FI 305 Morosan - Chapter 7

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

.05/(1 − t*) = .07.

A bond that can be paid off early at the issuer's discretion is referred to as being which type of bond? Par value Unsecured Senior Callable Subordinated

Callable

Allison just received the semiannual payment of $35 on a bond she owns. Which term refers to this payment? Coupon Discount Face value Call premium Yield

Coupon

The current yield is defined as the annual interest on a bond divided by the: call price. market price. coupon rate. par value. face value.

market price

taxability premium

the portion of a nominal interest rate or bond yield that represents compensation for unfavorable tax status

Inflation premium

the portion of a nominal interest rate that represents compensation for expected future inflation

bid price

the price a dealer is willing to pay for a security

Which bond would you generally expect to have the highest yield? Long-term, high-quality, tax-free bond Short-term, inflation-adjusted bond Risk-free Treasury bond Nontaxable, highly liquid bond Long-term, taxable junk bond

Long-term, taxable junk bond

If investors require a 10 percent real rate of return, and the inflation rate is 8 percent, what must be the approximate nominal rate? The exact nominal rate?

The nominal rate is approximately equal to the sum of the real rate and the inflation rate: 10% + 8% = 18%. From the Fisher effect, we have: 1 + R = (1 + r) x (1 + h) = 1.10 x 1.08 = 1.1880 Therefore, the nominal rate will actually be closer to 19 percent.

A premium bond that pays $60 in interest annually matures in seven years. The bond was originally issued three years ago at par. Which one of the following statements is accurate in respect to this bond today? The face value of the bond today is greater than it was when the bond was issued. The coupon rate is less than the current yield. The bond is worth less today than when it was issued. The yield to maturity is less than the coupon rate. The yield to maturity equals the current yield.

The yield to maturity is less than the coupon rate

A bond that is payable to whomever has physical possession of the bond is said to be in: collateral status. debenture status. new-issue condition. registered form. bearer form.

bearer form

BOND PRICES: RELATIONSHIP BETWEEN COUPON AND YIELD - If YTM < coupon rate, then par value (> or <) bond price 1. Why? 2. Price above par value, called a

- < 1. Higher coupon rate causes value above par. 2. premium bond

BOND PRICES: RELATIONSHIP BETWEEN COUPON AND YIELD - If YTM > coupon rate, then par value (> or <) bond price 1. Why? 2. Price below par value, called a

- > 1. The discount provides yield above coupon rate. 2. discount bond

THE FISHER EFFECT (1 + R) =

(1 + r)(1 + h), where - R = nominal rate - r = real rate - h = expected inflation rate

Q7. A Dr. Seuss Corp. bond carries an 8 percent coupon, paid semiannually. The par value is $1,000, and the bond matures in six years. If the bond currently sells for $911.37, what is its yield to maturity? 8.0% 10.0% 4.0% $80

10.0%

What is the price of a $1,000 par value bond with a 6% coupon rate paid semiannually, if the bond is priced to yield 5% and it has 9 years to maturity? 1071.77 911.01 2018.09

1071.77

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

3-year; 6 percent coupon

Consider a T-bond with a 4% semiannual yield and a clean price of $1,282.50: - Number of days since last coupon = 61 - Number of days in the coupon period = 184 What is the dirty price?

Accrued Interest = (61/184)(.04*1000) = $13.26 Dirty Price = $1,282.50 + $13.26 = $1,295.76

Q17. Which of the following statements about compounding and interest rates is least accurate? Present values and discount rates move in opposite directions. All else equal, the longer the term of a loan, the lower will be the total interest you pay. On monthly compounded loans, the effective annual rate (EAR) will exceed the annual percentage rate (APR).

All else equal, the longer the term of a loan, the lower will be the total interest you pay.

Which one of the following is the price at which a dealer will sell a bond? Call price Par value Asked price Bid price Bid-ask spread

Asked price

If an ordinary bond has a coupon rate of 14 percent, then the owner will get a total of $140 per year, but this $140 will come in two payments of $70 each. The yield to maturity is quoted at 16 percent. The bond matures in seven years. - Note: Bond yields are quoted like APRs; the quoted rate is equal to the actual rate per period multiplied by the number of periods. How many coupon payments are there? What is the semiannual coupon payment? What is the semiannual yield? What is the bond price?

