FP513 Module 2
A convertible bond has a 6.5% coupon rate, interest is paid semiannually, and the bond matures in five years. Comparable debt currently yields 7.5%. The bond is convertible into common stock at $25 per share. The current price of the stock is $28, and the current price of the convertible bond is $1,050. What is the investment value of the bond? A) $1,008.90 B) $958.94 C) $1,000.00 D) $968.95
A bond's investment value is the same as its intrinsic value as a straight bond. Using a financial calculator, the bond price is determined using the following inputs: N = 10 (5 x 2 periods per year) I/YR = 7.5% PMT = 1000 x 6.5% / 2 = $32.5 FV = $1,000 Solve for PV = -958.94, or $958.94. NOTE: There are several examples on bond calculations in the blue boxes in the Module 2 text; however, it may be beneficial to skip ahead to Module 7 for some additional practice.
A convertible bond's market value will NOT fall below its A) call value. B) investment value. C) downside value. D) conversion value.
A convertible bond's market value will not fall below its investment value. If the conversion premium is worthless, the bond still has value as a straight bond—its market value.
You want to generate additional income from your portfolio, and are considering purchasing either bonds or preferred stocks. Which of the following statements is NOT correct concerning the characteristics of bonds and preferred stocks? A) Corporations pay taxes on preferred stock dividends prior to distribution to preferred shareholders, whereas interest on bonds is a deductible expense. B) Bonds are subject to more interest rate risk than preferred stocks. C) In the event of a company's bankruptcy, bondholders would be paid first ahead of preferred stock shareholders. D) Bonds pay interest while preferred stocks pay dividends.
Because preferred stock does not have a maturity date, it is subject to more interest rate risk than bonds.
The intrinsic value of a preferred stock with an 8% dividend ($100 par stock) and a market interest rate of 7.5% is A) $108.00. B) $106.67. C) $107.50. D) $100.00. Explanation
The answer is $106.67. The preferred stock is a perpetuity and priced by the equation: P = D ÷ r = $8.00 ÷ 0.075 = $106.67.
Which of the following describes downside risk with respect to convertible bonds? A) The difference between the straight value of the bond and its conversion value. B) The difference between the current market value of the bond and its conversion value. C) The difference between the current market value of the bond and its investment value. D) The difference between the conversion value of the bond and its investment value. Explanation
Downside risk with respect to convertible bonds is the difference between the current market value of the bond and its investment value.
Select the incorrect statement regarding foreign bonds. A) Eurodollar bonds must be registered with the Securities and Exchange Commission (SEC). B) Yankee bonds are not subject to exchange rate risk, but they are subject to default risk. C) Foreign bonds may provide an investor with portfolio diversification benefits. D) Yankee bonds are sold in the United States by companies outside of the United States and provide all interest payments in U.S. dollars.
Eurodollar bonds do not have to be registered with the SEC.
Klaus Copenhagen's objective is to receive income, and he is considering a preferred stock with a $1.50 dividend that is currently trading at $25. What would be the approximate price movement of this preferred stock if interest rates were to rise 1%? A) -10% B) -4% C) -14% D) -7%
First, determine what the current interest rate is, $1.50 ÷ $25 = 0.06. Now, determine the percentage price movement if interest rates climb 1%—$1.50 ÷ 0.07 = $21.43. This is a decline of $3.57, or 14.28%.
The reason for using a ladder bond strategy is to A) turn a paper loss into an actual loss. B) lower interest rate risk. C) magnify gains. D) spread cash flows evenly over a given time horizon to eliminate default ri
For example, with a ladder bond strategy, instead of investing all money in a seven-year bond, an investor may divide the dollars among bonds with one, three, five, seven, and nine-year maturities. With this approach, instead of making a single bet on interest rates, the investor has both longer and shorter maturities, so that regardless of which way interest rates move the investor will not experience either great losses or great gains. LO 2.3.1
Bonds issued by state and local governments that are backed by the full faith and credit of the issuing government and repaid by the issuing municipality's taxing power are categorized as A) general obligation bonds. B) revenue anticipation bonds. C) revenue bonds. D) tax anticipation notes.
General obligation bonds (GOs) are the most secure of all municipal debt because they are backed by the full faith and credit of the issuer. Municipalities may increase taxes to make principal and interest payments on any debt issue; therefore, a voter referendum is usually required to approve their issuance.
Which of the following correctly illustrates a characteristic of an investment-grade general obligation municipal bond? A) The bond retains a direct claim on specific property. B) The taxing authority of the issuing government or municipality backs the issue's repayment. C) The bond's main source of investment risk is financial risk. D) The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality.
General obligation bonds are backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body. The main source of investment risk for a municipal security is interest rate risk. General obligation bonds do not retain a claim on specific property. The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, pay interest when sufficient revenue is collected from the financed project.
Which of the following risks relating to fixed-income investments have an offsetting effect on one another? A) Interest rate risk and reinvestment rate risk B) Interest rate risk and default risk C) Interest rate risk and purchasing power risk D) Interest rate risk and call risk Explanation
Interest rate risk and reinvestment rate risk have offsetting effects, and the offsetting of these two risks in a bond portfolio takes place through immunization (the matching of the durations of bonds to the durations of liabilities).
