in 10 years. What is the market price per bond if the face value is $1,000? $893.41 $894.65 $937.63 $671.36 $1,114.20

$893.41

Current Yield is the bond's annual coupon divided by its yield to maturity.

False

Coronel Corporation wants to issue new 20-year bonds. The company currently has 8.5 percent bonds on the market that sell for $994, make semiannual payments, and mature in seven years. What should the coupon rate be on the new bonds if the firm wants to sell them at par?

N=14 PV=-994 PMT=42.50 (.085*1000)/2 FV=1000 YTM=2(4.308%) YTM=8.62%

The yield to maturity on a bond is the interest rate you earn on your investment if interest rates do not change. If you actually sell the bond before it matures, your realized return is known as the holding period yield. Suppose that today you buy a coupon bond with 9 percent annual interest for $1,000. The bond has 12 years to maturity. Three years from now, the yield to maturity has declined to 7 percent and you decide to sell. What is your holding period yield? 8.84% 9.49% 10.96% 13.01% 12.83%

12.83%

Which one of the following statements is correct? The risk-free rate represents the change in purchasing power. Any return greater than the inflation rate represents the risk premium. Historical real rates of return must be positive. Nominal rates exceed real rates by the amount of the risk-free rate. Given a positive rate of inflation, the real rate must be less than the nominal rate.

Given a positive rate of inflation, the real rate must be less than the nominal rate.

The features of Municipal bonds make them attractive to high income, _________ bracket investors. Low-tax Average-tax High-tax No-tax Extra-tax

High-tax

A $1,000 face value bond has a coupon rate of 7 percent, a market price of $989.40, and 10 years left to maturity. Interest is paid semiannually. If the inflation rate is 2.2 percent, what is the yield to maturity when expressed in real terms? 5.03% 4.68% 4.92% 4.84% 5.68%

N=20 PV=-989.40 PMT = 35 FV=1000 YTM = 2(3.575%) = 7.15% r = 1.0715/1.022 - 1 r = 0.0484 or 4.84%

Assume the current market price of a bond exceeds its par value. Which one of these equations applies? Market value < Face value Yield to maturity = Current yield Market value = Face value Current yield > Coupon rate Yield to maturity < Coupon rate

Yield to maturity < Coupon rate

Protective covenants: apply to short-term debt issues but not to long-term debt issues. only apply to privately issued bonds. are a feature found only in government-issued bond indentures. only apply to bonds that have a deferred call provision. are primarily designed to protect bondholders.

are primarily designed to protect bondholders.

A zero coupon bond: is sold at a large premium. pays interest that is tax deductible to the issuer at the time of payment. can only be issued by the U.S. Treasury. has more interest rate risk than a comparable coupon bond. provides no taxable income to the bondholder until the bond matures.

has more interest rate risk than a comparable coupon bond.

Callable bonds generally: grant the bondholder the option to call the bond any time after the deferment period. are callable at par as soon as the call-protection period ends. are called when market interest rates increase. are called within the first three years after issuance. have a sinking fund provision.

have a sinking fund provision.

Genova Corporation has a four year 10% annual coupon bond. The price of the bond is $956.12. The Yield to Maturity is 11.43%. What is the current yield on this bond? 9.38% 10.01% 10.46% 11.05% 11.43%

10.46% Current Yield = annual coupon/price Current Yield = $100/$956.12

Assume the real rate was 9.5% and the inflation rate was 4%. Using the Fisher Effect, what was the nominal rate? 13.88% 12.88% 12.12% 11.50% 9.50%

13.88%

The term structure of interest rates includes all of the following basic components, except: Real Rate of Interest Rate of Inflation Weighted Average Cost of Capital Interest Rate Risk

Weighted Average Cost of Capital

The break-even tax rate between a taxable corporate bond yielding 7 percent and a comparable nontaxable municipal bond yielding 5 percent can be expressed as: .05/(1 − t*) = .07. .05 − (1 − t*) = .07. .07 + (1 − t*) = .05. .05(1 − t*) = .07. .05(1 + t*) = .07.

.05/(1 − t*) = .07.

Treasury issues are: Exempt from state income taxes but, not federal income taxes. Exempt from federal income taxes but, not state income taxes. Have large amounts of default risk. Securities that the U.S. government issues for periods up to 50 years. Dependent on whether the treasury can obtain money to make payments.

Exempt from state income taxes but, not federal income taxes.

The Fisher Effect has all of the following components, except: Real Rate on the Investment, r Compensation for Inflation of Original Investment, h Expected Rate of Return, E Compensation for Inflation on Investment Earned

Expected Rate of Return, E

The term structure of interest rates tells us what _________ interest rate are on default-free, pure discount bonds of all maturities.

Nominal

Matching Exercise: Match the type of bond to its definition. The catastrophe bond: A warrant bond: An income bond: A convertible bond: A put bond:

The catastrophe bond: covers hurricanes and earthquakes in the U.S A warrant bond: gives the buyer of a bond the right to purchase shares of stock in the company at a fixed price. An income bond: states that the bond's coupon payment depends on company income. A convertible bond:can be swapped for a fixed number of shares of stock anytime before maturity at the holder's option. A put bond: allows the holder to force the issuer to buy back the bond at a stated price.

All else constant, a bond will sell at _____ when the coupon rate is _____ the yield to maturity. a premium; less than a premium; equal to a discount; less than a discount; higher than par; less than

a discount; less than

A bond has a face value of $1,000. It can be redeemed early at the issuer's discretion for $1,015, plus any accrued interest. The additional $15 is called the: dirty price. redemption value. call premium. original-issue discount.

call premium.

Ana just received the semiannual payment of $35 on a bond she owns. This is called the ______ payment. coupon face value discount call premium yield

coupon

Dilan owns a bond that will pay him $45 each year in interest plus $1,000 as a principal payment at maturity. The $1,000 is referred to as the: coupon. face value. discount. yield. dirty price.

face value

A bond's principal is repaid on the ____ date. coupon yield maturity dirty clean

maturity