Chapter 5-Bonds Prices and Interest Rate Risk

(T/F) A zero coupon bond has no reinvestment risk.

True

(T/F) All else equal, the greater a security's coupon, the lower the security's price sensitivity to a change in interest rate.

True

(T/F) Expected yield is essentially a forecast.

True

(T/F) Price risk is of no concern to the investor if the bond is held to maturity.

True

(T/F) Price risk is one aspect of interest rate risk

True

(T/F) The coupon rate may be the market rate of interest for a bond.

True

(T/F) The duration of a bond with ten-year maturity and 10% coupon is less than ten years.

True

(T/F) The duration of a coupon bond must be shorter than its term to maturity.

True

(T/F) The duration of a zero coupon bond equals the term to maturity of the bond.

True

(T/F) The higher the coupon rate, the lower the bond price volatility

True

(T/F) The price of a bond and the market rate of interest are inversely related.

True

(T/F) The price risk of a bond tends to offset reinvestment risk somewhat as market interest rates vary.

True

(T/F) The realized yield may be influenced by coupon reinvestment rates.

True

(T/F) Yield to maturity assumes reinvestment of coupons at the same yield.

True

A $1000 2-year 10% coupon bond is priced at $1000 in the market. The duration is a. less than two years. b. more than two years. c. 10%. d. 2 years.

a.

A 3-year zero coupon bond selling at $900 and yielding 12.18 percent has a duration of a. 3 years. b. 2.78 years. c. 2.50 years. d. 2 years.

a.

A corporate bond, paying $65 interest at the end of each year for 6 years, has a face value of $1,000. If market rates on newly issued similarly rated corporate bonds are now 7.5%, what is the current market price of this bond? a. $953.06 b. $1,000.00 c. $1,048.41 d. $936.42

a.

Bond A has a duration of 5.6 while bond B has a duration of 6.0. Bond B... a. will have greater price variability, given a change in interest rates, relative to bond A. b. will have a longer maturity than bond A. c. will have a higher coupon rate than bond A. d. will have less price variability, given a change in interest rates, relative to bond A.

a.

Bonds with _______ coupon rates have a ________ duration than bonds with ________ coupons of the same maturity. a. higher; shorter; smaller b. lower; longer; smaller c. higher; longer; larger d. higher; shorter; larger

a.

In a fixed-rate bond, the variable which changes to determine market rate of return is a. price. b. coupon rate. c. coupon amount. d. face value.

a.

Price risk and reinvestment risk a. offset one another to a certain extent as interest rates change. b. are two bond risks related to credit risk. c. work together to magnify the price impact of a change in interest rate. d. both have an effect on bond price.

a.

The duration of any financial instrument a. cannot exceed the instrument's term to maturity b. is a proxy for the instrument's default risk c. must exceed the instrument's term to maturity d.must be calculated before yield to maturity can be accurately determined

a.

The yield to maturity measure assumes that coupon interest is reinvested at a. the yield to maturity. b. the changing market rates. c. the coupon rate. d. the treasury bond rate.

a.

There is generally a _______ relationship between term to maturity and duration. a. positive b. favorable c. inverse d. large

a.

Tom deposits $10,000 in a savings deposit paying 4%, compounded monthly. What amount would he have at the end of seven years? a. $13,225 b. $13,159 c. $13,179 d. $13,325

a.

Which of the following statements is true about bonds? a. The higher the coupon rate, the shorter the duration. b. The yield on a bond is usually fixed. c. A bond's coupon rate is equal to its face value. d. Most bonds pay interest annually.

a.

Formosan Independence Co. issues a 9-year semiannual payment bond with a par value of $1,000 a 10% coupon annual rate. The bond's credit rating is AA. Currently, this bond is a par bond in market. a. What is the duration of this par bond? b. If Standard and Poor's unexpectedly downgrades the U.S. government bond rating. The market interest rates increase. This bond's annual YTM increases by 2%. What is the impact on bond's interest rate risk? Please use duration to explain.

answer: a. Since this bond is a par bond, its YTM must be 10% annually. Using the duration formula... D = 6137.03/1000 = 6.137 (year) b. When YTM increases as 12% annually, the new bond price will be 891.72 and its duration will be 5.95 years. This means that the increase in market interest rate will lead a decrease in bond's interest rate risk.