Consider the yield curves below. Assume yield curve 1 (YC1) changed to yield curve 2 (YC2) over a period of time. Which of the following can be interpreted from these yield curves? The Fed has been decreasing the money supply. Duration has decreased. Interest rates for all time periods have decreased. The yield curve was positive at the time of YC1. A) II and III B) III and IV C) I and IV D) I, III, and IV
Option I is incorrect because the yield curve rises when the Fed tightens the money supply. Option II is incorrect because duration and interest rates are inversely related; when rates fall, duration rises. LO 2.4.1
Which of the following statements correctly describe differences between corporate preferred stock and long-term bonds? Bonds represent a creditor position; preferred stock represents an equity position. Bonds pay a fixed amount of interest; preferred stock pays a fluctuating dividend based on earnings. Interest paid by firms is a tax-deductible expense; dividends paid on preferred stock are not tax deductible. Bonds usually are not rated; preferred stock usually is rated. A) II and III B) I and IV C) III and IV D) I and III
Option II is not correct because preferred stock pays a fixed dividend. Option IV is not correct because almost all bonds, except some municipal and all U.S. government bonds, are rated.
A convertible bond has a par value of 1,000, a current market value of $1,200, and an investment value of $1,050. The bond is convertible into 25 shares of common stock. What is the investment premium of this bond? A) $75 B) $100 C) $200 D) $150
The answer is $150. The investment premium is a measure of the downside risk of the bond and is the difference between the current market value and the investment value. $1,200 - $1,050 = $150 investment premium.
A client is considering the purchase of a $25 par preferred stock to add income to his portfolio. The stock has an 8% stated annual dividend rate and will never change. The investor's discount rate is 12%. What is the most the investor should pay for this stock? A) $16.67 B) $3.20 C) If the required return exceeds the coupon rate, another valuation method must be used. D) The value cannot be determined without an appropriate growth rate.
The answer is $16.67. The zero growth or dividend in perpetuity formula would apply: 8% of $25 par is $2.00, so $2.00 ÷ 0.12 = $16.67
Chuck owns a convertible bond that has a conversion price of $40 per share and a coupon of 5.5%. Interest is paid semiannually. The current market price of the stock is $41 per share. The investment value of the bond is $940, and the bond currently sells for a market price of $1,120. What is the downside risk of this bond? A) $95 B) $120 C) $180 D) $85
The answer is $180. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,120 - $940 = $180.
George Jones owns a convertible bond that has a conversion price of $50 per share and an annual coupon rate of 6.0%. Interest is paid semiannually. The current market price of the stock is $51 per share. The investment value of the bond is $890, and the bond currently sells for a market price of $1,080. What is the downside risk of this bond? A) $190 B) $130 C) $210 D) $155
The answer is $190. The downside risk of a convertible bond is the dollar or percentage decline from the current market price of the convertible bond to the investment value of the bond: $1,080 - $890 = $190.
Today, a U.S. Treasury STRIP (Separate Trading of Registered Interest and Principal of Securities) bond has been created with a $100,000 par value, seven-year, 3% Treasury note. Assuming prevailing seven-year market rates are 4%, calculate the market value of the principal unit (rounded to nearest dollar). A) $92,665 B) $82,772 C) $72,788 D) $75,992
The answer is $75,992. If prevailing market interest rates are 4%, the principal unit is priced as follows: 100,000 = FV 7 = N 4 = I/YR 0 = PMT Solve for PV = 75,991.7813, or $75,992
Ellen purchased a BB rated convertible bond of TCD Corporation that has a 10% coupon and matures in nine years. Comparable debt (BB rated, nine years to maturity) yields 12%. The bonds are convertible at $32 per share of common stock, and the current market price of TCD common stock is $25. What is the conversion value of this bond? A) $800.00 B) $781.25 C) $916.25 D) $893.50
The answer is $781.25. The conversion value = conversion ratio × market price of common stock. Therefore, the conversion value equals ($1,000 ÷ $32) × $25 = $781.25.
Norma owns ABC Corporation bonds of AA rated quality that mature in seven years, pay semiannual interest, and have a coupon of 8%. Similar bonds (AA rated, seven years to maturity) yield 9%. The ABC Corporation bonds are convertible into common stock at $26 per share, and the current market price of ABC common stock is $23. What is the conversion value of an ABC Corporation bond? A) $766.47 B) $923.08 C) $851.85 D) $884.61
The answer is $884.61. The conversion value = conversion ratio × market price of common stock. Therefore, the conversion value equals ($1,000 ÷ $26) × $23 = $884.61.
Chris owns a bond that is convertible into common stock at $38 per share and has a coupon of 6.0%. Interest is paid semiannually. The current market price of the stock is $42 per share. The investment value of the bond is $1,050, and the bond currently sells for a market price of $1,225. Which one of these percentages is closest to the downside risk of this bond? A) 9.80% B) 4.98% C) 18.37% D) 14.29% Explanation
The answer is 14.29%. The downside risk of the bond is $175 ($1,225 current market price - $1,050 investment value). This translates into 14.29% ($175 downside risk ÷ $1,225 current market value).
Darla, a U.S. citizen and resident of Georgia, owns a 5% coupon corporate bond, a 4% coupon State of Georgia municipal bond, and a 3% coupon U.S. Treasury note. Darla's marginal state income tax rate is 6% and federal tax rate is 24%. If Darla invested equal amounts in each of the three bonds, what is her after-tax rate of return on the portfolio? A) 3.26% B) 4.91% C) 2.86% D) 4.00%
The answer is 3.26%. Because the corporate bond is taxable by the state and the federal government, its after-tax return is 3.5% [5% × (1 - 0.30)]. The State of Georgia municipal is not taxable by either government entity. The Treasury note is taxable by the federal government; therefore, its after-tax return is 2.28% [3% × (1 - 0.24)]. Averaging the three rates equals 3.26% [(3.5% + 4% + 2.28%) ÷ 3].
