Series 7 Chapter 2: Debt Securities

A customer bought a bond that yields 6-½% with a 5% coupon. If the bond matures at this point, the customer will receive: A) $1,050. B) $1,000 plus a call premium. C) $1,065. D) $1,025.

Your answer, $1,050., was incorrect. The correct answer was: $1,025. Upon redemption of a bond, whatever current interest rates may be, the investor receives par ($1,000) plus the final semiannual interest payment ($25 in this case), for a total of $1,025.

Which of the following agencies approves private lending institutions to issue bonds that are backed by the full faith and credit of the US government? A) FGIC. B) FNMA. C) FHLMC. D) GNMA.

Your answer, GNMA., was correct!. GNMA stands for Government National Mortgage Association. GNMA bonds are issued by private lending institutions approved by GNMA and are backed by the full faith and credit of the US government. They are considered to be default risk-free.

Which of the following usually does NOT pay interest semiannually? A) Public utility bonds. B) Treasury bonds. C) Treasury notes. D) GNMA.

Your answer, Public utility bonds., was incorrect. The correct answer was: GNMA. GNMA pass-through certificates pay principal and the interest monthly. All other choices usually pay interest semiannually.

The interbank market is: A) an agency of the World Bank. B) affected by international events. C) regulated. D) insulated from changes in individual countries' economies.

Your answer, an agency of the World Bank., was incorrect. The correct answer was: affected by international events. The interbank market is the unregulated, decentralized market for currencies among banks and central banking authorities. Currency exchange rates are affected by economic and political events taking place in individual countries and on a global scale.

A convertible corporate bond with a conversion price of $20 is trading at 115. The parity price of the common stock is: A) $23.00. B) $17.00. C) $26.00. D) $20.00.

Your answer, $23.00., was correct!. A conversion price of $20 means the conversion ratio is 50 (i.e., each bond can be converted into 50 shares of common stock). $1,150/50 = $23 parity price.

A 7% convertible debenture is selling at 101. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be: A) $25.00. B) $40.00. C) $25.25. D) $43.91.

Your answer, $43.91., was incorrect. The correct answer was: $25.25. To determine the parity price of the common, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock. (1010 / 40 = $25.25).

A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What must the market price of the debenture be to be at parity with the common? A) $920.00. B) $910.00. C) $850.00. D) $929.00.

Your answer, $920.00., was correct!. To determine the parity price of the bond, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920).

Treasury STRIPS and Treasury receipts are quoted based on A) amortization of premiums B) yield to maturity C) 0.125 (1/8 of a point in dollars) D) 0.03125 (1/32 of a point in dollars)

Your answer, 0.125 (1/8 of a point in dollars), was incorrect. The correct answer was: yield to maturity Noninterest-bearing securities, like zeroes, are quoted based on their yield to maturity. They are sold at a discount and mature at par.

If LMN, Inc. has filed for bankruptcy, in what order would interested parties be paid? Holders of secured debt. Holders of subordinated debentures. General creditors. Preferred stockholders. A) 4, 1, 2, 3. B) 3, 1, 2, 4. C) 1, 2, 3, 4. D) 1, 3, 2, 4.

Your answer, 1, 3, 2, 4., was correct!. The liquidation order is as follows: the IRS (and other government agencies), secured debt holders, unsecured debt holders and general creditors, holders of subordinated debt, preferred stockholders, and common stockholders.

An investor purchases 5 Mt. Vernon Port Authority J & J bonds in a regular way transaction on Wednesday, October 18. How many days of accrued interest are added to the bond's price? A) 110. B) 108. C) 114. D) 112.

Your answer, 112., was correct!. Interest accrues on municipal bonds on a 360-day-year basis, with all months having 30 days. Therefore, July, August, and September each have 30 days of accrued interest and October has 22 days of accrued interest; this totals 112 days. Settlement date is Monday, October 23.

A municipal A & O bond is issued on October 1, 1986 with a 10-year stated maturity. If a trade in this bond settles on April 1, 1996, how many days' worth of accrued interest will be added to the price of the bond? A) 180. B) 90. C) 0. D) 1.

