Finance Exam 2
What is the value of a 10-year 10% $1,000 bond when the market interest rate is 10%?
$1000
What is the value of a 12-year 10% $1,000 bond when the market interest rate is 5%?
$1443
What is the value of a 15-year 10% $1,000 coupon bond when the market interest rate is 15%?
$708
Bonds often pay a coupon twice a year. For the valuation of bonds that make semiannual payments, the number of periods doubles, whereas the amount of cash flow decreases by half. Using the values of cash flows and number of periods, the valuation model is adjusted accordingly. Assume that a $1,000,000 par value, semiannual coupon US Treasury note with three years to maturity has a coupon rate of 3%. The yield to maturity (YTM) of the bond is 11.00%. Using this information and ignoring the other costs involved, calculate the value of the Treasury note:
$800,178.79 N=6 I/Y= 5.5 (11/2) PV=? PMT = 15,000 (1,000,000 * 3% /2) PV= $800,178.79
Recall that on a one-year Treasury security the yield is 5.6100% and 8.4150% on a two-year security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.4%. What is the market's estimate of the one-year Treasury rate one year from now?
(1+1-year rate)(1+1-year rate in 1 year)= (1+2-year rate - MRP)^2 (1+0.0561)(1+x) = (1+0.08415-0.004)^2 = 10.4748%
The yield on a one-year Treasury security is 5.6100% and the two-year Treasury security has a 8.4150% yield. Assuming that the pure expectations theory is correct, what is the market's estimate of the one-year Treasury rate one year from now?
(1+1-year rate)(1+1-year rate in year 1) = (1+2-year rate)^2 =(1+0.0561)(1+x) = (1+0.08415)^2 = 11.2945%
Suppose the yield on a two-year Treasury security is 5.83%, and the yield on a five-year Treasury security is 6.20%. Assuming that the pure expectations theory is correct, what is the market's estimate of the three-year Treasury rate two years from now? (Note: Do not round your intermediate calculations.)
(1+2-year rate)^2(1+3-year rate in 2 years)^3 = (1+5-year rate)^5 (1+5-year rate)^5 = (1+2-year rate)^2(1+3-year rate in 2 years)^3 = (1+0.0620)^5) = (1+0.0583)^2(1+x)^3 =6.45%
Corporate Bond Yield
r* + IP + MRP + DRP + LP
This is the rate for a short-term riskless security when inflation is expected to be zero
real risk-free rate
A stock's contribution to the market risk of a well-diversified portfolio is called __________ risk. It can be measured by a metric called the beta coefficient, which calculates the degree to which a stock moves with the movements in the market.
relevant
In 2008, the United States began to witness one of the worst recessions since the 1930s. The collapse of the housing bubble in 2006 led to a massive decline in real estate prices, affecting consumers and institutions, especially banking and financial entities. Severe liquidity shortfalls in the United States as well as other global markets led to a serious credit crisis. During the credit crisis of 2008-2009, several banks and other businesses went through a reorganization process or were forced to liquidate. Consider the following example: In December 2008, Hawaiian Telcom took action to strengthen its balance sheet by reducing debt. Although the company continued to operate, its creditors could not collect their debts or loan payments that were due prior to the legal action that the company took. However, on November 30, 2009, the company had $75 million in cash on hand. This is an example of:
reorganization
What is rd?
required rate
Realized rate of return
returns that were actually earned during some past period. Actual returns usually turn out to be different from expected returns except for riskless assets
Stocks held alone
risk can be measured by the standard deviation
Required return equals
risk-free rate + premium for the stock's risk
These bonds are collateralized securities with first claims in the event of bankruptcy
senior mortgage bonds
Which tend to be more volatile, short- or long-term interest rates?
short-term interest rates
A bond contract feature that requires the issuer to retire a specified portion of the bond issue each year is called a
sinking fund provision
Beta coefficients change the
slope of the lines
These bonds are considered the riskiest of all corporate bonds and thus offer the highest interest rates
subordinated debentures
Diversifiable risk
that part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company specific, or unsystematic, risk
Market risk premium, RPM
the additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Inflation
the amount by which prices increase overtime
Capital gains yield
the capital gain during a given year divided by the beginning price
What is reinvestment risk?
the concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income
Nominal Interest Rate (iNOM)
the contracted interest rate
Default risk premium (DRP)
the difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability
When inflation changes,
the entire line shifts up or down
What is r hat?
the expected rate of return
Par value
the face value of a bond
The steeper the line
the greater the stock's volatility
Production opportunities
the investment opportunities in productive (cash generating) assets
The tighter the probability distribution of expected future returns
the lower the risk
Original maturity
the number of years to maturity at the time a bond is issued
Investment horizon
the period of time an investor plans to hold a particular investment
Time preferences for consumption
the preferences of consumers for current consumption as opposed to saving for future consumption
Risk return trade-off
the principle that the greater the risk a lender takes in making a loan, the higher the interest rate required
Real risk-free rate, r*
the rate of interest that would exist on default-free U.S. Treasury securities if no inflation were expected
Yield to Maturity
the rate of return earned on a bond if it is held to maturity
Yield-to-call
the rate of return earned on a bond when it is called before its maturity date
Expected rate of return
the rate of return on a common stock that a stockholder expects to receive in the future
Term structure of interest rates
the relationship between bond yields and maturities
Stand-alone risk
the risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns
Price risk
the risk of a decline in a bond's price due to an increase in interest rates
Interest rate risk
the risk of capital losses to which investors are exposed because of changing interest rates
Reinvestment risk
the risk that a decline in interest rates will lead to a lower income from a bond portfolio
Reinvestment rate risk
the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested
Market risk
the risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as nondiversifiable or systematic risk
Foreign trade deficit
the situation that exists when a country imports more than it exports
Coupon payment
the specified number of dollars of interest paid each year
Coefficient of variation
the standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return
Coupon interest rate
the stated annual interest rate on a bond
Correlation
the tendency of two variables to move together
Expected rate on a portfolio
the weighted average of the expected returns on the assets held in the portfolio
Duration
the weighted-average of the time it takes to receive each of the bond's cash flows
If the risk-free return (inflation) increases by 2 percentage points, then for the security market line
the y-intercept changes and the slope remains the same
Consider the following scenario: Your accountant has convinced you that you should invest your bonus from this year into your retirement account - instead of buying a new sports car - because of the high expected return on the investment. Determine which of these fundamental factors is affecting the cost of money in the scenario described: A. Time preferences for consumption B. Inflation
time preferences for consumption
Price risk for long-term and/or low-coupon bonds
high
Reinvestment risk for short-term and/or high-coupon bonds
high
Junk bonds
high-risk, high-interest bonds
The (higher/lower) the deficit, the (higher/lower) the interest rates
higher, lower
Effect of a call provision
-Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor). -Bond investors require higher yields on callable bonds. -In many cases, callable bonds include a deferred call provision and a declining call premium.
Risk
in a financial market context, the chance that an investment will provide a low or negative return
Nazim also recently bought bonds with a clause stating that interest will be paid only when the company has enough earnings to pay for it. Nazim has invested in
income bonds
If the market-risk premium doubles (say, from 4% to 8%), the required rate of return for a security
increases but less than double
If the risk-free return (inflation) increases by 2 percentage points, the required rate of return
increases the same 2% points for all securities
Printing _________ supply for money
increases; which increases inflation and interest rates
What is a sinking fund?
-Provision to pay off a loan over its life rather than all at maturity -Reduces risk to investor, shortens average maturity -Not good for investors if rates decline after issuance
If rd remains constant:
-The value of a premium bond would decrease over time, until it reached $1,000. -The value of a discount bond would increase over time, until it reached $1,000. -The value of a par bond stays at $1,000.
