Finance test 2

A $1,000 face value bond can be redeemed early at the issuer's discretion for $1,030, plus an accrued interest. The additional $30 is called...?

call premium

A call protected bond is a bond that:

cannot be called during a certain period of time

Real rate of interest

change in purchasing power

You are trying to compare the present values of two separate streams of cash flows which have equivalent risks. One stream is expressed in nominal values and the other stream is expressed in real values. You decide to discount the nominal cash flows using a nominal annual rate of 8 Percent. What rate should you use to discount the real cash flows?

comparable real rate

The interest rate risk premium is the

compensation investors demand for accepting interest rate risk.

The collar of a floating rate bond refers to the minimum and maximum

coupon rate

Yield to maturity

current yield+ capital gains yield

The Walthers Company has a semi-annual coupon bond outstanding. An increase in the market rate of interest will have which one of the following effects on this bond?

decrease the market price

Which one of the following risk premiums compensates for the possibility of nonpayment by the bond issuer?

default risk

The fisher effect

defines the relationship between real rates, nominal rates, and inflation - (1+R)= (1+r)(1+h) R= nominal rate r= real rate h= expected inflation rate Approximation - R=r+h

Pete paid $1,032 as his total cost of purchasing a bond. This price is referred to as the

dirty price

A bond's coupon rate is equal to the annual interest divided by which of the following?

face value

Treasury bonds are

generally issued as semi-annual coupon bonds

A zero coupon bond

has more interest rate risk than a comparable coupon bond

As a bond's time to maturity increases, the bonds sensitivity to interest rate risk:

increases at a decreasing rate.

The Fisher effect primarily emphasizes the effects of _____ on an investor's rate of return

inflation

Which one of the following premiums is compensation for expected future inflation?

inflation

A "fallen angel? is a bond that has moved from

investment grade to speculative grade

You expect interest rates to decline in the near future even though the bond market is not indicating any sign of this change. Which one of the following bonds should you purchase not to maximize your gains if the rate decline does occur?

long term; zero coupon

The current yield is defined as the annual interest on a bond divided by which one of the following?

market price

The specified date on which the principal amount of a bond is payable is referred to as which one of the following?

maturity

ex ante

nominal rate of interest includes our desired real rate of return plus an adjustment for expected inflation.

Interest rates that include inflation premium are referred to as

nominal rates

Municipal bonds

pay interest that is federally tax-free

As interest rates increase

present value decreases bond prices decrease

Dirty price

price actually paid= quoted price plus accrued expense

Clean price

quoted price

Nominal rate of interest

quoted rate of interest, change in actual number of dollars

Which one of the following rates represents the change, if any, in your purchasing power as a result of owning a bond?

real rate

The fisher effect is defined as the relationship between which of the following variables

real rates, inflation rates, and nominal rates

Default risk premium

remember bond ratings

taxability premium

remember municipal versus taxable

collateral security

secured by financial securities

Mortgage securities

secured by real property, normally land or buildings

The difference between the price that a dealer is willing to pay and the price at which he or she will sell is called the"

spread

The pure time value of money is known as the

term structure of interest rates

When computing the present value of an annuity stream of payments you should discount

the nominal cash flows using the real discount rate

If YTM < coupon rate,

then par value < bond price - Why? Higher coupon rate causes value above par - Price above par value, called a premium bond

If YTM> coupon rate

then par value > bond price - Why? the discount provides the yield above coupon rate - Price below par value, called a discount bond

IF YTM= coupon rate

then par value= bond price

Debentures

unsecured

Notes

unsecured debt with original maturity less than 10 years

Liquidity premium

bonds that have more frequent trading will generally have lower required returns - anything else that affects the risk of the cash flows to the bondholders will affect the required returns

Bond characteristics and required returns

* The coupon rate depends on the risk characteristics of the bond when issued * Which bonds will have the higher coupon, all else equal? - Secured debt versus a debtenture - Subordinated debenture versus senior debt - A bond with a sinking fund versus one without - A callable bond versus a non-callable bond

Bond pricing theorems

- Bonds of similar risk (and maturity) will be priced to yield about the same return, regardless of the coupon rate. - If you know the price of one bond, you can estimate its YTM and use that to find the price of the second bond - This is a useful concept that can be transferred to valuing assets other than bonds.

(Government Bond) Municipal Securities

- Debt of state and local governments - Varying degrees of default risk, rated similar to corporate debt - Interest received is tax-exempt at the federal level

Government Bonds (Treasury Securities)

- Federal government debt - T-Bills- pure discount bonds with original maturity of one year or less - T- notes- coupon debt with original maturity between one and ten years - T-bonds- coupon debt with original maturity greater than ten years

Medium Grade Bond Rating

- Moody's A and S&P A- capacity to pay is strong, but more susceptible to changes in circumstances - Moodys Baa and S&P BBB- capacity to pay is adequate, adverse conditions will have more impact on the firm's ability to pay.

High Grade Bond rating

- Moody's Aaa and S&P AAA- capacity to pay is extremely strong - Moody's Aa and S&P AA- capacity to pay is very strong

Very Low Grade

- Moody's C (and below) and S&P C ( and below) - income bonds with no interest being paid, or - in default with principal and interest in arrears

Debt

- Not an ownership interest - creditors do not have voting rights - Interest is considered a cost of doing business and is tax deductivle - Creditors have legal recourse if interest or principal payments are missed - Excess debt can lead to financial distress and bankruptcy

Equity

- Ownership interest - Common stockholders vote for the board of directors and other issues - Dividends are not considered a cost of doing business and are not tax deductible - Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid - An all equity firm can not go bankrupt merely due to debt since it has no debt.

