Unit 2 Checkpoint Exam
If an investor pays 95.28 for a Treasury bond, how much did the bond cost? A) $958.75 B) $95.28 C) $950.28 D) $9,528.00
a) Treasury bonds are quoted as a percentage of par ($1,000) plus 32nds. In this case, the price is $950 plus 28/32 (i.e., ⅞) of $10, for a total of $958.75.
A bond with a par value of $1,000 and a coupon rate of 6% paid semiannually is currently selling for $1,200. The bond is callable in 15 years at 105. In the computation of the bond's yield to call, which of these would be a factor? A) Future value of $1,200 B) Present value of $1,050 C) Interest payments of $30 D) 15 payment periods
c) The yield to call (YTC) computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon will make $30 semiannual interest payments. With a 15-year call, there are 30 semiannual payment periods, not 15. The present value is $1,200 and the future value is $1,050, which is the reverse of the numbers indicated in the answer choices.
An investor purchasing 10 corporate bonds at a price of 102¼ each will pay A) $1,020.25. B) $10,202.50. C) $1,022.50. D) $10,225.00.
d) $10,225.00 At 102¼, each bond costs $1,022.50 (102 = 1,020 and ¼ of $10 = $2.50). There are 10 bonds, so the total is $1,022.50 × 10 = $10,225.
Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond? A) Default risk B) Currency risk C) Inflation risk D) Interest rate risk
b) currency risk
A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal? A) ABC Growth and Income Fund B) JKL Municipal Bond Fund C) DEF High-Yield Bond Fund D) GHI Index Fund
c) DEF high-yield bond fund High-yield (junk) bonds, although carrying more risk, produce hgiher current income than other funds
One of the advantages of owning a corporation's debentures is that you have prior claim over A) employees. B) secured creditors. C) general creditors. D) preferred stockholders.
d) preferred stockholders Holders of a company's debentures are general creditors and, as such, have prior claim only over equity holders
Which of the following are general characteristics of negotiable jumbo CDs? A) Typically pay interest on a monthly basis B) Trade only in the primary market C) Issued in amounts of $100,000 to $1 million D) Always mature in one to two years with a prepayment penalty for early withdrawal
c) Issued in amounts of $100,000 to $1 million 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 one year or less. Being negotiable in the secondary market, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly.
Which of the following statements regarding convertible bonds is not true? A) The conversion rate is set at issuance and does not change. B) Convertible bondholders are creditors of the corporation. C) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature. D) Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
d. Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
A bond issued by the GEMCO Corporation has been rated BBB by a major bond-rating organization. This bond would be considered A) an investment-grade corporate bond. B) secured. C) callable. D) a high-yield corporate bond.
a) an investment-grade corporate bond An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds. The bond may or may not be secured; the rating does not indicate that fact.
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO? A) 110 B) 104 C) 106 D) 102
d) 102 MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown.
Which of the following debt instruments generally presents the least amount of default risk? A) Municipal revenue bonds B) Municipal general obligation bonds C) High-yield corporate bonds D) Convertible senior debentures
b) Municipal general obligation bonds Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a potentially greater degree of risk, as is a junk or high-yield corporate bond.
Which of the following is not a money market instrument? A) Treasury bills B) Commercial paper C) Banker's acceptances D) Newly issued Treasury notes
d) newly issued Treasury notes Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of one year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of two to 10 years and therefore would not be a money market instrument.
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? A) Municipal hospital B) Expansion of an airport C) Public golf course D) Public library
D) Public library Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through general obligation (GO) bond sales with the backing of taxes.
Your client is interested in investing in preferred stocks in an effort to receive dividend income. The client's target goal is a 6% current return on investment (ROI). If the RIF Series B preferred stock is paying a quarterly dividend of $0.53, your client's goal will be achieved if the RIF can be purchased at A) $22.55. B) $50.00. C) $8.83. D) $35.33.
d) $35.53 First, take the quarterly dividend and annualize it (4 × $0.53 = $2.12). Dividing that number by 6% gets you $35.3333, which rounds down to $35.33. Alternatively if you wish (but which takes more time), multiply each of the choices by 6% to see which of them equals $2.12.
Which of the following would you not expect to see issued at a discount? A) Bank jumbo CD B) Treasury bill C) Commercial paper D) Zero-coupon bond
a) bank jumbo CD Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value.
Which of the following would be most likely to increase a bond's liquidity? A) A higher rating B) No call protection C) A lower rating D) A longer maturity
a) a higher rating Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it or that a very large purchase or sale would not be possible at the current price. The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings. (Many institutions are only able to purchase bonds with higher credit ratings.) As a result, the lower the credit rating is, the greater the chance is of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid. The absence of call protection is negative to many investors, thus limiting the number of potential investors.
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of A) equipment trust certificates. B) collateral trust certificates. C) secured income notes. D) guarantee trust bonds.
b) collateral trust certificates When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.