B = 70[1 - 1/(1.08)^14] / .08 + 1,000 / (1.08)^14 = 917.56 Or PMT = 70; N = 14; I/Y = 8; FV = 1,000; CPT PV = -917.56

The Fisher Effect defines the relationship between ...

real rates, nominal rates, and inflation

Bearer form

the form of bond issue in which the bond is issued without record of the owner's name; payment is made to whomever holds the bond

If you sell a bond with a coupon of 6 percent to a dealer when the market rate is 7 percent, which one of the following prices will you receive? Call price Par value Bid-ask spread Asked price Bid price

Bid price

liquidity premium

the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity

Which one of the following applies to a premium bond? Yield to maturity > Current yield > Coupon rate Coupon rate > Yield to maturity > Current yield Coupon rate < Yield to maturity < Current yield Coupon rate = Current yield = Yield to maturity Coupon rate > Current yield > Yield to maturity

Coupon rate > Current yield > Yield to maturity

Jason's Paints just issued 20-year, 7.25 percent, unsecured bonds at par. These bonds fit the definition of which one of the following terms? Callable Note Zero-coupon Debenture Discounted

Debenture

Current Yield =

annual coupon / price

Coupon rate =

annual coupon divided by face value of a bond

You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase now to maximize your gains if the rate decline does occur? Short-term; high coupon Long-term; zero coupon Short-term; low coupon Long-term; low coupon Long-term; high coupon

Long-term; zero coupon

YTM WITH ANNUAL COUPONS Consider a bond with a 10% annual coupon rate, 15 years to maturity, and a par value of $1,000. The current price is $928.09. - Will the yield be more or less than 10%?

N = 15; PV = -928.09; FV = 1,000; PMT = 100; CPT I/Y = 11%

YTM WITH SEMIANNUAL COUPONS Suppose a bond with a 10% coupon rate and semiannual coupons, has a face value of $1,000, 20 years to maturity and is selling for $1,197.93. - Is the YTM more or less than 10%? - What is the semiannual coupon payment? - How many periods are there?

N = 40; PV = -1,197.93; PMT = 50; FV = 1,000; CPT I/Y = 4% (Is this the YTM?) YTM = 4% × 2 = 8%

PV of CF as rates change Bond Value = ? +? or ? + ?

PV of coupons + PV of par or PV of annuity + PV of lump sum

A $1,000 par value corporate bond that pays $60 annually in interest was issued last year. Which one of these would apply to this bond today if the current price of the bond is $996.20? The current yield exceeds the yield to maturity. The bond is selling at par value. The coupon rate has increased to 7 percent. The bond is currently selling at a premium. The current yield exceeds the coupon rate.

The current yield exceeds the coupon rate.

Q12. A $1,000 par value corporate bond that pays $60 annually in interest was issued last year. Which one of these would apply to this bond today if the current price of the bond is $996.20? The bond is currently selling at a premium. The current yield exceeds the coupon rate. The coupon rate has increased to 7 percent. The bond is selling at par value.

The current yield exceeds the coupon rate.

VALUING A PREMIUM BOND WITH ANNUAL COUPONS Suppose you are reviewing a bond that has a 10% annual coupon and a face value of $1000. There are 20 years to maturity, and the yield to maturity is 8%. What is the price of this bond?

Using the formula: • B = PV of annuity + PV of lump sum • B = 100[1 - 1/(1.08)^20] / .08 + 1000 / (1.08)^20 • B = 981.81 + 214.55 = 1196.36 Using the calculator: • N = 20; I/Y = 8; PMT = 100; FV = 1000 • CPT PV = -1,196.36

Which one of these equations applies to a bond that currently has a market price that exceeds par value? Yield to maturity < Coupon rate Market value = Face value Current yield > Coupon rate Market value < Face value Yield to maturity = Current yield

Yield to maturity < Coupon rate

You own a bond that pays an annual coupon of 6 percent that matures five years from now. You purchased this 10-year bond at par value when it was originally issued. Which one of the following statements applies to this bond if the relevant market interest rate is now 5.8 percent? The bond is currently valued at one-half of its issue price. The next interest payment will be $30. You will realize a capital gain on the bond if you sell it today. The current yield is 6 percent. The current yield to maturity is greater than 6 percent.

