FIN300 Exam 2 (Ch. 7 Material)- Wendy Liu

Types of Securities

1. Collateral 2. Mortgagee 3. Debentures 4. Notes

Types of Municipal Securities ("Munis")

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

Types of Treasury Securities

1. Federal government debt 2. T-bills 3. T-notes 4. T-bonds

Zero Coupon bonds

1. Make no periodic interest payments (coupon rate = 0%) 2. The entire yield-to-maturity comes from the difference between the purchase price and the par value 3. Cannot sell for more than par value 4. Sometimes called "zeroes", deep discount bonds, or original issue discount bonds (OIDs)

Yield curve

A plot of term structure

Medium grade bond rating

A- BBB

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

B. Callable

Interest rates that include an inflation premium are referred to as: a. Annual percentage rates. b. Stripped rates. c. Effective annual rates. d. Real rates. e. Nominal rates.

E. Nominal Interest rates

The items included in an indenture that limit certain actions of the issuer in order to protect a bondholder's interests are referred to as the: a. Trustee relationships. b. Bylaws. c. Legal bounds. d. Trust deed. e. Protective covenants.

E. Protective covenants

Bonds issued by the U.S. government: a. Are considered to be free of interest rate risk. b. Generally have higher coupons than comparable bonds issued by a corporation. c. Are considered to be free of default risk. d. Pay interest that is exempt from federal income taxes. e. Are called "munis."

C. Are considered to be free of default risk

Bid-ask spread

In %: Asked - Bid In $: (Asked - Bid) x Par value

A Treasury bond is quoted at a price of 101.6533 with a current yield of 6.276 percent. What is the coupon rate on a $10,000 bond? a. 7.20 percent b. 6.48 percent c. 6.41 percent d. 6.38 percent e. 6.27 percent

D. 6.38 percent

Seniority

preference in position over other lenders ("junior", "subordinated", "senior")

How is bond value determined?

present value of the coupon payments + the present value of the par (face) value (PV of annuity + PV of lump sum)

Discount Bond

price < par value

Premium Bond

price > par value

Par Value (face value)

principal repaid, usually $1,000 per bond two types: discount and premium

T-bills

pure discount bonds with original maturity of one year or less

Nominal interest rate

quoted rate of interest

Collateral

secured by financial securities (also known as asset pledged on a debt)

Mortgage

secured by real property, normally land or buildings

maturity date

specified date on which principal is repaid

coupon payment

stated interest payment (coupon rate expressed in dollars)

Accrued Interest

coupon amount x (days since last coupon payment / days in current coupon period)

T-notes

coupon debt with original maturity between one and ten years

T-bonds

coupon debt with original maturity greater than ten years

Yield to Maturity

current yield + capital gains yield

YTM _____ when bond rating ____

increases; deteriorates

The shape of the yield curve is influenced by...

interest rate expectations

Interest Rates are ________ related to present values (i.e., prices)

inversely

Fisher Effect

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

Clean Price

The price of a bond net of accrued interest; this is the price that is typically quoted. Cash(dirty) price - accrued interest

Coupon Rate

Annual Interest Rate

Ask Price

Asked x Par value (Dealers selling price)

Term structure of the interest rate

The relationship between the interest rate and the investment term

Examples of Zero Coupon Bonds

Treasury Bills and principle-only treasury strips

Debenture

Unsecured debt with original maturity over 10 years

Primary principle of bond valuation

Value of financial securities = PV of expected future cash flows

Premium on bond

When YTM < coupon When Price > par value

At par

When YTM = coupon

Discount on bond

When YTM > coupon When Price < par value

Basics of the bond market

1. Primarily over-the-counter transactions with dealers connected electronically. Low transparency. 2. Trading volume in bonds are many times bigger than the trading volume in stocks 3. Much larger number of bond issues than stock issues, but generally low daily volume in single issues. 4. Hard to get up-to-date bond prices, particularly on a small company or munis. Treasury securities are an exception.

Protective covenants against default risk

1. Sinking funds 2. Subordination of future debt restricts additional borrowing 3. Dividend restrictions- force firm to retain assets rather than paying them out to shareholders 4. Collateral- particular asset bondholders receive if the firm defaults

Inverted yield curve

1. downward-sloping 2. long-term yields are lower than short-term yields

Normal yield curve

1. up-ward sloping 2. long-term yields are higher than short-term yields

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? a. Default risk. b. Taxability. c. Liquidity. d. Inflation. e. Interest rate risk.

A. Default risk

Real rates are defined as nominal rates that have been adjusted for which of the following? a. Inflation. b. Default risk. c. Accrued interest. d. Interest rate risk. e. Both inflation and interest rate risk.

A. Inflation

High grade bond rating

Aaa- AA

Sinking funds

An account managed by the bond trustee for early bond redemption

U. S. Treasury bonds: a. Are highly illiquid. b. Are quoted as a percentage of par. c. Are quoted at the dirty price. d. Pay interest that is federally tax-exempt. e. Must be held until maturity.

B. Are quoted as a percentage of par

A sinking fund is managed by a trustee for which one of the following purposes? a. Paying bond interest payments. b. Early bond redemption. c. Converting bonds into equity securities. d. Paying preferred dividends. e. Reducing bond coupon rates.

B. early bond redemption

Low grade bond rating

Ba-B

When do we see an inverted yield curve?