Which of the following statements regarding U.S. government agency securities is true? A) They generally trade on the major stock exchanges. B) They are direct obligations of the U.S. government. C) They generally offer higher yields than direct U.S. obligations. D) Interest received on agency securities is exempt from federal income tax
c) They generally offer higher yields than direct U.S. obligations. In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk, and that means investors demand a higher return. They do not trade on any exchange. Their interest, like that of all U.S. government securities, is taxable on the federal level while being tax exempt on the state level.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years? A) $1,267 B) $1,240 C) $1,344 D) $1,300
a. $1,267 The unique feature of a TIPS bonds is its semiannual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semiannual periods in 4 years). Be sure to stop at 4 years—the question doesn't ask for the ending value for the 5th year. If this math is too challenging, there is a simple method that always works. That simple method has you take the annual inflation rate (6% = $60) for 4 years ($240) and add that to the original $1,000 face value. That is $1,240, and the correct answer on the exam will always be the next higher number ($1,267 in this case). This simple step means you are calculating the simple interest while the bond's principal growth is actually compounding.
Securities issued by which of the following issuers have the direct backing of the U.S Treasury? A) Government National Mortgage Association (Ginnie Mae) B) Federal Home Loan Mortgage Corporation (Freddie Mac) C) Federal Agricultural Mortgage Corporation (Farmer Mac) D) Federal National Mortgage Association (Fannie Mae)
a) Government National Mortgage Association (Ginnie Mae) Bonds issued or guaranteed by the Government National Mortgage Association (Ginnie Mae) are backed by the "full faith and credit of the U.S. government," just like U.S. Treasuries. Bonds issued by government-sponsored enterprises (GSE), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Agricultural Mortgage Corporation (Farmer Mac), are not backed by the same guarantee those issued by federal government agencies. Bonds issued by GSEs carry credit risk. The GSEs are publicly traded companies whose shares are registered with the SEC.
Probably the most significant characteristic of municipal bonds for investors is A) that their coupon yields are higher than comparably rated corporate issues. B) their safety. C) their exemption from registration on the state and federal level. D) their exemption from federal income tax.
d) their exemption from federal income tax Municipal bonds are unique in that their interest is not subject to federal income tax. As a result, their coupon yields are generally lower than corporate bonds with a similar rating; you get to keep all of the interest instead of paying taxes on it. The fact that they are exempt from registration with state and federal agencies is of little, if any, consequence to the typical investor. Although they tend to be quite safe, if safety is the primary concern, the investor would turn to U.S. Treasuries or government agency securities.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is A) $100.00 per share. B) $156.25 per share. C) $64.00 per share. D) $125.00 per share.
a) $100 per share What does parity mean? It means that two things have equal value. What two things do we have here? We have the convertible bond, and because it is convertible, it can be converted into common stock. There is a number where the value of the bond and the value of the stock are the same; this price is the parity price. The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP's stock at $125 per share. However, that conversion is not based on a market price, which can fluctuate every day; it is based on the amount of money initially borrowed—the $1,000 par value of the bond. DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares. Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 ÷ 8 = $100 per share. That means that if the stock is selling for $100 per share and we decide to convert the bond, we'll have the same $800 in value. Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then to be equal, the stock must be selling at 80% of the conversion value (80% × $125 = $100).
You are meeting with a relatively unsophisticated investor who doesn't understand very much about stocks and bonds. The investor asks, "Can you list the advantages of owning common stock as compared to bonds?" Among other reasons, you could reply that a) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired. B) bonds have priority over any equity security in the event of liquidation. C) income payments are more reliable. D) there is limited liability.
a) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired. One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of bonds; if the company goes under, the bondholder's maximum loss is the investment. Even then, because of the seniority of bonds, it is less likely that the entire investment will be lost.
The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately A) 6.50%. B) 8.00%. C) 7.11%. D) 7.50%.
c) 7.11% A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%.
The owner of a convertible debt issue A) is generally in a senior position to other bondholders. B) generally expects a higher current return than with a nonconvertible bond of the same quality and maturity. C) is a creditor of the issuer. D) has the choice of receiving the bond's interest or dividends on the underlying stock, whichever is higher.
c) is a creditor of the issuer The owner of any bond is a creditor of the issuer. Dividends are paid only on stock, and the investor will have to convert in order to be a stockholder. Because of the growth potential of the common stock, holders of convertible securities invariably accept a lower coupon rate resulting in a lower current yield (return). In almost all cases, convertible debt securities are debentures and, therefore, junior to secured bonds.
In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is A) greater risk. B) shorter maturities. C) higher yields. D) increased liquidity.
d) increased liquidity Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral—often U.S. Treasury zero-coupon bonds—thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors. These benefits cause the yields to be lower—less risk, less reward. There is nothing unique about the maturities of Brady bonds.
One of the benefits of adding foreign debt securities to an investor's portfolio is A) potentially higher risk. B) reduced taxation. C) receiving income in foreign currency. D) potentially higher yields.
d) potentially higher yields The interest rates paid on debt in many foreign countries, especially those in emerging economies, is higher than that available domestically. The tradeoff is higher risk. Receiving interest payments in foreign currency involves not only currency risk but the added expense of conversion into U.S. dollars. (ADRs are for equity, not debt securities.) In many cases, investors pay both foreign and U.S. tax on the interest.
The GHIJ Corporation has a 3% convertible debenture outstanding with a conversion price of $40. The bond's current market price is 126. The most probable reason for this is A)GHIJ's earnings have risen since the debenture was issued. B) the current market price of the GHIJ common stock is approximately $35 per share. C) interest rates have risen since the debenture was issued. D) the current market price of the GHIJ common stock is approximately $50 per share.
d) the current market price of the GHIJ common stock is approximately $50 per share. With a conversion price of $40, the bond is convertible into 25 shares. Convertible securities generally sell at a slight premium to their parity price, which—at $1,260—would be $50.40 per share.