You will realize a capital gain on the bond if you sell it today.

A bond that has only one payment, which occurs at maturity, defines which one of these types of bonds? Junk Callable Zero coupon Debenture Floating-rate

Zero coupon

Negative covenant

a "thou shalt not" type of covenant it limits or prohibits actions that company might take

Zero coupon bond

a bond that makes no coupon payments and is thus initially priced at a deep discount

Call-protected bond

a bond that, during a certain period, cannot be redeemed by the issuer

Deferred call provision

a call provision prohibiting the company from redeeming a bond prior to a certain date

Q25. A bond with a 12% coupon, 10 years to maturity and selling at 88% of face value has a yield to maturity of: above 14% between 13% and 14% between 10% and 12%

above 14%

Nominal rate of interest - quoted rate of interest, change in ...

actual number of dollars

The interest rate risk premium is the: difference between the yield to maturity and the current yield. difference between the market interest rate and the coupon rate. additional compensation paid to investors to offset rising prices. difference between the coupon rate and the current yield. compensation investors demand for accepting interest rate risk.

compensation investors demand for accepting interest rate risk.

PV of CF as rates change As interest rates increase, present values ...

decrease

PV of CF as rates change As interest rates increase, bond prices ...

decrease and vice verse

Which one of the following premiums is compensation for the possibility that a bond issuer may not pay a bond's interest or principal payments as expected? Liquidity Interest rate risk Taxability Default risk Inflation

default risk

Samantha owns a reverse convertible bond. At maturity, the principal amount will be repaid in: the form of a newly issued bond. either shares of stock or a newly issued bond. either cash or shares of stock. shares of stock. cash while the interest is paid in shares of stock.

either cash or shares of stock

A discount bond's coupon rate is equal to the annual interest divided by the: call price. dirty price. current price. clean price. face value.

face value

Bert owns a bond that will pay him $45 each year in interest plus $1,000 as a principal payment at maturity. What is the $1,000 called? Dirty price Face value Discount Coupon Yield

face value

A newly issued bond has a coupon rate of 7 percent and semiannual interest payments. The bonds are currently priced at par. The effective annual rate provided by these bonds must be: greater than 7 percent. greater than 3.5 percent but less than 7 percent. 7 percent. less than 3.5 percent. 3.5 percent.

greater than 7 percent

Yield or Yield to maturity =

rate of return required in the market for the bond

Real rates

interest rates or rates of return that have been adjusted for inflation

Nominal rates

interest rates or rates of return that have not been adjusted for inflation

BOND PRICING THEOREMS If you know the price of one bond, you can estimate ... and use that to find the ...

its YTM price of the second bond

Which one of the following risk premiums compensates for the inability to easily resell a bond prior to maturity? Liquidity Interest rate risk Default risk Inflation Taxability

liquidity

DLQ Inc. bonds mature in 12 years and have a coupon rate of 6 percent. If the market rate of interest increases, then the: coupon rate will also increase. coupon payment will increase. current yield will decrease. yield to maturity will be less than the coupon rate. market price of the bond will decrease.

market price of the bond will decrease.

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

maturity

Interest rates that include an inflation premium are referred to as: real rates. nominal rates. effective annual rates. stripped rates. annual percentage rate

nominal rates

The *ex ante* nominal rate of interest includes ...

our desired real rate of return plus an adjustment for expected inflation

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

pay interest that is federally tax free.

Dirty price

price actually paid = quoted price + accrued interest

The difference between the price that a dealer is willing to pay and the price at which he or she will sell is called the: premium. spread. call price. discount. equilibrium.

spread

Coupon =

stated interest payment made on a bond

term structure of interest rates

the relationship between nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money

Indenture

the written agreement between the corporation and the lender detailing the terms of the debt issue

A Treasury yield curve plots Treasury interest rates relative to: inflation rates. time to maturity. comparable corporate bond rates. the risk-free rate. market rates.

time to maturity

TERM STRUCTURE OF INTEREST RATES Term structure is the relationship between ...

time to maturity and yields, all else equal.

