FINN 3053 test 2

1. Tom deposits $10,000 in a savings deposit paying 4% compounded monthly. What amount would he have at the end of seven years?

$13,225

1. Julie Orzabal deposits $5,000 in a savings account offering 5.125% annual return. This savings account compounds daily. Assuming she makes no further deposits, what will be the balance in her account after 5 years?

$6,461. 17

1. Find the price of a corporate bond maturing in 5 years that has a 5% coupon (annual payments), a $1,000 face value, and an AA rating. A local newspaper's financial section reports that the yields on 5 year bonds are: AAA = 6%, AA = 7%, and A = 8%.

$918

1. All else equal, callable bonds pay a higher yield because

the call option increases the bondholder's reinvestment risk

Interest rate risk is:

the potential variability in the realized rate of return caused by changes in market interest rates

How do you calculate duration of a bond?

the price of the bond is the denominator Numerator: use CF 2nd CE|C in financial calculator and type in each cash flow to compute NPV divide to get duration

1. A bond's price would likely fall as a result of any of the following except

heavy federal reserve buying on the open market

market segmentation theory

market participants do not trade outside their maturity preferences and this leads to two unrealistic predictions: 1. this assumption means that investors would never take advantage of arbitrage opportunities 2. market participants do not trade outside their maturity preferences, discontinuities and spikes are possible in the yield curve

1. If market interest rates fall after a bond is issued, the

market value of the bond is increasing

Strategies for managing interest rate risks

maturity matching- matching the maturity of a bond (portfolio) with investment horizon duration matching- match the duration (portfolio) of a bond with investment horizon

Expectation theory

the shape of the yield curve is determined by investor's expectations of future interest rate movements, so changes in these expectations change the shape of the yield curve. it assumes that investors are profit-maximizing so that they will exhaust any arbitrage opportunities in the market, meaning that there would never be arbitrage opportunity left in equilibrium. Formula: (1 + 𝑅𝑡 𝑛 )^𝑛= (1 + 𝑅𝑡1) (1+ft1) (1+ft)

tax treatment

the way the tax laws treat the interest earned on the bond. Most bonds are taxable tax bond yields: 𝑦𝑖𝑒𝑙𝑑𝑎t= 𝑦𝑖𝑒𝑙𝑑𝑏𝑡(1 − 𝑡)

1. Suppose that you purchase a $1,000 3-year bond with an 8% coupon rate (annual payments). Yields on comparable bonds are 10%. You expect that, one year from now, yields on comparable bonds will have declined to 9%. Find your expected yield, assuming the bond is sold in one year.

0.12

With reference to the data above, what is the default risk premium on commercial paper?

0.79%

How do you calculate yields?

1. find the price of the bond PMT= coupon amount/ number of compounding periods PV= price of the bond FV= face value N= number of compounding periods* years of maturity CPT I/Y= YTM

1. Carol Chastain purchases a one-year discount bond with a face value of $1,000 for $862.07. What is the yield-to-maturity of the bond?

16%

1. A 3-year zero coupon bond selling at $900 and yielding 12.18 percent has a duration of

3 years

1. Calculate the duration of a $1,000 4-year bond with an 8% coupon (annual payments) that is currently selling at par.

3.577 years

1. Suppose the 1-year spot rate is 1% and the 4-year spot rate is 3%. The implied forward rate on a 3-year security of the same risk class originating 1 year from now is

3.676%

1. Applying the expectations theory, a bank depositor chooses between purchasing a one-year CD paying 5% and a two-year CD paying 5.5%. If indifferent between the two, the depositor must expect one-year CDs one year from now to have a rate of

6%

1. Use the below interest rate data to answer following questions 90-day Treasury bills 8.36 percent 180-day Treasury bills 8.48 percent 2-year Treasury notes 9.10 percent 3-year Treasury notes 9.25 percent 90-day Commercial paper 9.15 percent 3-year Corporate bonds (AA) 10.10 percent 3-year Municipal (AA) 7.07 percent Which one of the above bonds does the market view as having the greatest default risk?

90-day commercial paper

1. You purchase a 6‐year $1,000 face value annual payment bond that has a 5 percent coupon and a 7 percent yield. If your investment horizon is 5 years, find the bond's potential return if interest rates fall to 6.5 percent immediately and again if interest rates rise immediately to 7.5 percent. (Hint: Use the bond's duration to find out interest rate changes' impact on bond price first.)

A bond with these characteristics has a duration of 5.16 years. Using the price volatility-duration linkage (Equation 5.9 in the book), a half-point drop in interest rates should then produce an increase of approximately 2.4% in the bond's price, for a potential return of 9.4% (7% yield plus 2.4% capital gain). A half-point rise in rates would produce a change of the same absolute value, but in the opposite direction—the bond's price will fall by approximately 2.4%, for a net potential return of 4.6% (7% yield plus 2.4% capital loss).

1. You have a 7‐year investment horizon and you are considering one of three bonds to purchase, Bond A with a 10‐year maturity and a 7‐year duration, Bond B with a 15‐year maturity and a 10‐year duration, and Bond C with a 7‐year maturity and a 5‐year duration. Suppose your goal is to minimize exposure to interest rate risks, which bond would you buy? Why?