Your answer, 180., was incorrect. The correct answer was: 0. Interest on a municipal bond begins to accrue on the previous payment date and ends the day before settlement date. Whenever a bond trade settles on a payment date, it trades flat (without accrued interest). The seller is entitled to receive the current interest payment.

The longest initial maturity for U.S. T-bills is: A) 13 weeks. B) 39 weeks. C) 26 weeks. D) 2 years.

Your answer, 2 years., was incorrect. The correct answer was: 26 weeks. Maximum initial maturity for T-bills is subject to change. Though T-bills have been issued in 1 yr (52 weeks) maturities, historically the longest initial maturity of T-bills has been 6 months (26 weeks); the shortest initial maturity is 4 weeks.

On February 13, your customer buys an 8% Treasury bond maturing in 2009 for settlement on February 14. If the bonds pay interest on January 1 and July 1, how many days of accrued interest are added to the buyer's price? A) 14. B) 44. C) 43. D) 45.

Your answer, 43., was incorrect. The correct answer was: 44. Accrued interest for government bonds is figured on an actual-days-elapsed basis. The number of days begins with the previous coupon date and continues up to, but not including, the settlement date. The bonds pay interest on January 1. There are 31 days of accrued interest for January. The bonds settle February 14. There are 13 days of accrued interest for February. Do not count the settlement date (31 + 13 = 44 days).

A customer purchased a callable XYZ Corporation 5% debenture to yield 4.5%. The price paid for the bond would most likely be: A) 97½. B) 100½. C) 95. D) 99½.

Your answer, 99½., was incorrect. The correct answer was: 100½. In this example the stated coupon is greater than the yield or yield to maturity. This relationship exists when a bond is trading at a premium to par.

Which of the following is the most sensitive/volatile short-term interest rate? A) Prime rate. B) Federal funds rate. C) Discount rate. D) Broker call loan rate.

Your answer, Broker call loan rate., was incorrect. The correct answer was: Federal funds rate. The federal funds rate is considered to be the most volatile of all short-term interest rates.

Which of the following statements describes the discount rate? A) Charge on loans to brokers on stock exchange collateral. B) Rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more. C) Base rate on corporate loans at large U.S. money center commercial banks. D) Charge on loans to member banks by the New York Federal Reserve Bank.

Your answer, Charge on loans to member banks by the New York Federal Reserve Bank., was correct!. The discount rate is the charge on loans to member banks by the New York Federal Reserve Bank. The prime rate is the base rate on corporate loans at large U.S. money center commercial banks. The federal funds rate is the rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more. The call rate, or broker call loan rate, is the charge on loans to brokers for margin loans.

A customer expresses the need to invest a fixed dollar sum now that will return a fixed dollar sum in 10 years. He mentions several investments. Of those listed which would not be a suitable recommendation for his objective? A) A zero-coupon bond maturing in 10 years B) Treasury Inflation Protection Securities (TIPS) C) Collateralized mortgage obligations (CMOs) D) A high-yield corporate bond maturing in 10 years

Your answer, Collateralized mortgage obligations (CMOs), was correct!. Due to the interest rate sensitivity of mortgage-backed securities and the possibility of high prepayment risk (receiving the invested funds back earlier than anticipated) CMOs would not be suitable. TIPs, designed to protect against inflation, and the high yield corporate bond if held to maturity, could each meet the objective. Zero coupon bonds are specifically designed to meet the objective of investing a fixed sum now and realizing a fixed sum later and in this regard would be the most suitable of those listed.

Which of the following is NOT part of the Federal Farm Credit System (FFCS)? A) Federal Home Loan Bank. B) Federal Land Bank. C) Bank For Cooperatives. D) Federal Intermediate Credit Bank.

Your answer, Federal Intermediate Credit Bank., was incorrect. The correct answer was: Federal Home Loan Bank. The Federal Land Bank, Bank for Cooperatives, and Federal Intermediate Credit Bank are all parts of the FFCS. The Federal Home Loan Bank is not part of the FFCS.