The Bond Pricing Equation

Bond Value = C((1-(1/(1+r)^t)/r)) + (FV/((1+r)^t))

Suppose taxable bonds are currently yielding 8 percent, while at the same time, munis of comparable risk and maturity are yielding 6 percent. Which is more attractive to an investor in a 40 percent bracket? What is the break-even tax rate? How do you interpret this rate?

For an investor in a 40 percent tax bracket, a taxable bond yields 8 × (1 − .40) = 4.8 percent after taxes, so the muni is much more attractive. The break-even tax rate is the tax rate at which an investor would be indifferent between a taxable and a nontaxable issue. If we let t* stand for the break-even tax rate, then we can solve for it as follows: .08 x (1 - t*) = .06 1 - t* = .06/.08 = .75 t* = .25 An investor in a 25 percent tax bracket would make 6 percent after taxes from either bond.

A bond has a quoted price of $1,080.42. It has a face value of $1,000, a semiannual coupon of $30, and a maturity of five years. What is its current yield? What is its yield to maturity? Which is bigger? Why?

Notice that this bond makes semiannual payments of $30, so the annual payment is $60. The current yield is thus $60/1,080.42 = 5.55 percent. To calculate the yield to maturity, refer back to Example 7.1. In this case, the bond pays $30 every six months and has 10 six-month periods until maturity. So, we need to find r as follows: $1,080.42 = $30 x [1 - 1/(1+r)^10]/r + 1,000/(1+r)^10 After some trial and error, we find that r is equal to about 2.1 percent. But, the tricky part is that this 2.1 percent is the yield per six months. We have to double it to get the yield to maturity, so the yield to maturity is 4.2 percent, which is less than the current yield. The reason is that the current yield ignores the built-in loss of the premium between now and maturity.

THE FISHER EFFECT Approximation:

R = r + h

Yield to maturity =

current yield + capital gains yield

Call premium

the amount by which the call price exceeds the par value of a bond

Q1. A Dumbledore, Inc. bond has a 10 percent coupon rate and a $1,000 face value. Interest is paid semiannually, and the bond has 20 years to maturity. Investors require a 12 percent yield. What is the bondâ s value? $849.5 $100,000 $1,000 77%

$849.5

BOND CLASSIFICATIONS Security

- Collateral - securd by financing securities - Mortgage - secured by real property, normally land or buildings - Debentures - unsecured - Notes - unsecured debt with original maturity less than 10 years

SUKUK - Sukuk are ... - Sharaih does not permit ... - Sukuk are typically ...

- bonds that have been created to meet a demand for assets that comply with Shariah, or Islamic law. - the charging or paying of interest. - bought and held to maturity, and they are extremely liquid.

TERM STRUCTURE OF INTEREST RATES Yield curve - 1. Normal 2. Inverted

- graphical representation of the term structure 1. upward-sloping; long-term yields are higher than short-term yields 2. downward-sloping; long-term yields are lower than short-term yields

INTEREST RISK RATE Price Risk - Change in price due to changes in ... - Long-term bonds have (more or less) price risk than short-term bonds - Low coupon rate bonds have (more or less) price risk than high coupon rate bonds

- interest rates - more - more

BOND MARKETS - Primarily ... transactions with dealers connected electronically - Extremely (high or low) number of bond issues, but generally (high or low) daily volume in single issues - Makes getting up-to-date prices (easy or difficult), particularly on ... - What is an exception?

- over-the-counter - high, low - difficult, small company or municipal issues - treasury securities

INTEREST RISK RATE Reinvestment Rate Risk - Uncertainty concerning rates at which cash flows can be ... - Long-term bonds have (more or less) reinvestment rate risk than short-term bonds - Low coupon rate bonds have (more or less) reinvestment rate risk than low coupon rate bonds

- reinvested - less - less

COMPUTING YIELD TO MATURITY - Yield to Maturity (YTM) is the rate implied by - Finding the YTM is similar to the process for finding ...

- the current bond price - r with an annuity

BOND CLASSIFICATIONS (4)

1 & 2. Registered vs Bearer Forms 3. Security 4. Seniority

A taxable bond has a yield of 8%, and a municipal bond has a yield of 6%. 1. If you are in a 30% tax bracket, which bond do you prefer? 1. At what tax rate would you be indifferent between the two bonds?