XYZ Corporation issues a 20-year callable bond paying a 6% coupon (semiannual payments) selling at par ($1,000). XYZ Corporation has the option to call the bonds in five years for 105% of par value. Calculate the bond's nominal yield. A) 5.00% B) 6.00% C) 6.86% D) 4.86%
The answer is 6.00%. The nominal yield (coupon rate) is 6%. The nominal yield is stated as a percentage of the par value of the bond.
Tom owns a taxable investment that earns 8% interest annually. Tom pays taxes at a marginal rate of 24%. Calculate the after-tax rate of return that Tom will receive on this investment. A) 2.24% B) 6.25% C) 6.08% D) 6.30%
The answer is 6.08%. The after-tax return is 8% × (1 − 0.24) = 6.08%.
Terri has been an active investor for many years, and her present portfolio consists of listed stocks, penny stocks, and options. She earns approximately $175,000 annually, has $35,000 in cash to invest, and is in the 32% marginal income tax bracket. Terri is interested in accumulating wealth for the future and does NOT need current income. Which one of these fixed-income securities best suits Terri's needs at this time? A) AAA rated, premium, intermediate-term, tax-free, municipal general obligation bond B) AAA rated, par value, short-term, U.S. Treasury bond C) A rated, discount, long-term, tax-free, municipal revenue bond D) A rated, par value, short-term, corporate debenture bond
The answer is A rated, discount, long-term, tax-free, municipal revenue bond. Because Terri is in a high income tax bracket, an investment-grade municipal bond would be the best choice. The long-term nature of this bond may afford Terri a higher net interest payment than the other bonds.
Choose the agency issue which historically did NOT have an indirect backing and guarantee of the U.S. government. A) Student Loan Marketing Association B) Federal National Mortgage Association C) Government National Mortgage Association D) Federal Home Loan Mortgage Corporation
The answer is Government National Mortgage Association. Historically, only GNMA had a direct backing and guarantee from the U.S. government.
Which of these statements correctly describes differences between preferred stock and long-term bonds? Interest paid by firms is a tax-deductible expense; dividends paid on preferred stock are not tax deductible. Bonds usually have a finite maturity; preferred stock is usually perpetual. Bonds pay a fixed amount of interest; preferred stock pays a fluctuating dividend based on earnings. Interest on bonds and preferred stock dividends are legal obligations of a firm that must be paid. A) I and II B) II and III C) I and III D) I, II and IV
The answer is I and II. Bonds pay a fixed periodic interest that is tax deductible by the firm; preferred stock dividends are fixed, but they are not tax deductible. Only the interest on bonds is a legal obligation that must be paid; dividends on preferred stock can be deferred (if there is a cumulative feature) or skipped.
Portfolio immunization is designed to protect bondholders from which of the following risks? Interest rate risk Reinvestment rate risk Default risk A) II and III B) I and II C) I, II, and III D) I and III
The answer is I and II. Portfolio immunization protects bondholders from fluctuations in interest rates and from reinvestment rate risk but does not protect against default risk.
Identify which of these statements regarding revenue bonds is NOT correct. They are secured by a specific pledge or property. They are a type of full faith and credit bond. Their interest is tax-exempt at the federal level. They are analyzed by the project's ability to generate earnings. A) I and II B) III and IV C) II and IV D) I and III
The answer is I and II. Revenue bonds are not secured by property and are not a type of general obligation bond. They are only secured by user fees.
A $1,000 bond may be converted into common stock at $40 per share. The current market price of the stock is $35 per share. The bond matures in 15 years, has a 7% coupon, and a current market price of $914. The current interest rate paid on comparable debt is 8%. Calculate the conversion value of the bond and determine which of these statements are CORRECT. The bond is selling at a premium over its conversion value. The bond should be converted because its conversion value is less than its value as a bond. The bond should not be converted because its conversion value is less than its value as a bond. The market price of the stock will increase as the market price of the bond increases. A) I and III B) I, III, and IV C) I only D) I and II
The answer is I and III. The bond is currently selling for a premium ($914) over its conversion value [($1,000 ÷ 40) × $35 = $875]. Therefore, the bond should not be converted.
Identify which of these statements regarding bonds is CORRECT. If a bond is issued in registered form, payments will be made to the owner of record. If a bond is issued in bearer form, payments will be made to whoever holds or possesses the bond. A bond acquired in the secondary market at a discount is called a market discount bond. The amount attributable to a market discount is always includable in income in the year of acquisition. A) II, III, and IV B) I, II, and III C) II and IV D) I only Explanation
The answer is I, II and III. Only statement IV is incorrect. A bond is a debt security obligating the issuer to make periodic interest payments and to repay the principal at the time of maturity. The amount attributable to a market discount is generally not includable in income until sale or disposition of the bond, and then it is treated as interest income.
Identify which of these statements regarding zero-coupon bonds is NOT correct. Zero-coupon bonds are purchased at par and defer interest payments until maturity. Because there are no coupon payments for zero-coupon bonds, no current income is recognized. A zero-coupon bond is issued at a discount and pays semiannual interest payments. Corporations may favor zero-coupon bonds because they have an extended period to use the money that has been raised by the offering. A) I, II, and III B) I and IV C) II and III D) IV only
The answer is I, II, and III. Zero-coupon bonds are issued at a discount and pay only the par value at maturity; 'interest' is not paid during the term of the bond but 'interest/growth' are paid at the end. Even though no periodic interest payments are made, the bondholder must recognize the accrued interest each year for income tax purposes.