Exchange-traded notes (ETNs) are unsecured debt securities are unsecured equity securities are issued by financial institutions such as banks have no credit risk associated with them A) II and IV B) I and III C) I and IV D) II and III

Your answer, I and III, was correct!. Exchange-traded notes (ETNs) are unsecured debt securities issued by financial institutions such as banks. Their prices can be impacted by changes in the credit rating of the issuer.

Freddie Mac does which of the following? Issues pass-through securities. Purchases student loans. Purchases conventional residential mortgages from financial institutions. Issues securities backed directly by the full faith and credit of the U.S. government. A) II and III. B) I and III. C) I and IV. D) II and IV.

Your answer, I and III., was correct!. Freddie Mac is a publicly owned and traded U.S. government agency that issues pass-through securities based on a pool of conventional residential mortgages purchased from financial institutions. Ginnie Mae is the only U.S. agency that issues securities backed by the full faith and credit of the U.S. government.

Which of the following statements are TRUE regarding brokered CDs? If customers choose to sell the CD before maturity, there may be a loss of principal. If customers choose to sell the CD before maturity, all transactions are made at par. Brokered CDs may be called before maturity. Brokered CDs are noncallable. A) II and III. B) I and III. C) I and IV. D) II and IV.

Your answer, I and III., was correct!. If interest rates have risen since purchase, a secondary market sale will likely result in loss of principal. Similarly, if rates have fallen since purchase, a CD is likely to be called, forcing investors to reinvest at a lower rate.

Which of the following are characteristics of negotiable (sometimes referred to as jumbo) CDs? Issued in amounts of $100,000 to $1 million. Always FDIC insured to face value. Always mature in 1 to 2 years. Trade in the secondary market. A) I and IV. B) II and III. C) I and III. D) II and IV.

Your answer, I and III., was incorrect. The correct answer was: I and IV. Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of less than a year. The FDIC insures up to $250,000 per account.

If an investor keeps $100,000 invested in U.S. Treasury bills at all times during a 10-year period, he is subject to which of the following? Stable principal. Unstable principal. Stable interest. Unstable interest. A) I and IV. B) II and III. C) II and IV. D) I and III.

Your answer, I and III., was incorrect. The correct answer was: I and IV. Treasury bills are purchased at a discount and mature at face value. This feature provides principal stability to investors who own them. The discount on bills is determined by current market interest rates and fluctuates accordingly.

Which of the following are ordinarily TRUE concerning prepayment of CMOs? If interest rates fall, prepayments increase. If interest rates rise, prepayments increase. If interest rates fall, prepayments decrease. If interest rates rise, prepayments decrease. A) I and IV. B) III and IV. C) I and II. D) II and III.

Your answer, I and IV., was correct!. When interest rates fall, homeowners often refinance their homes to take advantage of lower interest rates, resulting in the existing mortgages being paid off early. Also, homeowners tend to sell their homes to upgrade to larger homes when mortgage interest rates (and monthly payments) are low. When interest rates rise, homeowners do not usually refinance, and housing turnover is reduced.

Accrued interest on a bond confirmation is: added to the buyer's contract price. added to the seller's contract price. subtracted from the buyer's contract price. subtracted from the seller's contract price. A) I and IV. B) I and II. C) III and IV. D) II and III.

Your answer, I and IV., was incorrect. The correct answer was: I and II. The accrued interest calculation is made to determine the seller's share of the upcoming interest payment. It is added to the buyer's contract price (the buyer pays), and it is added to the seller's contract price (the seller receives).

A 10-year bond, callable in 5 years at par, is sold at a discount. Rank the following yields from lowest to highest. Nominal yield. Current yield. Yield to call. Yield to maturity. A) I, II, III, IV. B) I, II, IV, III. C) IV, II, III, I. D) II, I, IV, III.