What are the relationships between bond price volatility and (a) bond maturity; (b) coupon rate?

answer: As the maturity of a bond increases, the price risk and price volatility increases. As the coupon rate decreases, the present value is impacted more by the maturity value, so price risk increases.

What is bond duration and what are the implications of holding a bond to its duration versus holding the bond to maturity?

answer: Bond duration is a time-weighted maturity and is the sum of the PV of the time-weighted cash flows divided by the market price. Holding a bond for its duration period yields the expected yield to maturity. The offsetting risks of price risk and reinvestment risk, depending on market rate changes, are neutralized at the duration point. An investor holding to maturity eliminates price risk but still absorbs reinvestment risk.

Define and discuss interest rate risk. What are the two risk components of interest rate risk and how do these interact with each other?

answer: Interest rate risk is the impact of varying market interest rates on the realized rate of return on a bond. The price risk component causes the market price of the bond to vary inversely with changing interest rates and increasingly with longer maturity. Reinvestment risk is the change in the realized return from the expected caused by varying reinvestment yields on the coupon reinvested. Price risk and reinvestment risk offset one another at the duration point.

Name and discuss the variables that determine the price or value of a fixed-rate coupon bond.

answer: The market value of a bond is the present value sum of future coupon payments over the life of the bond plus the maturity par value of the bond discounted at the market rate of return (the sum of the real rate + expected inflation + risks associated with the issuer and the bond).

Name and discuss the factors that must be considered when calculating the realized rate of return on a bond.

answer: The risks associated with a bond, default and interest rate risk, may cause the realized return to vary from the expected. Increased default risk increases market discount rates, causing the bond value to fall if sold before maturity (price risk). As market rates vary over time, reinvestment risk may cause the realized return to vary from the expected.

A $1000 bond with a coupon rate of 7% matures in eight years. The bond is now selling for $950, what is the expected yield to maturity on the bond? a. 6.5% b. 7.9% c. 9.0% d. 8.3%

b.

A 10-year semiannual payment bond with a par value of $1,000 has a 7% coupon annual rate. Currently this bond is a par bond in market. According to the above, when increases of market interest rates cause an increase in YTM, ceteris paribus, the interest rate risk of this bond should a. Increase b. Decrease c. Unchange

b.

A bond currently selling at a premium price above face value a. has a yield equal to its coupon rate. b. has a yield below its coupon rate. c. has a yield above its coupon rate. d. has no risk.

b.

All of the following are contractually fixed except a. par value b. yield c. maturity d. coupon

b.

An 16 year corporate bond pays has a 3.5% coupon rate. What should be the bond's price if the required return is 3% and the bond pays interest annually? a. $1060.44 b. $1062.81 c. $1065.45 d. $1072.99

b.

An increase in the demand for securities a. will be associated with an increase in interest rates. b. will be associated with a decrease in interest rates. c. will have no affect on interest rates. d. will be matched with an increase in the supply of securities.

b.

If a 7% coupon (semiannual) bond purchased at par sells 2 years later for $990, what is the realized rate of return (annualized)? a. 8% b. 6.52% c. 7.32% d. 5.75%

b.

Jane needs a specific sum of money in five years. She should invest in a. high quality, 20 year Treasury bonds. b. high quality coupon bonds with a duration of five years. c. high quality coupon bonds maturing in five years. d. high credit risk bonds maturing before five years.

b.

The duration of a $1000, 2-year, 7% coupon bond (interest paid annually) is _____ when market rates are 8%? a. 2.036 b. 1.934 c. 1.902 d. 1.856

b.

Tom purchased a bond last year for $1240, received $60 in interest return, and sold the bond for $1300 one year later. What is Tom's realized annual rate of return? a. 4.8% b. 9.7% c. 9.2% d. More than 10%.

b.