1. - 8% (1-.3) = 5.6% - The after-tax return on the the corporate bond is 5.6%, compared to a 6% return on the municipal. 2. - 8% (1-T) = 6% - T = 25%

ZERO COUPON BONDS 1. Are there periodic interest payments? 2. The entire yield-to-maturity comes from the difference between the ... 3. Cannot sell for more than ... 4. Somtimes called (3 things) 5. What are 2 good examples of zeroes?

1. (no coupon rate = 0%) 2. purchase price and the par value 3. par value 4. zeroes, deep discount bonds, original issue discount bonds (OIDs) 5. Treasury Bills and principal-only Treasury strips

INTEREST RATE RISK The risk that arises for bond owners from fluctuating interest rates is called interest rate risk. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes. This sensitivity directly depends on two things: The time to maturity and the coupon rate. As we will see momentarily, you should keep the following in mind when looking at a bond (2):

1. All other things being equal, the longer the time to maturity, the greater the interest rate risk. 2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.

4 other bond types

1. Catastrophe bonds 2. Income bonds 3. Convertible bonds 4. Put bonds

GOVERNMENT BONDS Municipal Securities (3)

1. Debt of state and local governments 2. Varying degrees of default risk, rated similar to corporate debt 3. Interest received is tax-exempt at the federal level

GOVERNMENT BONDS Treasury Securities (4)

1. Federal government debt 2. T-bills: pure discount bonds with original maturity of one year or less 3. T-notes: coupon debt with original maturity between one and ten years 4. T-bonds: coupon debt with original maturity greater than ten years

Debt (5 things)

1. not an ownership interst 2. creditors do not have voting rights 3. interest is considered a cost of doing business and is tax deductible 4. creditors have legal recourse if interest of principal payments are missed 5. excess debt can lead to financial distress and bankruptcy

Equity (5 things)

1. ownership interest 2. common stockholders vote for the board of directors and other issues 3. dividends are not considered a cost of doing business and are no tax deductible 4. dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid 5. an all equity firm can not go bankrupt merely due to debt since it has no debt

6 factors affecting bond yields

1. real rate of interest 2. expected future inflation premium 3. interest rate risk premium 4. default risk premium 5. taxability premium 6. liquidity premium

BOND CHARACTERISTICS AND REQUIRED RETURNS Which bonds will have the higher coupon, all else equal? 1. secured debt vs. debenture 2. senior debt vs. subordinated debenture 3. a bond with a sinking fund vs. one without 4. a callable bond vs. non-callable bond

1. secured 2. subordinated 3. sinking fund 4. callable

FLOATING RATE BONDS 1. Coupon rate floats depending on ... 2. Examples (2) 3. There is (more or less) price risk with floating rate bonds. - The coupon floats, so it is (more or less) likely to differ substantially from the yield-to-maturity. 4. Coupons may have a "collar" -

1. some index values 2. adjustable rate mortgages and inflation-linked treasuries 3. less - less 4. the rate cannot go above a specified "ceiling" or below a specified "floor".

There are many different kinds of sinking fund arrangements, and the details are spelled out in the indenture. For example (3):

1. some sinking funds start about 10 years after the initial issuance 2. some sinking funds establish equal payments over the life of the bond 3. Some high-qualityt bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there is the possibility of a large "balloon payment" at maturity.

THE BOND INDENTURE Contract between the company and the bondholders that includes: (6)

1. the basic terms of the bonds 2. the total amount of bonds issued 3. a description of property used as security, if applicable 4. sinking fund provisions 5. call provisions 6. details of protective covenants

Q15. Harry Corp has bonds on the market making annual payments, with eight years to maturity, a par value of $1,000, and selling for $948. At this price, the bonds yield 5.1 percent. What must the coupon rate be on the bonds? 5.35% 4.29% 3.14% 5.1%

4.29%

Q24. Assuming the risk-free rate is 5% and the appropriate risk premium for a AAA-rated issuer is 4%, the appropriate discount rate for a 10-year Treasury note is: 9% 4% 5%