Borrowing _______ demand for money
increases; which leads to higher interest rates
The contract that describes the terms of a borrowing arrangement between a firm that sells a bond issue and the investors who purchase the bonds is called the
indenture
Use the slider to set the standard deviation for Martin Products to be 6.0. The probability of having a rate of return of at least 5% (move the cursor to 5.0)
is greater for U.S. Water than for Martin Products
For a 10% $1,000 coupon bond, when the market interest rate is greater than 10%, the value of the bond:
is less than its par value of $1000
Use the slider to set the standard deviation for the Martin Products distribution to 8.0. The probability of having a rate of return of at least 10% (move the vertical line to 10.0)
is the same for both U.S. Water and the Martin Products distribution
The entity that promises to make the interest and maturity payments for a bond issue is called the
issuer
This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value
liquidity risk premium
Probability distributions
listings of possible outcomes or events with a probability assigned to each outcome
Warrant
long-term option to buy a stated number of shares of common stock at a specified price
Price risk for short-term and/or high-coupon bonds
low
Reinvestment risk for long-term and/or low-coupon bonds
low
On balance, a sinking fund provision
makes a bond less risky
Portfolio basis
where an asset is held as one of a number of assets in a portfolio
a bond's coupon rate partially determines the interest-based return that a bond _______ pay, and a bondholder's required return reflects the return that a bondholder __________ like to receive from a given investment
will; would
assume Oliver wants to earn a return of 12.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 10.00% coupon rate (distributed semiannually) with three years remaining to maturity. Complete the following table by identifying the appropriate corresponding variables used in the equation. Bond's semiannual coupon payment = Par Value = Semiannual required return = Based on this equation and the data, it is ______________ to expect that Oliver's potential bond investment is currently exhibiting an intrinsic value of less than $1,000
1. $50 2. $1,000 3. 6.0% 4. Reasonable
Assumptions of Pure Expectations
1. Assumes MRP for Treasury Securities is 0 2. Long-term rates are an average of current and future short-term rates 3. If the pure expectations theory is correct, you can use the yield curve to back out expected future interest rates
Credit ratings affect the yields on bonds. Based on the scenario described in the following table, determine whether yields will increase or decrease and whether it will be more expensive or less expensive, as compared to other players in the market, for a company to borrow money from the bond market. 1. A car manufacturing company loses 40% of its market share and has a declining investment in new product development. 2.A start-up company is struggling with finances for its projects. 3. A company's interest coverage ratio improves. 4. A company's credit rating was upgraded from AA to AAA.
1. Increase; more expensive 2. Increase; more expensive. 3. Decrease; less expensive 4. Decrease, less expensive
Semiannual bonds
1. Multiply years by 2. Number of periods = 2N. 2. Divide nominal rate by 2: Periodic rate (I/YR) = Rd/2 3. Divide annual coupon by 2: PMT = Annual Coupon / 2
Apart from risk components, several macroeconomic factors—such as Federal Reserve (the Fed) policy, federal budget deficit or surplus, international factors, and levels of business activity—influence interest rates. Based on your understanding of the impact of macroeconomic factors, identify which of the following statements are true or false: 1. When the Fed increases the money supply, short-term interest rates tend to decline. 2.Actions that lower short-term interest rates will always lower long-term interest rates. 3. During recessions, short-term interest rates decline more sharply than long-term interest rates. 4. The Federal Reserve's ability to use monetary policy to control economic activity in the United States is limited because US interest rates are highly dependent on interest rates in other parts of the world.
1. True 2. False 3. True 4. True
Based on your understanding of the beta coefficient, indicate whether each statement in the following table is true or false: 1. Beta coefficients are generally calculated using historical data. 2. Higher-beta stocks are expected to have higher required returns. 3. Stock A's beta is 1.0; this means that the stock has a negative correlation with the market.
1. True 2. True 3. False
Based on your understanding of the determinants of interest rates, if everything else remains the same, which of the following will be true?
An AAA-rated bond has less default risk than a BB-rated bond
Based on your understanding of bond ratings and bond-rating criteria, which of the following statements is true?