What is the price of a $1,000 face value bond with a 10% coupon if the market rate is 10%? a. more than $1,000 b. $1,000 c. less than $1,000 d. cannot ascertain

b.

Which of the following risks will not affect zero coupon bonds? a. price risk b. reinvestment risk c. credit risk d. default risk

b.

Which of the following statements is true? a. Bond prices and interest rates move together. b. Coupon rates are fixed at the time of issue. c. Short-term securities have large price swings relative to long-term securities. d. The higher the coupon, the lower the price of a bond.

b.

$5,000 invested at 6%, compounded quarterly, will be worth how much after 5 years? a. $6,691 b. $16,036 c. $6,734 d. $5,386

c.

A $1000 bond with a coupon rate of 10%, interest paid semiannually, matures in eight years and sells for $1120. What is the yield to maturity? a. 10.8% b. 11.0% c. 7.9% d. 7.6%

c.

A $1000 bond with an 8.2% coupon rate, interest paid semiannually, and maturing in six years is currently yielding 7.6% in the market. What is the current price of the bond? a. $1,027.08 b. $1,131.19 c. $1,028.48 d. $972.00

c.

A 10-year semiannual payment bond with a par value of $1,000 has a 7% coupon annual rate. Currently this bond is a par bond in market. If the Federal Reserve announces a QE and, therefore, pushes interest rates unexpectedly fall. This bond's YTM drops by 1%. What is the new duration? a. 10.00 years b. 9.592 years c. 7.461 years d. 6.352 years

c.

A bond yield measure should capture all of the following except a. coupon payments. b. reinvestment income. c. changing coupon rate levels. d. capital gains or losses.

c.

An increase in the supply of bonds in the bond market will a. be associated with a decrease in interest rates. b. always be matched by an increased demand for securities. c. be associated with an increase in bond interest rates. d. not affect interest rates, only security prices.

c.

An investor worried about interest rate risk should a. not purchase coupon bonds. b. select bonds whose maturity matches the investor's investment holding period. c. select bonds whose duration matches the investor's investment holding period. d. invest only in U.S. Treasury bonds.

c.

As bond maturity _________, so does the _________ and ________. a. decreases; coupon rate; market price. b. decreases; duration; face value. c. increases; duration; price variability. d. increases; risk; coupon rate.

c.

Calculate the volatility of $1,000 face value 8% coupon bond whose price has varied from $1,020 to $1,050. a. $30.00 b. 5% c. 3% d. $50.00

c.

If a $1000 par value bond has an 8% coupon (annual payments) rate, a 4-year maturity, and similar bonds are yielding 11%, what is the price of the bond? a. $1,000.00 b. $880.22 c. $906.93 d. $910.35

c.

If market interest rates fall after a bond is issued, the a. face value of the bond increases. b. investor will sell the bond. c. market value of the bond is increasing. d. market value of the bond is decreasing.

c.

Interest rate risk is a. duration. b. the extent that coupon rates vary with time. c. the potential variability in the realized rate of return caused by changes in market rates. d. the potential variability in the bond maturity caused by changing discount rates.

c.

Judy would like to accumulate $70,000 by the time her son starts college in ten years. What amount would she need to deposit now in a deposit account earning 6%, compounded yearly, to accumulate her savings goal? a. $4,200 b. $39,513 c. $39,088 d. $125,359

c.

Reinvestment risk is the variability of return associated with a. the variability of bond maturities. b. the variability of bond coupon payments. c. the variability of rates of return on reinvested coupons. d. the variability of the market price on the bond.

c.

The _______ the interest rate and the ________ the number of compounding periods in a year, the _________ the rate of return on a present sum. a. lower, greater, lower b. higher, fewer, higher c. higher, greater, higher d. lower, lower, higher

c.

The bond yield to maturity calculation is a. the guaranteed rate of return to an investor. b. the same as the coupon rate. c. the expected rate of return on the bond. d. the realized rate of return on the bond.

c.

The sum of time weighted discounted cash flows divided by the price of the security is the a. volatility of the security. d. present value of the security cash flows. c. duration of the security. d. always greater than the maturity of the security.

c.