5%

Al is retired and his sole source of income is his bond portfolio. Although he has sufficient principal to live on, he only wants to spend the interest income and thus is concerned about the purchasing power of that income. Which one of the following bonds should best ease Al's concerns? 20-year coupon bonds 7-year income bonds 5-year TIPS 5-year municipal bonds 6-year coupon bonds

5-year TIPS

What is the current yield of a $1,000 par value bond with a 6% coupon rate paid semiannually, if the bond is priced to yield 7% and it has 9 years to maturity? 6.42% 3.14% 7.00%

6.42%

Q14. Harry Corp has bonds on the market making annual payments, with eight years to maturity, a par value of $1,000, and selling for $948. At this price, the bonds yield 5.1 percent. What is the present value of the final payment of $1000? 276.30 977.35 671.70 $1000

671.70

Nadine is a retired widow who is financially dependent upon the interest income produced by her bond portfolio. Which one of the following bonds is the least suitable for her to own? 6-year, high-coupon, put bond 5-year TIPS 7-year income bond 5-year floating rate bond 10-year AAA coupon bond

7-year income bond

Q31. Thomas & Percy Rail bonds have a 9.5 percent coupon and pay interest semi-annually. Currently, the bonds are priced at $1,063.15. The company issued this 20-year bond twelve years ago. What is the yield to maturity? 9.38 percent 9.13 percent 8.82 percent 8.64 percent 8.40 percent

8.40 percent

Q20. Which of the following statements about zero-coupon bonds is FALSE? A zero coupon bond may sell at a premium to par when interest rates decline. The lower the price, the greater the return for a given maturity. All interest is earned at maturity.

A zero coupon bond may sell at a premium to par when interest rates decline.

You're looking at two bonds identical in every way except for their coupons and, of course, their prices. Both have 12 years to maturity. The first bond has a 10 percent annual coupon rate and sells for $935.08. The second has a 12 percent annual coupon rate. What do you think it would sell for?

Because the two bonds are similar, they will be priced to yield about the same rate. We first need to calculate the yield on the 10 percent coupon bond. Proceeding as before, we know that the yield must be greater than 10 percent because the bond is selling at a discount. The bond has a fairly long maturity of 12 years. We've seen that long-term bond prices are relatively sensitive to interest rate changes, so the yield is probably close to 10 percent. A little trial and error reveals that the yield is actually 11 percent: Bond value = $100 x (1 - 1/1.11^12)/.11+1,000/1.11^12 = $100 x 6.4924 + 1,000/3.4985 = $649.24 + 285.85 = $935.08 With an 11 percent yield, the second bond will sell at a premium because of its $120 coupon. Its value is: Bond value = $120 x (1-1/1.11^12)/.11+1,000/1.11^12 = $120 x 6.4924 + 1,000/3.4985 = $779.08 + 285.84 = $1,064.92

Which one of the following relationships applies to a par value bond? Coupon rate < Yield to maturity < Current yield Yield to maturity > Current yield > Coupon rate Coupon rate > Current yield > Yield to maturity Coupon rate > Yield to maturity > Current yield Coupon rate = Current yield = Yield to maturity

Coupon rate = Current yield = Yield to maturity

Q28. Which one of the following relationships is stated correctly? An increase in market rates increases the market price of a bond. The coupon rate exceeds the current yield when a bond sells at a discount. Increasing the coupon rate decreases the current yield, all else constant. Decreasing the time to maturity increases the price of a discount bond, all else constant.

Decreasing the time to maturity increases the price of a discount bond, all else constant.

Which one of the following relationships is stated correctly? An increase in market rates increases the market price of a bond. The call price must equal the par value. Decreasing the time to maturity increases the price of a discount bond, all else constant. Increasing the coupon rate decreases the current yield, all else constant. The coupon rate exceeds the current yield when a bond sells at a discount.

Decreasing the time to maturity increases the price of a discount bond, all else constant.

Q27. Which of the following statements about the yield curve is TRUE? Parallel shifts in the yield curve are not of concern to bond investors. In a typical upward sloping yield curve, short and intermediate term rates are lower than long term rates. If long-term rates are low, the present value of cash flows far into the future will be low, and the bond's value will be low.