An indenture is a legal document that details the rights of bondholders. If the indenture includes a sinking funds provision, the bond will have less default risk.
may be exchanged for common stock of the firm, at the holder's option
Convertible bonds
Expected total return= YTM=
Expected current yield + expected current gains yield
The pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates. Based on the pure expectations theory, is the following statement true or false? The pure expectations theory assumes that a one-year bond purchased today will have the same return as a one-year bond purchased five years from now.
False
True or False: Assuming all else is equal, the shorter a bond's maturity, the more its price will change in response to a given change in interest rates.
False
The S&P 500 Index is one of the most commonly used benchmark indices for the U.S. equity markets. Consisting of 500 companies, it is a market value-weighted index. This means that each company's performance is reflected in the index, weighted by the ratio of the company's value to the total value of all the companies. Based on your understanding of P/E ratios, in which of the following situations would the average trailing P/E ratio (current price divided by earnings per share over the previous 12 months) of the S&P 500 Index be higher?
Forecast earnings for S&P 500 companies are expected to rise in the future
Erik is an investor with $5,000 available for investment. He has the following three investment possibilities from which to choose: 1. Keep the $5,000 in cash for one year. 2. Invest in a friend's business with a 50% chance of getting $10,000 after one year and a 50% chance of getting nothing. 3. Invest in a relative's business with a 30% chance of getting $15,000 after one year, 20% chance of getting $2,500 after one year, 50% chance of getting nothing. Suppose Erik cares about the risk involved in options 2 and 3, and decides to select option 1 because it has no risk. Which of the following statements would be true about Erik?
He is risk averse
When is a call more likely to occur?
In general, if a bond sells at a premium, then (1) coupon > rd, so (2) a call is more likely. So, expect to earn: YTC on premium bonds. YTM on par and discount bonds.
Over the past several years, Germany, Japan, and Switzerland have had lower interest rates than the United States due to lower values of this premium
Inflation premium
Which of the following statements is true, based on a humped yield curve?
Interest rates on medium-term maturities are higher than rates on long- and short-term maturities
What effect would a high time preference have on interest rates?
It would lead to higher interest rates because it would take a lot to change their preferences
A bond has a $1,000 lump sum due at maturity (10 years), and annual $100 coupon payments. The price of the bond is
N = 10 I/Y = 10 PMT = 100 FV= 1000 PV = 1,000
A bond has a $1,000 lump sum due at maturity (10 years), and annual coupon $130 payments. The price of the bond is
N = 10 I/Y= 10 PMT= 130 FV = 1000 PV = $1,184.34
What is the YTM on a 10-year bond with a 9% annual coupon rate, par value of $1,000 and selling for $887?
N= 10 PV = 887 PMT = 90 (1000 x 9%) FV = 1000 I/Y= 10.91
A bond has a $1,000 lump sum due at maturity (10 years), and annual coupon $70 payments. The price of the bond is
N=10 I/Y = 10 PMT = 70 FV= 1000 PV=815.66
What is the YTM on a 10-year bond with a 9% annual coupon rate, par value of $1,000 and selling for $1,134.20?
N=10 PV= 1,134.20 PMT= 90 FV= 1000 I/Y= 7.08%
What is the value of a 10-year, 10% semiannual coupon bond, if the required rate is 13%? Par value is 1000
N=20 (10 x 2) I/Y = 6.5 (13/2) PMT= 50 (100 / 2) FV= 1000 PV = 834.72
Suppose that a firm is facing an upward-sloping yield curve and needs to borrow money to invest in production. Does this mean that the firm should consider borrowing only at short-term rates?
No, the firm needs to take the volatility of short-term rates into account.
What does r nom mean?
Nominal rate- a rate that doesn't reflect the compounding effects
This is the rate on a Treasury bill or a Treasury bond
Nominal risk-free rate
The real risk-free rate (r*) is 2.8% and is expected to remain constant. Inflation is expected to be 4% per year for each of the next four years and 3% thereafter. The maturity risk premium (MRP) is determined from the formula: 0.1(t-1)%, where t is the security's maturity. The liquidity premium (LP) on all Gauge Import Inc.'s bonds is 0.55%. The following table shows the current relationship between bond ratings and default risk premiums (DRP): AAA - 0.60% AA - 0.80% A - 1.05% BBB- 1.45% Gauge Imports Inc. issues 15-year AA-rated bonds. What is the yield on one of these bonds?