Your answer, I, II, IV, III., was correct!. The lowest of all yields for a discount bond is the nominal yield (coupon rate), which is a fixed percentage of par. The highest possible return to the owner of a bond purchased at a discount would occur if the bond were called before maturity, because less time must elapse for the investor to receive the discount.

Which of the following scenarios would be TRUE about a step-down CD? Initially purchased the CD at a lower rate. Initially purchased the CD at a higher rate. Later the interest rate adjusts to a lower rate than when it was purchased. Later the interest rate adjusts to a higher rate than when it was purchased. A) I and III. B) II and III. C) I and IV. D) II and IV.

Your answer, II and III., was correct!. With a step-down CD the interest rate will pay a higher rate in the earlier months and adjust downward in later months to pay a lower rate than when it was initially purchased.

Which of the following statements regarding Treasury bills (T-bills) are TRUE? The government auctions T-bills at a discount. The difference between the cost of a T-bill and its value at maturity is treated as a capital gain. T-bills have longer maturities than T-notes. The minimum denomination of a T-bill is $100 face amount. A) I and III. B) II and IV. C) I and IV. D) II and III.

Your answer, II and III., was incorrect. The correct answer was: I and IV. T-bills are sold at a discount and can be purchased in minimum denominations of $100. The difference between the purchase price and the maturity value is taxed as interest income, not as a capital gain. Treasury bills are short-term investments maturing in 1 year or less. T-notes have maturities of 2 to 10 years. T-bonds have maturities of longer than 10 years.

A money market mutual fund would be least likely to invest in which of the following assets? A) Bank certificates of deposit. B) U.S. Treasury notes. C) Repurchase agreements. D) U.S. Treasury bills.

Your answer, Repurchase agreements., was incorrect. The correct answer was: U.S. Treasury notes. A money market mutual fund typically invests in money market instruments, or those with a maturity date not exceeding 397 days. Treasury notes have maturity dates of 2-10 years.

All of the following are used to back collateralized mortgage obligations EXCEPT: A) Freddie Mac. B) Sallie Mae. C) Ginnie Mae. D) Fannie Mae.

Your answer, Sallie Mae., was correct!. Sallie Mae is the Student Loan Marketing Association, which purchases student loans and packages them for the secondary market. The FNMA, GNMA, and FHLMC sell mortgage-backed securities.

Which of the following statements regarding a bond quoted as QRS Zr 12 is TRUE? A) The interest payable is tax free. B) The bond pays $120 interest annually. C) The bond pays no interest until maturity. D) The bond pays $12 interest annually.

Your answer, The bond pays $120 interest annually., was incorrect. The correct answer was: The bond pays no interest until maturity. QRS Zr 12 represents a zero-coupon bond issued by the QRS Company maturing in 2012. Zero-coupon bonds are bought at a discount and mature at face value. If a bond is held to maturity, the difference between the purchase price and the maturity price is considered interest, though it is taxed on a yearly basis.

Which of the following statements regarding puttable bonds is TRUE? A) The issuer may require that the put feature be exercised if interest rates drop significantly. B) Their yields are usually lower than those of nonputtable bonds. C) The put feature is likely to be exercised when interest rates are falling. D) The bondholder can expect to receive a premium over par if he chooses to put the bonds.

Your answer, The put feature is likely to be exercised when interest rates are falling., was incorrect. The correct answer was: Their yields are usually lower than those of nonputtable bonds. A put feature is advantageous to the bondholder, and therefore carries with it a lower yield. Exercise of the put feature is at the discretion of the bondholder, not the issuer, and will most likely be used if interest rates are rising.

Which of the following statements regarding private label CMOs is TRUE? A) They can only be issued if they contain government agency securities. B) If they include government agency securities such as GNMAs in their portfolio, the CMO carries the guarantee of that agency. C) They carry no guarantee other than that of the good faith and credit of their issuer. D) They can only be issued by government agencies.

Your answer, They carry no guarantee other than that of the good faith and credit of their issuer., was correct!. Private label CMOs are issued by private entities such as financial institutions, investment banks or even home builders. They may or may not include government agency securities in their portfolios and never carry any implied guarantee other than that of the good faith and credit of their issuer.