Which of these describe similarities between preferred stock and long-term bonds? Both dividends and interest are tax-deductible expenses for the issuing corporations. Both generally pay a fixed periodic payment. Both preferred dividends and interest must be paid before common stock cash dividends are paid. A) I and III B) I and II C) II and III D) III only
The answer is II and III. Both preferred stock and long-term bonds generally pay a fixed periodic payment, and both preferred dividends and interest must be paid before common stock cash dividends are paid.
Which of these describe differences between preferred stock and long-term bonds? Preferred stock usually has a shorter maturity than long-term bonds. Corporations receive more favorable tax treatment when investing in preferred stock than when investing in long-term bonds. Preferred stock dividends are a stronger legal obligation to the firm than interest payments on long-term bonds. The market price of preferred stock tends to fluctuate more than the market price of long-term bonds. A) II and IV B) I and III C) II and III D) I and IV
The answer is II and IV. Corporations receive preferential tax treatment when investing in preferred stock. The market price of preferred stocks is more volatile than long-term bonds when interest rates fluctuate.
A transaction whereby an investor sells a bond for a loss, in order to reduce capital gains, while investing the proceeds of the sale in a bond of similar quality and maturity is considered A) a tax swap. B) a pure yield pickup swap. C) an intermarket spread swap. D) a substitution swap.
The answer is a tax swap. A tax swap results in a tax savings generated by the realized loss.
Which of these statements regarding bond portfolio immunization is CORRECT? Immunization allows an investor to ensure that the value of his or her bond portfolio remains the same, regardless of whether interest rates increase or decrease. Immunization is accomplished by creating a portfolio whose duration is equal to the investor's investment time horizon. Immunization allows investors to earn a current yield that is equal to the yield to maturity. Immunization allows an investor to earn a specific rate of return, regardless of whether interest rates increase or decrease. A) I and II B) II and IV C) III only D) I, III, and IV
The answer is II and IV. Immunization attempts to protect the yield of a bond portfolio from changes in interest rates. An immunized portfolio is expected to provide a specific return over the investment time horizon. If interest rates change during the investment period, the capital losses are expected to be offset by the gains on reinvestment income. Immunization is accomplished by creating a portfolio whose duration is equal to the investor's investment time horizon.
Select which of these statements regarding Treasury notes and Treasury bonds is CORRECT. Both Treasury notes' and bonds' interest payments are income tax free at the state and federal level. Treasury notes and bonds are considered default risk free. If held for more than one year, interest paid on Treasury bonds is eligible for long-term capital gain treatment. Both Treasury notes and bonds are not traded in the secondary market. A) II only B) I and II C) I, III, and IV D) III and IV
The answer is II only. Both Treasury notes and bonds are considered default risk free. Both obligations trade in the secondary market and pay interest, which is income tax free at both the state and local level, but taxed as ordinary income in the year earned at the federal level.
Barbara, a Louisiana resident, is in the 35% marginal federal income tax bracket and the 6% marginal state income tax bracket. Select the bond that would provide Barbara with the highest after-tax rate of return. A) Corporate bond with a coupon rate of 8% B) Texas municipal bond with a coupon rate of 5.8% C) U.S. Treasury bond with a coupon rate of 6% D) Louisiana municipal bond with a coupon rate of 5.5%
The answer is Louisiana municipal bond with a coupon rate of 5.5%. U.S. Treasury bond (exempt from state income tax): 6% × (1 - 0.35) = 3.90% Corporate bond: 8% × [1 - (0.35 + 0.06)] = 4.72% Texas municipal bond (exempt from federal income tax): 5.8% × (1 - 0.06) = 5.45% Louisiana municipal bond (exempt from both federal and state income tax): 5.5%
Sam holds a considerable amount of both Series EE and Series HH savings bonds. He is nearing retirement and likes the fact that his Series HH bonds pay interest semiannually and would like to exchange most of his Series EE bonds for Series HH bonds to increase his cash flow. Choose which of these statements regarding such an exchange is CORRECT. A) Sam may exchange the bonds but must recognize the Series EE accrued interest at the time of exchange. B) Sam may exchange the bonds but will be subject to a three-month interest penalty. C) Only Sam's Series EE bonds issued prior to 2004 may be exchanged. D) Series EE bonds may no longer be exchanged for Series HH bonds.
The answer is Series EE bonds may no longer be exchanged for Series HH bonds. Until September 2004 (when Series HH bonds were no longer issued by the Treasury), the exchange of EE bonds for HH bonds was a popular way of continuing the income tax deferral on the accrued interest portion of the EE bonds. Such changes are no longer possible.
All of these statements correctly describe yield curves except A) a flat yield curve occurs when the economy is peaking and, therefore, no change in future interest rates is expected. B) a positive yield curve can signal an upcoming economic recession. C) an inverted yield curve occurs when the Federal Reserve has tightened credit in an overheating economy. D) a normal yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise in the future.
The answer is a positive yield curve can signal an upcoming economic recession. A positive (or normal) yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise.
Carol sells her AA rated 5% YTM bond for $940 and buys a BB-rated 6% bond for $900. Both bonds mature in four years. This transaction illustrates which of these swaps? A) An intermarket swap B) A rate anticipation swap C) A substitution swap D) A pure yield pickup swap Explanation
The answer is a pure yield pickup swap. In a pure yield pickup swap, a lower YTM bond is substituted for a higher YTM bond. LO 2.3.1
Expecting rising interest rates, an investor sells his BB rated, 3.5% coupon bonds with 20-year maturities and purchases A rated, 6% coupon bonds with maturities of four years. The investor has executed A) a pure yield pickup swap. B) an intermarket swap. C) a tax swap. D) a rate anticipation swap.
