Finance Exam 2

A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline. True False

False

Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, generally be subject to much more price risk if you purchased a 30-day bond than if you bought a 30-year bond. True False

False

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant. True False

False

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. True or False

False

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve. True False

True

Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength. True False

True

"Risk aversion" implies that investors require higher expected returns on riskier than on less risky securities. True or False

True

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a well-diversified portfolio. True or False

True

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as "company-specific," or "unsystematic," events, and their effects on investment risk can in theory be diversified away. True or False

True

Because the maturity risk premium is normally positive, the yield curve is normally upward sloping. True False

True

One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant. True False

True

Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity. True False

True

The "yield curve" shows the relationship between bonds' maturities and their yields. True False

True

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak. True False

True

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation. True False

True

Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are noncallable, are as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were most probably caused primarily by: a. Default risk and liquidity differences. b. Maturity risk differences. c. Real risk-free rate differences. d. Inflation differences. e. Tax effects.

a. Default risk and liquidity differences.

Which of the following statements is CORRECT about a sinking fund? a. A sinking fund is a provision to pay off a loan (the par value) over its life rather than all at maturity. b. A sinking fund is a provision to pay off a loan (the par value) all at maturity rather than over its life. c. A sinking fund increases the average maturity of a bond. d. A sinking fund reduces risks for the corporate issuers.

a. A sinking fund is a provision to pay off a loan (the par value) over its life rather than all at maturity.

Which of the following statements is CORRECT about call provision? a. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. b. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. c. The bond is currently selling at a price below its par value. d. The bond should currently be selling at its par value. e. If market interest rates decline, the price of the bond will also decline.

a. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.

Based on the following example, which of the following statements is CORRECT? A 10-year bond is priced at $1100 at time 0. (Par value = $1000) a. The bond price would decrease over time, until it reaches $1,000. b. The bond price would decrease over time. But the bond price at maturity will be higher than $1,000. c. The bond price would decrease over time. But the bond price at maturity will be lower than $1,000. d. The bond price would increase over time.

a. The bond price would decrease over time, until it reaches $1,000.

In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t 1)%, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT? a. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds. b. The yield curve must be upward sloping. c. The yield curve must be "humped." d. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate bonds. e. The yield on 2-year Treasury securities must exceed the yield on 5-year Treasury securities.

b. The yield curve must be upward sloping.

Which if the following statements are NOT CORRECT? a. Junk bonds are those rated between "BB" and "C". b. Debentures are less risky compared to mortgage bonds because they are backed up by collaterals. c. Subordinated debentures are paid after debentures. d. Investment-grade bonds are those rated "AAA" and "BBB".

b. Debentures are less risky compared to mortgage bonds because they are backed up by collaterals.

Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. Stock A must have a higher dividend yield than Stock B. b. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's. c. Stock B must have a higher dividend yield than Stock A. d. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. e. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B's.

b. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's.

If in the opinion of a given investor a stock's expected return exceeds its required return, this suggests that the investor thinks a. dividends are not likely to be declared. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. the stock is experiencing supernormal growth. e. the stock should be sold.

b. the stock is a good buy.

Which of the following factors would be most likely to lead to an increase in nominal interest rates? a. The Federal Reserve decides to try to stimulate the economy. b. Households reduce their consumption and increase their savings. c. A new technology like the Internet has just been introduced, and it increases investment opportunities. d. The economy falls into a recession. e. There is a decrease in expected inflation.

c. A new technology like the Internet has just been introduced, and it increases investment opportunities.

Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT? a. The interest rate today on a 3-year bond should be approximately 8%. b. The interest rate today on a 2-year bond should be approximately 7%. c. The interest rate today on a 3-year bond should be approximately 7%. d. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. e. The interest rate today on a 2-year bond should be approximately 6%.

c. The interest rate today on a 3-year bond should be approximately 7%.

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT? a. Inflation is expected to be zero. b. In equilibrium, long-term rates must be equal to short-term rates. c. The maturity risk premium is assumed to be zero. d. An upward-sloping yield curve implies that future short-term rates are expected to decline. e. Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

c. The maturity risk premium is assumed to be zero.

Stock A has a beta of 1.2 and a standard deviation of 20%. Stock B has a beta of 0.8 and a standard deviation of 25%. Portfolio P has $200,000 consisting of $100,000 invested in Stock A and $100,000 in Stock B. Which of the following statements is CORRECT? (Assume that the stocks are in equilibrium.) a. Portfolio P has a standard deviation of 22.5%. b. More information is needed to determine the portfolio's beta. c. Portfolio P has a beta of 1.0. d. Stock A's returns are less highly correlated with the returns on most other stocks than are B's returns. e. Stock B has a higher required rate of return than Stock A.

c. Portfolio P has a beta of 1.0.

Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks? a. The diversifiable risk will remain the same, but the market risk will likely decline. b. The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline. c. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change. d. The expected return of your portfolio is likely to decline. e. Both the diversifiable risk and the market risk of your portfolio are likely to decline.

c. The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.

Which of the following statements is CORRECT? a. If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat. b. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. c. If the expectations theory holds, the Treasury bond yield curve will never be downward sloping. d. If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. e. If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.

d. If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.

Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by: a. Maturity risk differences. b. Inflation differences. c. Real risk-free rate differences. d. Default and liquidity risk differences. e. Tax effects.

d. Default and liquidity risk differences.

A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT? a. The bond should currently be selling at its par value. b. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today. c. If market interest rates decline, the price of the bond will also decline. d. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. e. The bond is currently selling at a price below its par value.

d. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.

Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond. b. The real risk-free rate should increase if people expect inflation to increase. c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. d. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. e. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.

d. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and both have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT? a. The prices of both bonds would increase by the same amount. b. The prices of the two bonds would remain constant. c. One bond's price would increase, while the other bond's price would decrease. d. The prices of both bonds will decrease by the same amount. e. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.

e. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price.

Which of the following would be most likely to lead to a higher level of interest rates in the economy? a. Households start saving a larger percentage of their income. b. The level of inflation begins to decline. c. The economy moves from a boom to a recession. d. The Federal Reserve decides to try to stimulate the economy. e. Corporations step up their expansion plans and thus increase their demand for capital.

e. Corporations step up their expansion plans and thus increase their demand for capital.

Which of the following statements is CORRECT? a. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. b. Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. c. A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. d. The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. e. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

e. A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock.

For a portfolio of 40 randomly selected stocks, which of the following is most likely to be true? a. The beta of the portfolio is less than the weighted average of the betas of the individual stocks. b. The riskiness of the portfolio is greater than the riskiness of each of the stocks if each was held in isolation. c. The riskiness of the portfolio is the same as the riskiness of each stock if it was held in isolation. d. The beta of the portfolio is larger than the weighted average of the betas of the individual stocks. e. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.

e. The beta of the portfolio is equal to the weighted average of the betas of the individual stocks.

Which of the following statements is CORRECT? a. The real risk-free rate should increase if people expect inflation to increase. b. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond. c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. d. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond. e. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

e. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

Which of the following factors would be most likely to lead to a decrease in nominal interest rates? a. high expected inflation b. all of the above c. more production opportunities d. high level of risks e. no urgent needs for consumption and more savings

e. no urgent needs for consumption and more savings