Rc-bond = R* + IP + DRP + LP + MRP IP15 = [4(4%)+ (15-4) x (3%)]/15 = 3.27 t= 15 MRP = 0.1(15-1)% = 1.40% = 2.8%+ 3.27 %+ 0.8% + 0.55% + 1.40% = 8.82%
Risk aversion
Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.
Does a stock have more risk in a stand-alone basis, or as part of a portfolio?
Stand-alone
New York City issued a general obligation bond for a canal in 1812. It was the first formal debt instrument with a fixed repayment schedule issued by a city. Who is the issuer of the bonds? What type of bonds are these?
The New York City government; municipal bonds
Coupon payments are fixed, but the percentage return that investors receive varies based on market conditions. This percentage return is referred to as the bond's yield. Yield to maturity (YTM) is the rate of return expected from a bond held until its maturity date. However, the YTM equals the expected rate of return under certain assumptions. Which of the following is one of those assumptions?
The bond will not be called
What is the opportunity cost of debt capital?
The discount rate (ri) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk.
Relevant risk
The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market.
A portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk. True or false
True
The unsystematic risk component of the total portfolio risk can be reduced by adding negatively correlated stocks to the portfolio. True or false
True
Issuers can gradually reduce the outstanding balance of a bond issue by using a sinking fund account into which they deposit a specified amount of money each year. To operationalize the sinking fund provision of an indenture, issuers can (1) purchase a portion of the debt in the open market or (2) call the bonds if they contain a call provision. Under what circumstances would a firm be more likely to buy the required number of bonds in the open market as opposed to using one of the other procedures?
When interest rates are higher than they were when the bonds were issued
Given your computation and conclusions, which of the following statements is true?
When the coupon rate is greater than Oliver's required return, the bond should trade at a premium
Consider the case of RTE Inc.: RTE Inc. has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $1,070.35. However, RTE Inc. may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on RTE Inc.'s bonds?
YTM: 8.24% YTC: 8.32%
Mortgage bond
a bond backed by fixed assets
Indexed, or purchasing power, bond
a bond that has interest payments based on an inflation index so as to protest the holder from inflation
Income bond
a bond that pays interest only if it is earned
Premium bond
a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate
Discount bond
a bond that sells below its par value; occurs when the going rate of interest is above the coupon rate
When the bond's coupon rate is less than the bondholder's required return, the bond's intrinsic value will be less than its par value, and the bond will trade at
a discount
Inverted yield curve
a downward-sloping yield curve
Indenture
a formal agreement between the issuer and the bondholders
Yield curve
a graph showing the relationship between bond yields and maturities
Debenture
a long-term bond that is not secured by a mortgage on specific property
Bond
a long-term debt instrument
Generally, investors would prefer to invest in assets that have:
a low level of risk and high expected returns
Sharpe ratio
a measure of stand-alone risk that compares the asset's realized excess return to its standard deviation over a specified period. An investment with a higher ratio has performed better than one with a lower ratio
Correlation coefficient
a measure of the degree of relationship between two variables
Capital Asset Pricing Model (CAPM)
a model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification
Market portfolio
a portfolio consisting of all stocks
Liquidity premium (LP)
a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short-notice and at close to its "fair market value"
Inflation premium (IP)
a premium equal to expected inflation that investors add to the real risk-free rate of return
Maturity risk premium (MRP)
a premium that reflects interest rate risk
Call provision
a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date
Sinking fund provision
a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year
Maturity date
a specified date on which the par value of a bond must be repaid
Standard deviation
a statistical measure of the variability of a set of observations
Pure expectations theory
a theory that states that the shape of the yield curve depends on investors' expectations about future interest rates
Humped yield curve
a yield curve where interest rates on intermediate-term maturities are higher than rates on both short-and long-term maturities
For a stock with a beta coefficient of b = 1.50, in a year when the market return is -10%, we expect, in this particular example, the stock's return to be:
about -20%
For a stock with a beta coefficient of b = 1.50, in a year when the market return is 20%, we expect, in this particular example, the stock's return to be:
about 25%
A steeper line on the graph suggests that
an average investor is very risk averse
Security line (SML) equation
an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities
Normal yield curve
an upward-sloping yield curve
Current Yield equals
annual coupon payment/current price
Original issue discount (OID) bond
any bond originally offered at a price below its par value
Suppose the standard deviation for the Martin Products Distribution is 4.0. If an investor is hoping for a return of at least 13%, the chances that investing in Martin Products will return at least 13%
are greater than in investing in U.S. Water
As the standard deviation for Martin Products' distribution increases, the distribution for Martin Products:
becomes flatter and less like the distribution for U.S. Water
Subordinated debentures
bonds having a claim on assets only after the senior debt has been paid in full in the event of liquidation
Corporate bonds
bonds issued by corporations
Foreign bonds
bonds issued by foreign governments or by foreign corporations
Municipal bonds
bonds issued by local and state governments
Treasury bonds
bonds issued by the government; sometimes referred to as government bonds
Convertible bonds
bonds or preferred stock that can be exchanged at the option of the holder for the common stock of issuing firms
Investment-grade bonds
bonds rated BBB or higher; many banks and other institutional investors are permitted by law to hold only investment-grade bonds
Floating-rate bonds
bonds whose interest rate fluctuates with shifts in the general level of interest rates
Fixed-rate bond
bonds whose interest rate is fixed for their entire life
Putable bonds
bonds with a provision that allows investors to sell them back to the company prior to maturity at a prearranged price
Why use a bond?
businesses and governments use bonds because they are cheaper and less restrictive than borrowing money from a bank
Federal Reserve
buys and sells short-term securities to influence short-term interest rates; buying leads to lower short-term interest rates and selling leads to higher short-term rates; can increase/decrease the money supply. Increase leads to higher inflation expectations and decrease leads to lower inflation expectations
Capital gains yield equals
change in price/beginning price
Changing the market risk premium
changes only the slope of the security market line
Changing the risk-free return (inflation)
changes only the y-intercept of the security market line
Allows a bondholder or preferred stockholder to convert their bond or preferred share, respectively, into a specified number or value of common shares
convertibility provision
Refers to the interest payment or payments paid by a bond
coupon payment
YTM=
current yield + capital gains yield
These bonds are not backed by any physical collateral. They are backed by the reputation and creditworthiness of the issuing company
debentures
A bond issuer is said to be in ________ if it does not pay the interest or the principal in accordance with the terms of the indenture agreement or if it violates one or more of the issue's restrictive covenants
default
It is based on the bond's rating; the higher the rating, the lower the premium added, thus lowering the interest rate
default risk premium
An investor's goal should be to
earn returns that are sufficient to compensate for the perceived risk of the investment
When the bond's coupon rate is greater than the bondholder's required return, the bond's intrinsic value will _________ its par value, and the bond will trade at a premium.
exceed
Because of the effects of diversification, the portfolio's risk is likely to be more than the average of all stocks' standard deviations. True or false
false
Portfolio risk will increase if more stocks that are negatively correlated with other stocks are added to the portfolio. True or false
false
True or false: if a company's beta doubles, its required return doubles
false
If the coupon interest rate is 4.375% for the first six months and changes to a rate equal to the 10-year Treasury bond rate plus 1.3% thereafter, the bond is called a
floating-rate bond
As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty
maturity risk premium
For a 10%, $1,000 coupon bond, a longer term bond (say, 15 years) is:
more affected by changes in the market rate than a 1-year bond
For a stock with a beta coefficient of b = 1.50, it is:
more volatile than the average stock
A portfolio of stocks with a B= 0.5
move up and down with the market, but half as rapidly, and therefore have half the risk of an average portfolio (B=1)
A portfolio of stocks with a B=0.5 will
move up and down with the market, but half as rapidly, and therefore have half the risk of an average portfolio (B=1)
Trade Deficits
must borrow to fund the trade deficit with other countries. Borrowing leads to higher demand in the loanable funds market. Higher demand leads to higher rates
As the name suggests, convertible bonds allow the owner the option to convert the bonds into a fixed number of shares of common stock. Which of the following are most likely to have higher yields?