The answer is a rate anticipation swap. A rate anticipation swap seeks to take advantage or avoid the impact of expected changes in interest rates.
Select which of these statements regarding Series I savings bonds is CORRECT. A) A semiannual inflation rate is combined with the fixed rate of return to determine the Series I bond's interest rate for the next six months. B) A fixed interest rate is paid on an inflation-adjusted principal amount every six months. C) Series I bonds are always subject to state and federal income taxation. D) Series I bonds pay semiannual interest in cash.
The answer is a semiannual inflation rate is combined with the fixed rate of return to determine the Series I bond's interest rate for the next six months. The interest rate is a combination of two separate rates: (1) a fixed rate of return that remains the same for the life of the bond and (2) a semiannual inflation rate based on changes in the Consumer Price Index (CPI) during the previous six-month period. The semiannual inflation rate is then combined with the fixed rate of return to determine the Series I bond's interest rate for the next six months.
An active bond management strategy, where one bond is swapped for another bond with similar characteristics but a higher yield to maturity, is considered A) a rate anticipation swap. B) an intermarket spread swap. C) a substitution swap. D) a pure yield pickup swap.
The answer is a substitution swap. A substitution swap is an active investment strategy whereby one bond is swapped for another bond with almost identical characteristics other than yield to maturity. The substitution swap capitalizes on bond market inefficiency. An intermarket spread swap involves the exchange of one type of bond (e.g., government bond) with another type of bond (e.g., corporate bond). This occurs when investors believe one type of bond is currently mispriced in relation to the other. The goal of this type of swap is to capitalize on a yield to maturity (YTM) disparity across bond markets. A pure yield pickup swap involves selling short-term bonds and purchasing long-term bonds. A rate anticipation swap is one in which bonds are swapped as a result of expected changes in interest rates.
Choose the CORRECT statement regarding yield curves. A) A normal yield curve occurs during periods of economic expansion and generally predicts that market interest rates will rise in the future. B) All of these statements are correct. C) A flat yield curve occurs when the economy is peaking and, therefore, no near-term change in future interest rates is expected. D) An inverted yield curve occurs when the Federal Reserve has tightened credit in an inflationary economy.
The answer is all of these statements are correct. The yield curve is a graph of interest rate yields for bonds of the same quality, ranging in maturity from 31 days to 30 years. An inverted yield curve predicts interest rates will fall and sometimes can signal an upcoming recession.
An investor who carefully chooses a bond that has a duration that matches the investor's required holding period is practicing A) a passive holding strategy. B) an indexing strategy. C) an immunization strategy. D) an active management strategy.
The answer is an immunization strategy. An investor who chooses a bond that has a duration equal to the investor's desired holding period is practicing immunization. Because a bond's reinvestment rate risk and price risk tend to 'offset' each other, immunization can be used to cancel out interest rate risk.
Identify which of these is NOT a characteristic of a normal yield curve. A) The curve has a tendency to slope upward and outward. B) A normal yield curve indicates that long-term market interest rates are higher than short-term rates. C) As the maturity date of bonds lengthens, the corresponding bond yield decreases. D) A normal yield curve occurs during periods of economic expansion.
The answer is as the maturity date of bonds lengthens, the corresponding bond yield decreases. When the maturity date of the bonds lengthen, the corresponding yields will increase.
An investor wants all of her bonds to mature in 10 years. She buys two bonds immediately, two bonds two years from now, and two more bonds four years from now. As a result, the bonds purchased immediately have a maturity of 10 years, the bonds purchased two years later have a maturity of eight years, and the bonds purchased four years later have a maturity of six years. Select the type of bond strategy she is using for her portfolio. A) Bond ladder B) Bond bullet C) Bond barbell D) Bond swap
The answer is bond bullet. When using the bond bullet strategy, an investor purchases a series of bonds with similar maturities focused on one point in time. This strategy may be an effective method in matching duration to the cash needs of an investor.
Which of the following statements regarding duration is CORRECT? Risk-averse investors should consider bonds with low durations. Aggressive investors should consider bonds with low durations when they anticipate that interest rates will rise. A) Both I and II B) I only C) Neither I nor II D) II only
The answer is both I and II. Risk-averse investors should consider bonds with low durations. Aggressive investors should consider bonds with high durations when they anticipate that interest rates will decline, and they should consider bonds with low durations when they anticipate that interest rates will rise.
Which of the following statements is CORRECT? If an investor expects a decline in market interest rates, she should attempt to construct a portfolio of long maturity bonds with low coupon rates. If the investor expects an increase in market interest rates, he should attempt to construct a portfolio of short maturity bonds with high coupon rates. A) II only B) I only C) Both I and II D) Neither I nor II
The answer is both I and II. The portfolio in Statement I will provide the investor with a portfolio that has the maximum interest rate sensitivity to take advantage of the capital gains experienced by bonds from the decrease in market interest rates. The portfolio in Statement II will provide the investor with a portfolio that has the minimum interest rate sensitivity to minimize the capital losses experienced by bonds from the increase in market interest rates.
Select which of these is NOT a primary risk associated with a coupon-paying bond. A) Interest rate risk B) Purchasing power risk C) Debenture risk D) Default risk
The answer is debenture risk. A coupon-paying bond is also subject to reinvestment rate risk.
If an investor is looking to purchase bonds that are free from default risk, which of these should be purchased? A) Corporate bonds B) Municipal bonds C) Revenue bonds D) Government bonds Explanation
The answer is government bonds. Unlike corporate, revenue, and municipal bonds, government bonds are free from default risk.