Before a recession. Tend to precede recessions by 6-18 months.

Bid Price

Bid x Par value (Dealers purchase price)

Which bonds will have the HIGHER coupon, all else equal?

Bonds with higher risk

Very low grade bond rating

C- D

A bond that is payable to whomever has physical possession of the bond is said to be in: a. New-issue condition. b. Registered form. c. Bearer form. d. Debenture status. e. Collateral status.

C. Bearer form

A $1,000 face value bond can be redeemed early at the issuer's discretion for $1,030, plus any accrued interest. The additional $30 is called the: a. Dirty price. b. Redemption value. c. Call premium. d. Original-issue discount. e. Redemption discount.

C. Call Premium

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

C. Liquidity

The pure time value of money is known as the: a. Liquidity effect. b. Fisher effect. c. Term structure of interest rates. d. Inflation factor. e. Interest rate factor.

C. Term structure of interest rates

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? a. The face value of the bond today is greater than it was when the bond was issued. b. The bond is worth less today than when it was issued. c. The yield-to-maturity is less than the coupon rate. d. The coupon rate is greater than the current yield. e. The yield-to-maturity equals the current yield.

C. The yield to maturity is less than the coupon rate

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

C. a discount; less than

A bond is quoted at a price of $1,011. This price is referred to as the: a. Call price. b. Face value. c. Clean price. d. Dirty price. e. Maturity price.

C. clean price

Bond Pricing Equation

C[(1- (1/(1+r)^t)/R]+(FV/(1+r)^t)

Bond default risk is also known as...

Credit Risk

A note is generally defined as: a. A secured bond with an initial maturity of 10 years or more. b. A secured bond that initially matures in less than 10 years. c. Any bond secured by a blanket mortgage. d. An unsecured bond with an initial maturity of 10 years or less. e. Any bond maturing in 10 years or more.

D. An unsecured bond with an initial maturity of 10 years or less.

Protective covenants: Apply to short-term debt issues but not to long-term debt issues. a. Only apply to privately issued bonds. b. Are a feature found only in government-issued bond indentures. c. Only apply to bonds that have a deferred call provision. d. Are primarily designed to protect bondholders.

D. Are primarily designed to protect bondholders

Callable bonds generally: Grant the bondholder the option to call the bond anytime after the deferment period. a. Are callable at par as soon as the call-protection period ends. b. Are called when market interest rates increase. c. Are called within the first three years after issuance. d. Have a sinking fund provision.

D. Have a sinking fund provision

The bond market requires a return of 9.8 percent on the five-year bonds issued by JW Industries. The 9.8 percent is referred to as which one of the following? a. Coupon rate. b. Face rate. c. Call rate. d. Yield to maturity. e. Current yield.

D. Yield to maturity

The taxability risk premium compensates bondholders for which one of the following? a. Yield decreases in response to market changes. b. Lack of coupon payments. c. Possibility of default. d. A bond's unfavorable tax status. e. Decrease in a municipality's credit rating.

D. a bond's unfavorable tax status

A newly issued bond has a 7 percent coupon with semiannual interest payments. The bonds are currently priced at par. The effective annual rate provided by these bonds must be: a. 3.5 percent. b. Greater than 3.5 percent but less than 7 percent. c. 7 percent. d. Greater than 7 percent. e. Less than 3.5 percent.

D. greater than 7 percent

Dirty Price

The price of a bond including accrued interest, also known as the full or invoice price. This is the price the buyer actually pays.

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? a. Note. b. Discounted. c. Zero-coupon. d. Callable. e. Debenture.

E. Debenture

Which bond would you generally expect to have the highest yield? a. Risk-free Treasury bond b. Non-taxable, highly-liquid bond c. Long-term, high-quality, tax-free bond d. Short-term, inflation-adjusted bond e. Long-term, taxable junk bond

E. Long-term, taxable junk bond

A Treasury yield curve plots Treasury interest rates relative to which one of the following? a. Market rates. b. Comparable corporate bond rates. c. The risk-free rate. d. Inflation. e. Maturity.

E. Maturity

Approximation of interest rate

R= r + h

If the present value of the bond has a "-" sign....

The bondholder pays the price

Effect of Time on bond prices

While bond yield remains constant (to isolate the time effect), bond's premium and discount decline over time as bonds approach maturity. Price of coupon bonds rises between coupon payment but falls on the coupon date.

What does "asked yield" refer to?

Yield based on asked price (YTM)

Callable bond

a bond that can be repurchased

Bond

a debt security issued by companies or government agencies

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: a. .05 / (1 - t*) = .07. b. .05 - (1 - t*) = .07. c. .07 + (1 - t*) = .05. d. .05 × (1 - t*) = .07. e. .05 × (1 + t*) = .07.

a. .05 / (1 - t*) = .07.

Sinking Fund

an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. (bond without sinking fund means repayment was done earlier than maturity)

Current Yield

annual coupon ÷ price

If the present value of the bond has a "+" sign....

cash inflows to bondholder

Real interest rate

change in purchasing power

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

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

Yield or Yield to maturity (YTM)

market interest rate (= required return) on a bond

Bond prices and market interest rates move in _______ directions

opposite

Debentures

unsecured debt with original maturity of 10+ years

Notes

unsecured debt with original maturity under 10 years