nonconvertible bonds
You invest $100,000 in 40 stocks, 20 bonds, and a certificate of deposit (CD). To which kind of risk will you primarily be exposed?
portfolio risk
Consider the case of an investor, Nazim: Nazim wants to include bonds in his investment portfolio, but he wants the option to sell the bond to the issuer at a specified price on a certain date before the maturity of the bond. Which of the following bond redemption features should he pick?
putable bond
There are three factors that can affect the shape of the Treasury yield curve (r*, IP, and MRP), and five factors that can affect the shape of the corporate yield curve (r*, IP, MRP, DRP, and LP). The yield curve reflects the aggregation of the impacts from these factors. 1. Suppose the real risk-free rate and inflation rate are expected to remain at their current levels throughout the foreseeable future. Consider all factors that affect the yield curve. Then identify which of the following shapes that the US Treasury yield curve can take 2. Identify whether each of the following statements is true or false: - If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the Treasury yield curve is downward sloping. -All else equal, the yield on new bonds issued by a leveraged firm will be less than the yield on the new bonds issued by an unleveraged firm. -The yield curve for a BBB-rated corporate bond is expected to be above the US Treasury bond yield curve. -Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets. 3. Based on an upward-sloping normal yield curve, which of the following statements is correct?
1. Upward sloping 2. True; False; True; True 3. If the pure expectations theory is correct, future short-term rates are expected to be higher than current short-term rates
For a stock with a beta coefficient of b = 0, which of these statements is true in this particular example? The line in the graph is flat
1. the line in the graph is flat 2. It is a riskless asset with a guaranteed return of 10% no matter what the market does. 3. There is no chance of lower performance than the market but also no chance of better performance.
As the standard deviation of outcomes for Martin Products increases, investing in Martin Products becomes riskier because
1. the range of outcomes having some probability becomes wider 2. an outcome at or near the expected return of 10% becomes less likely 3. Although the chances of some big gains increase, the chances for some losses also increase
consider the situation in which Oliver wants to earn a return of 13%, but the bond being considered for purchase offers a coupon rate of 10.00%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of_______ is ___________ its par value, so that the bond is __________
1.$927 2. less than 3. trading at a discount
For a risk-free return rate of 5%, a market risk premium of 6%, what is the required rate of return for a security with a beta coefficient of 1.5?
14%
If the market-risk premium were 4% and a security's beta coefficient were 2.0, what would be the required rate of return for the security? (The risk-free return is fixed at 6% in this graph.)
14%
If the risk-free return were 4.0% and a security's beta coefficient were 2.0, what would be the required rate of return for the security?
14%
If interest rates are expected to remain constant, what is the best estimate of the remaining life left for RTE Inc.'s bonds?
18 years
Suppose you read an article about the Golden Gate Bridge and Highway District bonds. It includes the following information: Bridge Bonds Series A Dated 7-15-2005 4.375% Due 7-15-2055 @100.00 What is the coupon interest rate of this bond?
4.375%
If the inflation rate was 2.20% and the nominal interest rate was 5.60% over the last year, what was the real rate of interest over the last year?
5.60% - 2.20% = 3.40%
If RTE Inc. issued new bonds today, what coupon rate must the bonds have to be issued at par?
8.24%
Beta coefficient
A metric that shows the extent to which a given stock's returns move up and down with the stock market. Beta measures market risk.
A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation?
A portfolio with 10 randomly selected stocks from U.S. and international markets.