Revenue bonds are used to finance any municipal facility that generates sufficient income to satisfy the ongoing debt obligation. Which of these is NOT a type of revenue bond? A) Housing debentures B) Special tax bonds C) Industrial development revenue bond D) Special assessment bond
The answer is housing debentures. New housing authority (or Section 8) bonds are an example of a revenue bond.
If a bond is immunized against interest rate risk, a dollar decline in the bond's price, resulting from rising interest rates, will be approximately offset by a dollar increase in the A) price of comparable bonds in the market. B) bond's call price. C) income from coupons reinvested over the investment horizon. D) bond issuer's common stock
The answer is income from coupons reinvested over the investment horizon. By investing in bonds that have a duration equal to the investor's investment time horizon, any bond price/value changes caused by interest rate fluctuations will be approximately offset by changes in the interest earned on the reinvested coupons.
Immunization offsets which two risks in a bond portfolio? A) Liquidity risk and market risk B) Interest rate risk and reinvestment rate risk C) Reinvestment rate risk and call risk D) Interest rate risk and default risk
The answer is interest rate risk and reinvestment rate risk. Immunization offsets interest rate risk and reinvestment rate risk.
he risk associated with volatility in the price of securities due to shifts in the yield curve is A) financial risk B) interest rate risk C) liquidity risk D) unsystematic risk Explanation
The answer is interest rate risk. When a yield curve shifts, that means that interest rates have changed. When interest rates change, bond prices change. If rates rise, bond prices fall; if rates fall, bond prices rise.
A convertible bond's market value will NOT fall below A) a floor guaranteed by the issuer. B) none of the these. C) its investment value. D) its conversion value. Explanation
The answer is its investment value. A convertible bond's market value will not fall below its investment value.
The interest rate theory that states investors are compensated for the increased price risk of holding long-term maturities is known as A) liquidity preference theory. B) unbiased expectations theory. C) preferred habitat theory. D) market segmentation theory.
The answer is liquidity preference theory. The liquidity preference theory holds that long-term bonds should provide higher returns than shorter-term obligations because investors are willing to sacrifice some yield to invest in short-term bonds in order to avoid the higher price volatility of longer-term issues.
Which of these investments should be recommended during periods of falling interest rates? A) Short-term bonds B) U.S. Treasury bills C) Long-term bonds D) Money market mutual funds
The answer is long-term bonds. If an investor anticipates a drop in interest rates, he or she should take a more bullish attitude toward interest-sensitive investments like long-term bonds.
An investor would consider converting a convertible bond into common stock if the bond's A) market price is less than the conversion value. B) duration exceeds 10 years. C) yield to call is the same as a comparable municipal bond. D) yield to maturity is less than its conversion premium.
The answer is market price is less than the conversion value. An investor would consider converting a convertible bond into common stock if the bond's conversion value exceeds its market price.
Identify the yield-curve theory that relies on the laws of supply and demand for various maturities of borrowing and lending. A) Brownian theory B) Unbiased expectations theory C) Market segmentation theory D) Liquidity premium theory
The answer is market segmentation theory. Market segmentation theory relies on the laws of supply and demand for various maturities of borrowing and lending. Unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates. The liquidity premium theory is based on the unbiased expectations theory but incorporates a liquidity premium into the model.
To immunize a bond portfolio over a specific investment horizon, an investor would do which of the following? A) Match the duration of each bond to the investment horizon. B) Match the average weighted duration of the bond portfolio to the investment horizon. C) Match the average weighted maturity of the portfolio to the investment horizon. D) Match the maturity of each bond to the investment horizon. Explanation
The answer is match the average weighted duration of the bond portfolio to the investment horizon. When a portfolio is immunized, its liabilities and expected future cash outflows are funded by making sure that the cash flow from investments (income and principal) will be there at the time that the cash outflow is needed. That is done by matching the duration, not the maturity, of the bond portfolio to the number of years until the cash outflow will occur. The duration of the portfolio as a whole should be matched, not the duration of each bond in the portfolio.
Which one of these is CORRECT regarding preferred stock? A) Preferred stockholders have voting rights. B) Failure to pay preferred stock dividends results in bankruptcy. C) Preferred stock's value is based on prevailing interest rates. D) Preferred stock's dividends are tax deductible for corporations.
The answer is preferred stock's value is based on prevailing interest rates. The value for a preferred stock is its dividend divided by prevailing interest rates.
Which one of these risks is specifically related to mortgage pass-through securities? A) Credit risk B) Liquidity risk C) Prepayment risk D) Default risk
The answer is prepayment risk. The payments received from mortgage-backed securities consist of both interest and principal payments. When interest rates fall, homeowners refinance their homes, thereby paying off the principal on the original mortgages. This prepayment of principal is called prepayment risk.
An individual with a short-term investment time horizon would choose what type of bonds when interest rates are expected to rise? A) Short-term bonds B) Long-term bonds C) High-yield bonds D) Low-coupon, long-term bonds
The answer is short-term bonds. Long-term bonds are affected by interest rate changes more than short-term bonds. If interest rates are expected to rise, an investor should invest in short-term bonds until rates peak. Risk of default of high-yield bonds increases when rates rise.
Which of these statements regarding the bond ladder strategy is CORRECT? A) A laddered portfolio will provide lower yields than a portfolio consisting entirely of short-term bonds. B) The bond ladder strategy involves the purchase of a mixture of very long-term and very short-term bonds. C) The bond ladder strategy is used to immunize a portfolio against interest rate risk. D) The bond ladder strategy is generally more aggressive than the barbell strategy.