In a typical upward sloping yield curve, short and intermediate term rates are lower than long term rates.

If we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?

R = (1.1)(1.08) - 1 = .188 = 18.8% Approx: R = 10% + 8% = 18% Because the real return and expected inflation are relatively high, there is significant difference between the actual Fisher Effect and the approximation.

Round Dot Inns is preparing a bond offering with a coupon rate of 6 percent, paid semiannually, and a face value of $1,000. The bonds will mature in 10 years and will be sold at par. Given this, which one of the following statements is correct? The final payment will be in the amount of $1,060. The bonds will sell at a premium if the market rate is 5.5 percent. The bonds will pay 10 interest payments of $60 each. The bonds will become discount bonds if the market rate of interest declines. The bonds will initially sell for $1,030 each.

The bonds will sell at a premium if the market rate is 5.5 percent.

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

The real rate must be less than the nominal rate given a positive rate of inflation.

VALUING A DISCOUNT BOND WITH ANNUAL COUPONS Consider a bond with a coupon rate of 10% and annual coupons. The par value is $1,000, and the bond has 5 years to maturity. The yield to maturity is 11%. What is the value of the bond?

Using the formula: • B = PV of annuity + PV of lump sum • B = 100[1 - 1/(1.11)^5] / .11 + 1,000 / (1.11)^5 • B = 369.59 + 593.45 = 963.04 Using the calculator: • N = 5; I/Y = 11; PMT = 100; FV = 1,000 • CPT PV = -963.04

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

a discount; less than

Protective covenant

a part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest.

Sinking funds

an account managed by the bond trustee for early bond redemption

Call provision

an agreement giving the corporation the option to repurchase a band at a specified price prior to maturity

Debenture

an unsecured debt, usually with a maturity of 10 years or more

Note

an unsecured debt, usually with a maturity under 10 years

BOND PRICES: RELATIONSHIP BETWEEN COUPON AND YIELD If YTM = coupon rate, then par value =

bond price

Recently, you discovered a convertible, callable bond with a semiannual coupon of 5 percent. If you purchase this bond you will have the right to: convert the bond into a perpetuity paying 5 percent. force the issuer to repurchase the bond prior to maturity. have the principal amount adjusted for inflation. defer all taxable income until the bond matures. convert the bond into equity shares.

convert the bond into equity shares.

The price sensitivity of a bond increases in response to a change in the market rate of interest as the: time to maturity decreases. coupon rate increases. time to maturity and coupon rate both decrease. coupon rate and time to maturity both increase. coupon rate decreases and the time to maturity increases.

coupon rate decreases and the time to maturity increases.

The collar of a floating-rate bond refers to the minimum and maximum: maturity dates market prices call periods coupon rates yields to maturity

coupon rates

Par value (face value) =

principal amount, repaid at maturity

Q13. Which of the following statements is FALSE? Compared to a callable bond, a non-callable bond: has more predictable cash flows. provides a higher yield. is more attractive to an investor concerned with reinvestment risk.

provides a higher yield

Real rate of interest - change in ...

purchasing power

Clean price

quoted price

BOND CHARACTERISTICS AND REQUIRED RETURNS The coupon rate depends on the ...

risk characteristics of the bond when issued

Interest rate risk premium

the compensation investors demand for bearing interest rate risk

bid-ask spread

the difference between the bid price and the asked price

TERM STRUCTURE OF INTEREST RATES It is important to recognize that we pull out ...

the effect of default risk, different coupons, etc.

Registered form

the form of bond issue in which the registrar of the company records ownership of each bond; payment is made directly to the owner of record

default risk premium

the portion of a nominal interest rate or bond yield that represents compensation for the possibility of default

asked price

the price a dealer is willing to take for a security

BOND PRICING THEOREMS This is a useful concept that can be transferred to ...

valuing assets other than bonds

BOND PRICING THEOREMS Bonds of similar risk (and maturity) will be priced to ... , regardless of the ... .

yield about the same return coupon rate

The bond market requires a return of 9.8 percent on the 5-year bonds issued by JW Industries. The 9.8 percent is referred to as the: coupon rate. face rate. current yield. call rate. yield to maturity.

yield to maturity