Your customer wishes to lock in a long-term yield with minimal risk and is not interested in regular income. Which of the following securities should you recommend? A) Treasury Bill. B) Corporate A-rated zero coupon bond. C) Treasury Bond. D) Treasury STRIPS.

Your answer, Treasury Bill., was incorrect. The correct answer was: Treasury STRIPS. The Treasury STRIPS is long-term, no-interim income, and has a locked-in yield since it is purchased at a discount from par. The T-bill is short term, the T-bond provides semiannual interest, and the corporate zero is riskier than the STRIPS.

A customer purchased 10 9% convertible debentures at 98. The bonds are callable at 101. The conversion ratio is 40. The bonds are called while the common is trading at $24 and the debenture is trading at 98. Which of the following options would be most beneficial to the customer? A) Wait for a better offer from the corporation. B) Tender the bonds to the corporation. C) Convert the bonds and sell the common stock. D) Sell the bonds.

Your answer, Wait for a better offer from the corporation., was incorrect. The correct answer was: Tender the bonds to the corporation. The option most beneficial to the investor is tendering the bond to the corporation for $10,100. If the bond were sold on the market, the investor would receive $9,800. If the bond were converted into common, the investor would receive 400 common shares that could be sold for their current price of $24 for a total of $9,600.

Which of the following accounts would a CMO Z-tranche be best suited for? A) a custodial account set up under the uniform transfer to minors act (UTMA) B) a joint account with a non working spouse C) an IRA account for a middle aged client D) a professionally managed hedge fund specializing in real estate portfolio securities

Your answer, a professionally managed hedge fund specializing in real estate portfolio securities, was correct!. A zero tranche (Z-Tranche) CMO is considered to be among the most volatile CMO tranches because they receive no payments until all preceding tranches of the CMO are retired. Generally CMO tranches are not suitable for smaller or unsophisticated investors which is why customers are required to sign a suitability statement before purchasing any CMO tranche. Of the answer choices given the best suited account would be the one that is professionally managed and already specializing in real estate investments.

f an investor is anticipating that the yield spread between U.S. government and BBB-rated corporate bonds will widen, the investor is expecting the U.S. economy to: A) experience volatility over the coming months. B) enter a recession over the coming months. C) expand over the coming months. D) remain flat over the coming months.

Your answer, enter a recession over the coming months., was correct!. If investors anticipate a recession, they tend to flee to quality. In this case, they would likely sell lower quality corporate bonds (forcing prices down and yields up) and use the proceeds to buy higher quality U.S. government bonds (forcing prices up and yields down). Thus, the yield spread would widen between corporate and government bonds. Yields on corporate bonds are higher than yields on U.S. government bonds to begin with. If yields on corporate bonds go up and yields on government bonds decline, the spread will widen.

A customer buys a 6% Treasury bond, maturing in 10 years, at a price of 91.07. The yield to maturity is: A) same as current yield. B) less than nominal yield. C) greater than nominal yield. D) less than current yield. .

Your answer, greater than nominal yield., was correct!. A bond whose price is below par or at a discount has a higher yield to maturity than current yield, which in turn is higher than the nominal yield

All of the following statements regarding bonds with both a convertible and callable feature are correct EXCEPT: A) dilution of company stock will occur on conversion of the bonds. B) after the call redemption date, interest payments will cease. C) if called, the owners have the option of retaining the bonds and will continue to receive interest. D) the coupon rate on a convertible bond would be less than the rate for comparable nonconvertible debt.

Your answer, if called, the owners have the option of retaining the bonds and will continue to receive interest., was correct!. After bonds are called, the issuer no longer pays interest. Conversion of convertible bonds causes more shares outstanding, resulting in a reduced proportionate ownership interest (dilution) for current shareholders. The coupon rate paid on convertible bonds is lower than the coupon for nonconvertible bonds. There is a trade-off in the amount of interest for the ability to convert the bonds into common stock.