The answer is the bond ladder strategy is used to immunize a portfolio against interest rate risk. It is an investment strategy in which equal amounts of money are invested in a series of bonds with staggered maturities. The barbell strategy involves the purchase of a mixture of very long-term and very short-term bonds. The laddered portfolio will provide higher yields than a portfolio consisting entirely of short-term bonds. The barbell strategy is generally more aggressive than the ladder strategy because the barbell strategy only utilizes short-term and long-term bonds.
According to the unbiased expectations theory of interest rates, A) an upward sloping yield curve indicates that investors require a yield premium to invest in long-term securities. B) the current long-term rate is the average of today's short-term rate and expected future short-term rates. C) yields are a function of the supply and demand of funds in each maturity segment of the market. D) investors require a higher yield on long-term bonds because they are riskier.
The answer is the current long-term rate is the average of today's short-term rate and expected future short-term rates. The other statements relate to the liquidity premium theory and the market segmentation theory. Under the unbiased expectations theory, an upward sloping yield curve indicates increasing inflation expectations.
The conversion value of a convertible bond with a conversion ratio of 25, a conversion price of $40, and a market price of the underlying stock of $32 is A) $1,000. B) $900. C) $800. D) $200. Explanation
The conversion value is the value if converted and is determined by multiplying the market price of the underlying stock by the conversion ratio: $32 × 25 = $800
Martha owns a convertible bond that has a current market value of $1,200. The bond's conversion ratio is 22 shares, and its conversion value is $1,100. The bond has a coupon of 8%, payable semiannually, and matures in 16 years. With market interest rates currently at 7.5%, the bond's investment value is $1,050. Martha wants to sell the convertible bond if, assuming the stock falls in price, her risk of loss exceeds 10%. Which one of these statements about this convertible bond is CORRECT? A) The downside risk exceeds 10%, and the bond should be sold. B) The downside risk is between 5% and 10%, and the bond should be retained. C) Downside risk is not a factor when the conversion price exceeds the investment value of the bond. D) Downside risk cannot be calculated because the price of the stock is not given.
The answer is the downside risk exceeds 10%, and the bond should be sold. The downside risk of the bond is $170 ($1,200 current market value - $1,050 investment value). This translates into 14.17% ($170 downside risk ÷ $1,200 current market value). Therefore, the bond should be sold.
Which of these statements regarding Treasury Inflation-Protected Securities (TIPS) is CORRECT? A) The principal value is adjusted for inflation every six months based on the Consumer Price Index (CPI), and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value. B) TIPS are issued at 50% of the par value with the par value being adjusted every six months for inflation. C) A semiannual inflation rate is combined with the stated coupon rate to determine the TIPS interest rate for the next six months. D) The TIPS coupon rate is adjusted every 12 months based on changes in the Consumer Price Index (CPI). Explanation
The answer is the principal value is adjusted for inflation every six months based on the CPI, and one-half of the stated coupon rate is paid semiannually on the inflation-adjusted principal value. TIPS coupon rate stays the same for the life of the security, but the interest payment changes based on the inflation-adjusted principal or par value.
What is one disadvantage of investing in convertible bonds? A) The dividend yield on the underlying stock is usually greater than the interest income on the bonds. B) There is substantial business and market risk. C) The likelihood of a call increases as the price of the underlying stock decreases. D) The yield to maturity tends to be lower than that of similar nonconvertible bonds.
The answer is the yield to maturity tends to be lower than that of similar nonconvertible bonds. A disadvantage of investing in a convertible bond is that its yield to maturity tends to be lower than a similar nonconvertible bond due to the conversion feature.
Which of these statements correctly explain zero-coupon bonds? A) They sell at a premium. B) They eliminate reinvestment rate risk. C) They have low interest rate risk. D) They offer minimum price volatility.
The answer is they eliminate reinvestment rate risk. Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. They are redeemed for their face value at maturity. These bonds have maximum price volatility and respond sharply to interest rate changes.
The yield curve theory that states current long-term interest rates contain an implicit prediction of future short-term interest rates is known as A) market segmentation theory. B) liquidity preference theory. C) unbiased expectations theory. D) preferred habitat theory.
The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates.
The interest rate theory that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates is known as A) rate preference theory. B) preferred habitat theory. C) market segmentation theory. D) unbiased expectations theory.
The answer is unbiased expectations theory. The unbiased expectations theory states that long-term rates consist of many short-term rates and that long-term rates will be the average of short-term rates.
The yield curve graphically plots A) yield on the y-axis and price on the x-axis. B) yield on the y-axis and time on the x-axis. C) price on the y-axis and yield on the x-axis. D) price on the y-axis and time on the x-axis.
The answer is yield on the y-axis and time on the x-axis. Yield on the y-axis, plotted against time, on the x-axis, is the yield curve.
Yield curves are constructed from daily information published on U.S. Treasury bond A) current yields. B) coupon payments. C) yields-to-maturity. D) yields-to-call.
The answer is yields-to-maturity. Yields-to-maturity represent a bond's promised yield if held to maturity.
Identify the statement that best describes Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities). A) A trust receipt issued by a U.S. government agency for shares of a domestic company purchased and held by a credit union B) Zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note or bond C) A negotiable, short-term, unsecured promissory note issued by a regional government agency D) A short-term draft drawn by a government agency on a major bank Explanation
The answer is zero-coupon bonds created by separating the semiannual coupon payments and the principal repayment portions of a U.S. Treasury note and bond. Although the securities underlying Treasury STRIPS are the U.S. government's direct obligation, major banks and dealers perform the actual separation and trading.