What is the price of the bond in the above question, if the market rate rises to 12% and the bond matures in 5 years? (Assume semiannual compounding). a. $829.60 b. $1,000.00 c. $926.40 d. $1,040.80

c.

When a bond's coupon rate is equal to the market rate of interest, the bond will sell for a. a discount. b. a premium. c. par. d. a variable rate.

c.

Which of the following statements about duration is true? a. Duration is the length of time necessary to pay back the investor's original investment. b. The duration of a bond is some time longer than the maturity of the bond. c. Duration is the investment period necessary to offset price risk and reinvestment risk. d. A bond sold at the duration point will always be priced at $1,000.

c.

A $1,000 par, 8% Treasury bond maturing in three years is priced to yield 7%. Its market price (assuming semiannual compounding) is a. $974.21 b. $813.50 c. $927.50 d. $1,026.64

d.

A 10-year semiannual payment bond with a par value of $1,000 has a 7% coupon annual rate. Currently this bond is a par bond in market. What is the duration of this par bond? a. 10.00 years b. 8.392 years c. 8.452 years d. 7.355 years

d.

A semiannual payment bond with a $1,000 par has a 5% coupon rate, a 6% YTM, and 5 years to maturity. What is the bond's duration? a. 5.00 years b. 4.85 years c. 4.76 years d. 4.47 years

d.

A semiannual payment bond with a $1,000 par has a 7% coupon rate, a 6% YTM, and 5 years to maturity. What is the bond's duration? a. 4.85 years b. 4.57 years c. 4.46 years d. 4.32 years

d.

An investor who selects coupon bond maturities matching his/her holding period a. has eliminated price risk, but not reinvestment risk. b. has eliminated just one part of interest rate risk. c. cannot precisely predict the rate of return on the bond. d. All of the above.

d.

Calculate the realized return on a $1,000 face value, 9 percent coupon bond (annual) purchased for $800 and sold one year later for $850. a. 9% b. 11.25% c. 14.5% d. 17.5%

d.

Duration is a measure of a. a bond's price. b. a bond's contractual maturity. c. the length of time it takes to get back the original investment. d. bond price volatility.

d.

If a bond investor receives all the coupon payments on time and the face value on the contract maturity date, investor's return could still vary because of a. default risk b. price risk c. liquidity risk d. reinvestment risk.

d.

In a fixed rate bond, the variable which changes to provide the current market rate of return to investors is a. face value b. coupon rate c. maturity d. price

d.

Two factors that affect interest rate risk are a. default risk and reinvestment risk. b. liquidity risk and reinvestment risk. c. price risk and political risk. d. price risk and reinvestment risk.

d.

Which of the following statements is true? a. Bonds vary directly with interest rates. b. Bond volatility varies inversely with maturity. c. Low coupon bonds have lower bond volatility than high coupon bonds. d. Bond duration increases with maturity.

d.

(T/F) A bond with an 9% coupon and a 10% required return will sell at a premium to par.

False

(T/F) A zero-coupon bond bears no interest.

False

(T/F) Bonds with lower coupon rates have a shorter duration than similar bonds with high coupon rates.

False

(T/F) Ceteris paribus, the holder of a fairly priced premium bond must expect a capital gain over their holding period.

False

(T/F) Duration is a measure of interest rate volatility.

False

(T/F) Duration matching eliminates risk.

False

(T/F) If market interest rates have increased since a bond was purchased, price risk will increase the price of the bond and reinvestment risk will decrease the return on the coupons.

False

(T/F) If the coupon rate equals the market rate, a bond is likely to be selling at a discount.

False

(T/F) In a short-term bond price risk is not a problem, but reinvestment risk is a considerable concern.

False

(T/F) Money has time value because of inflation.

False

(T/F) Price risk is a measure of bond volatility.

False

(T/F) Short-term bonds have greater price risk compared to long-term bonds

False

(T/F) The coupon rate varies inversely with bond prices

False

(T/F) The price of a bond is the present value of future payments discounted at the coupon rate.

False