Bond trust indentures are required for: A) Treasury securities. B) municipal general obligation bonds. C) municipal revenue bonds. D) corporate debt securities.

Your answer, municipal general obligation bonds., was incorrect. The correct answer was: corporate debt securities. Municipal and government bonds are exempt from the trust indenture requirement of the Trust Indenture Act of 1939. Revenue bonds are frequently issued with a trust indenture, but no legal requirement to do so exists. The Trust Indenture Act of 1939 requires that corporate bond issues of $50 million or more sold interstate must be issued with a trust indenture.

All of the following statements regarding a 6% municipal bond that is puttable at par are true EXCEPT the: A) bond may be put to the issuer at the owner's discretion. B) owner will receive $1,000 from the issuer when the put option is exercised. C) owner would likely put the bond to the issuer when interest rates are rising. D) bond is likely to trade at a discount in the secondary market when it is puttable.

Your answer, owner would likely put the bond to the issuer when interest rates are rising., was incorrect. The correct answer was: bond is likely to trade at a discount in the secondary market when it is puttable. Once a bond becomes puttable, the holder has the right to put the bond to the issuer at par. As a result, the bond would not trade below par in the secondary market. This effectively insulates the holder from interest rate risk-the risk that rising rates will force prices down.

The prime rate is the: A) rate on loans offered by large U.S. money center commercial banks to their most creditworthy corporate customers. B) charge on loans to brokers for margin investors. C) rate on reserves traded among commercial banks for overnight use in amounts of $1 million or more. D) charge on loans to depositary institutions by the Federal Reserve Bank of New York.

Your answer, rate on reserves traded among commercial banks for overnight use in amounts of $1 million or more., was incorrect. The correct answer was: rate on loans offered by large U.S. money center commercial banks to their most creditworthy corporate customers. The prime rate is the rate on corporate loans at large U.S. money center commercial banks. The federal funds rate is the rate for excess reserves traded among commercial banks for overnight use in amounts of $1 million or more. The discount rate is the charge on loans to member institutions by the New York FRB. The broker call loan rate is the charge on loans to brokers for margin investors.

The term "trading flat" means: A) the bond is in default. B) the bond is sold without markup or commission. C) there is no accrued interest. D) the price of the bond has remained level.

Your answer, the price of the bond has remained level., was incorrect. The correct answer was: there is no accrued interest. When a bond trades flat, the buyer does not owe accrued interest to the seller. Trading flat means there is no accrued interest due. While it is true that a bond in default trades flat, one can not say that the term trading flat means the bond is necessarily in default.

If the federal funds rate falls to an all-time low, all of the following statements are true EXCEPT that: A) the Fed is trying to expand credit. B) the prime rate will rise. C) the money supply will increase. D) banks will have no difficulty borrowing short-term monies.

Your answer, the prime rate will rise., was correct!. The federal funds market involves short-term loans (sometimes overnight) to one member bank from another that has excess reserves. If the funds rate is falling, short-term interest rates are low, and banks will have no difficulty borrowing required reserves, therefore the money supply will expand. These conditions could be the result of the Fed's deliberate actions to expand credit. The prime rate, which is the rate that commercial banks charge their best customers, will also undoubtedly fall.

ABC Corporation has an outstanding 8% convertible bond that is callable at 102. Currently, the bond is trading at 101. The conversion price is $40, and the common stock is currently trading at $39.50. ABC announces a call at 102. To realize the greatest profit, a bondholder should: A) convert the bonds into common and sell the converted shares. B) sell the bonds at the current market price. C) tender the bonds. D) continue to hold the bonds.

Your answer, sell the bonds at the current market price., was incorrect. The correct answer was: tender the bonds. The investor would realize the greatest sales proceeds by tendering the bond to the corporation for 102. Selling the bond at its current market value of 101 is not an attractive option. Converting the bond to common stock would result in 25 shares ($1,000 par converted at $40 = 25 shares) sold at $39.50 per share (39.50 × 25 = $987.50).