The coupon rate or nominal yield of a bond is the stated annual interest rate that will be paid each period for the term of the bond. Select the statement that best describes how the coupon rate is stated. A) As a percentage of the par value of the bond B) As a percentage of the annuitized value of the bond C) As a percentage of the intrinsic value of the bond D) As a percentage of the discount rate of the bon
The coupon rate is stated as a percentage of the par value.
One advantage of convertible bonds is that they A) are usually offered only by firms with high bond credit ratings. B) offer the ability to buy the underlying stock at a discount. C) have a higher coupon rate than the underlying stock's dividend. D) have higher coupon rates than straight coupon bonds. Explanation
The coupon rate on the convertible bond is usually greater than the stock's dividend yield because the stock usually pays little, if any dividends. This enables the investor to get a higher periodic cash flow while waiting for the stock to appreciate.
What is the downside risk of a 6% coupon convertible bond currently trading at $1,040 with a maturity of 12 years and a conversion value of $950? The current interest rate on comparable debt is 7.5%. A) $40 B) $157 C) $50 D) $90 Explanation
The downside risk of a convertible bond is the difference between the market price and its investment value. To determine the investment value, calculate what the bond would be worth based just on interest rates. Use a financial calculator with the following inputs:
ennifer owns a state public purpose bond. She sells the bond and realizes a capital gain of $4,000. Prior to selling the bond, the total interest she had earned for the year was $99. Considering the sale and the interest amount, calculate the amount she must include in gross income. A) $4,099 B) $4,000 C) $3,901 D) $99 Explanation
The interest on public purpose bonds is received tax-free by the holder. Only the capital gain realized on the sale is subject to income taxation.
An investor pays a premium for a convertible bond because A) the investor is buying a straight bond and selling a put option. B) the investor is buying a straight bond and buying a put option. C) the investor is buying a straight bond and selling a call option. D) the investor is buying a straight bond and buying a call option. Explanation
The investor is long the straight bond (bought) and long the call option (bought).
The reason for using a barbell bond strategy is to A) maximize the potential capital gain in a bond portfolio. B) increase interest rate risk. C) decrease default risk. D) offset price and reinvestment rate risk.
The purpose for using a barbell strategy in a bond portfolio is to offset the opposite effects of interest rates on bond prices. If rates rise, short-term bonds can be reinvested at higher rates. If rates drop, long-term bonds are used to lock in rates.
The main purpose of a laddered bond portfolio is to A) minimize the effect of changes in interest rates. B) have a higher yield to maturity. C) increase the duration of a bond portfolio. D) achieve the highest possible capital gains when interest rates decline. Explanation
The purpose of a laddered strategy is to minimize the effect of swings in interest rates. Rather than trying to forecast interest rates, an investor spreads out the bond investment over a period of time.
Which of the following is CORRECT with respect to convertible bonds and convertible preferred stock if the value of the common stock rises? A) The value of convertible bonds rises, but convertible preferred stock falls. B) The value of convertible bonds and convertible preferred stock declines. C) The value of convertible bonds and convertible preferred stock rises. D) The value of convertible bonds falls, but convertible preferred stock rises. Explanation
The value of any convertible will rise with a rise in the underlying common stock into which it can be converted. The convertibles will not necessarily have the same gain; it will depend on their premium and conversion terms.
Cindy, 38, has been an active investor for many years. She currently has a money market mutual fund and has a number of equity mutual fund shares. She wants to maximize her return on an intermediate-term bond and plans to hold the bond to maturity. Which of these two bonds would be more appropriate for Cindy and why? Bond 1: callable at par value; BBB rated; coupon = 6%; matures in six years; selling for $863; duration = 5.16 Bond 2: callable at par value; A rated; coupon = 10%; matures in four years; selling for $1,103; duration = 3.5 Bond 1, because it is selling for a discount and is less likely to be called. Bond 1, because it has a higher yield to maturity than Bond 2. Bond 2, because its higher coupon gives it a better total return. Bond 2, because it has a higher yield to maturity than Bond 1. A) III and IV B) I and II C) I only D) II only Explanation
YTM for Bond 1 is calculated with the following inputs: - $863 = PV $1,000 = FV $1000 x 6% = $60/2 = $30 = PMT N = 12 (6 x 2 periods per year) Solve for I/YR = 9% YTM Bond 2 is calculated with the following inputs: -$1,103 = PV $1,000 = FV $1000 x 10% = $100/2 = $50 = PMT N = 8 (4 x 2 periods per year) Solve for I/YR = 7% In addition, Bond 1 is selling at a discount—unlike Bond 2 selling at a premium—so it is not likely to be called. NOTE: there are several examples on bond calculations in the blue boxes in Module 2; however, it may be necessary to skip ahead to Module 7 for some additional practice.
Which of these is a feature of zero-coupon bonds? A) Have a duration less than their term to maturity B) Offer minimum price volatility C) Have low interest rate risk D) Eliminate reinvestment rate risk Explanation
Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. They are redeemed for their face value at maturity. These bonds have maximum price volatility and respond sharply to interest rate changes. Zero-coupon bonds have durations equal to their term to maturity.
If interest rates are expected to decrease in the near future, which of the following combinations of strategies is recommended? A Buy bonds with shorter maturities Buy bonds with lower coupons B Buy bonds with higher coupons Buy bonds with longer maturities C Buy zero-coupon bonds Buy bonds with longer maturities A) Option A B) Option B C) Option C D) None of these
c: When rates are expected to decline, low-coupon bonds with long maturities have the highest duration and can be expected to increase in price more than any other type of bond.