Bond A because its duration equals investment horizon. Employing duration-matching strategy eliminate price and reinvestment risks so the potential return of this investment stays the same no matter how interest rates change.

1. The actual yield curve is usually more upward sloping than the one predicted by expectation theory because

investors usually demand a liquidity premium on longer term securities

1. Define interest rate risk. Explain the two types of interest rate risk. How can an investor with a given holding period use duration to reduce interest rate risk?

Interest rate risk is the potential deviation of realized yield from expected yield caused by changes in market interest rates. Interest rate risk comprises two subsidiary risks. Price risk is the potential variability in price (capital gains/losses) as price varies inversely with yields. Reinvestment risk is the potential variability in reinvestment rates, relative to the yield to maturity, caused by changing market interest rates. Selecting an investment with duration equal to the planned holding period locks in the yield to maturity.

How do you calculate bond prices?

Financial calculator: Pmt: annual coupon payment divided by number of compounding periods FV- face value N= number of compounding periods* maturity I/Y= market rate of interest CPT PV: price of bond

options on debt securities

Many bond contracts contain options that permit the lender or the borrower to change the nature of the contract before maturity Call Option (or Call Provision) Allows the bond issuer to buy back the bond at a specific price before maturity Put Option Allows the investor to sell the bond back to issuer at a pre-determined price Conversion Option Allows the investor to convert the bond to another type of security (usually stocks) at a predetermined price ---> Example: A convertible bond of Apple Inc. may allow investors of their bond to convert every $500 face value of the bond into a share of its stock

1. If the coupon rate on a bond is equal to the market rate of interest on similar bonds, what is the price of the bond? What are these bonds commonly called?

Price is equal to par value of the bond. This type of bonds are called par bonds.

1. Explain why yields and prices of debt instruments are inversely related.

Yields of individual bonds must be adjusted to reflect market-wide opportunity costs of money, which is measured by market interest rate. Once the bond contract is fixed, coupon, par value, and maturity cannot be adjusted any more. So the only way to adjust the yield on the bond to the prevailing market rate of interest is to bid the price upward or downward.

how do interest risks affect bond prices and yields?

as interest rates rise, bond prices fall and vice versa. this means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.

1. Which of the following statements about bonds is NOT true?

bonds selling at premium are especially high quality

Which of the following statements about callable bonds is not true? A. Callable bonds have higher yields than comparable noncallable bonds B. The call price is usually above the bond's par value C. Calls usually benefit the bondholder D. Investors are notified when bonds are called

calls usually benefit the bondholder

1. Suppose a U.S Treasury note with 10 years to maturity yields 2 percent. An XYZ Corporation Bond with the same term to maturity yields 3 percent. Most of the difference is probably because of

default risk

1. The major determinant of the bond ratings assigned by Moody's, Standard and Poors, or Fitchs is

default risk

Duration of a bond vs. maturity of a bond

duration is the the time an investor needs to wait to recoup all the initial investment--- used to measure interest rate sensitivity maturity is the length of time until the principal must be paid back (number of years to maturity)

1. An important difference between "yield to maturity" and "expected yield" is that

expected yield requires an interest rate forecast

A downward sloping yield curve forecasts higher future interest rates.

false

If the coupon rate equals the market rate, a bond is likely to be selling at a discount

false

Short-term bonds have greater price risk compared to long-term bonds

false

As bond maturity _________, so does the _________ and ________

increases; duration; price volatility

1. The the value of a conversion option from a variable-coupon bond to a fixed-coupon bond should rise when

interest rates fall

Liquidity premium augmented expectation theory

liquidity premium suggests that investors must be compensated to hold longer maturity bonds even if the yields are the same as shorter term bonds on paper-- longer bonds are riskier and therefore easy to re-sell once purchased - always higher when maturity is longer

Interest rate risks and subsidiary components

longer bonds have more interest rate risks (higher price volatility) than shorter bonds low coupon bonds have more interest rate risks than high coupon bonds Duration, price volatility, maturity matching, and duration matching are strategies for managing

1. Each of the following bonds was issued at the same time by the same issuer with the same maturity. Which has the shortest duration?

quarterly coupon bond

How do interest rate changes affect bond prices and yields?

price of a bond decreases in its maturity (decreases as maturity increases) price of bond becomes higher when coupon rate increases when the market yield is lower, bond prices are higher

Default risks

probability of borrowers not honoring promised payments difference between the yield and the yield of a comparable security without any default risks

preferred habitat theory

this theory allows market participants to trade outside of their preferred maturity if adequate compensation is provided -- implies a smooth yield curve

An investor in the 33 percent tax bracket should buy a 6 percent municipal bond rather than a similarly rated 8.5 percent corporate bond

true

Default risk premiums are usually smaller during periods of high economic growth.

true

The higher the coupon rate, the lower the bond price volatility

true

The less marketable a security, the higher its yield

true

The price of a bond and the market rate of interest are inversely related.

true

The realized yield may be influenced by coupon reinvestment rates.

true

The shape of the yield curve is at least partly determined by expectations of change in future interest rates.

true

1. Which bond characteristic is not fixed by contract?

yield

1. Assume all the following bonds were issued at the same time with the same maturity by the same issuer and that market yield is now higher than coupon rates of all bonds. Which should trade at the deepest discount from par?

zero coupon bond