Bond markets

- Primarily over-the counter transactions with dealers connected electronically - Extremely large number of bond issues, but generally low daily volume in single issues - Makes getting up-to-date prices difficult, particularly on small company or municipal issues - Treasury securities are an exception

Bond classifications

- Registered vs. bearer forms - Security - Seniority

Term Structure of Interest Rates

- Term structure is the relationship between time to maturity and yields, all else equal - It is important to recognize that we pull out the effect of default risk, different coupons, etc. - Yield curve- graphical representation of the term structure -> normal- upward sloping; long term yields are higher than short term yields -> inverted- downward sloping; long term yields are lower than short-term yields

Price risk

- changes in price due to changes in interest rates - long-term bonds have more price risk than short term bonds - Low coupon rate bonds have more price risk than high coupon rate bonds

Floating rate bonds

- coupon rate floats depending on some index value - Ex. adjustable rate mortgages and inflation linked treasuries - there is less price risk with floating rate bonds *the coupon floats, so it is less likely to differ substantially from the yield-to-maturity - coupons may have a "collar"- the rate cannot go above a specified "celiling" or below a speicifed "floor"

Zero coupon bonds

- make no periodic interest payments (coupon rate= 0%) - The entire yield to maturity comes from the difference between the purchase price and the par value - cannot sell for more than par value - sometimes called zeroes. deep discount bonds, or original issue discount bonds (OIDs) - Treasury Bills and principal only treasury strips are good examples of zeroes.

Reinvestment rate risk

- uncertainity concerning rates at which cash flows can be reinvested - Short-term bonds have more reinvestment rate risk than long-term bonds - High coupon rate bonds have more reinvestment rate risk than low coupon rate bonds

Low Grade Bond Rating

-Moody's Ba and B - S&P BB and B - considered possible that the capacity to pay will degenerate

YTM

-YTM is the rate implied by the current bond price - Finding the YTM requires trial and error if you do not have a financial calculator and is similar to the process for finding r with an annuity

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

0.05/ (1-t*)= 0.07

You want to buy a bond from a dealer. Which one of the following prices will you pay?

Asked price

Which one of the following is the price a dealer will pay to purchase a bond?

Bid price

A bond that can be paid off early at the issuer's discretion is referred to as being which one of the following?

Callable

A bond is quoted at a price of $989. This price is referred to as which one of the following?

Clean price

Bond indenture

Contract between the company and the bondholders that includes - the basic terms of the bonds - the total amount of bonds issued - A description of property used as security, if applicable - sinking fund provisions - call provisions - details of protective covenants

Mary just purchased a bond which pays $60 a year in interest. What is this $60 called?

Coupon

Which one of the following relationships is stated correctly?

Decreasing the time to maturity increases the price of a discount bond, all else constant.

Bert owns a bond that will pay him $75 each year in interest plus a $1,000 principal payment at maturity. What is the $1,000 called?

Face value

An 8% corporate bond that pays interest semi-annually was issued last year. Which two of the following most likely apply to this bond today if the current yield to maturity is 7 %? I. a structure as an interest only loan II. A current yield that equals the coupon rate III. a yield to maturity equal to the coupon rate IV. a market price that differs from the face value.

I. A structure as an interest only loan IV. a market price that differs from the face value

Which of the following statements concerning bonds are correct? I. Bonds provide tax benefits to issuers II. The risk of a firm financially failing increases when the firm issues bonds. III. Most long-term bond issues are referred to unfunded debt IV. All bonds are treated equally in a bankruptcy proceeding

I. Bonds provide tax benefits to issuers II. The risk of a firm financially failing increases when the firm issues bonds.

Which of the following statements is correct concerning the term structure of interest rates? I. Expectations of lower inflation rates in the future tend to lower the slope of the term structure of interest rates. II. The term structure of interest rates includes both an inflation premium and an interest rate risk premium. III. The real rate of return has minimal, if any, affect on the slope of the term structure of interest rates. IV. The term structure of interest rates and the time to maturity are always directly related.

I. Expectations of lower inflation rates in the future tend to lower the slope of the term structure of interest rates. II. The term structure of interest rates includes both an inflation premium and an interest rate risk premium. III. The real rate of return has minimal, if any, affect on the slope of the term structure of interest rates.

Which of the following increase the price sensitivity of a bond to changes in interest rates? I. increase in time to maturity II. Decrease in time to maturity III. increase in coupon rate IV. decrease in coupon rate

I. increase in time to maturity IV. Decrease in coupon rate

Which of the following defines a note? I. Secured II. Unsecured III. maturity less than 10 years IV. maturity in excess of 10 years

II. Unsecured III. Maturity less than 10 years

Which of the following are characteristics of a premium bond? I. coupon rate < yield to maturity II. coupon rate > YTM III. coupon rate < current yield IV. coupon rate> current yield

II. coupon rate> YTM IV. coupon rate> current yield

Which of the following relationships apply to a par value bond? I. coupon rate < YTM II. current yield= YTM III. market price= call price IV. market price= face value

II. current yield= YTM IV. market price= face value

A bond has a market price that exceeds its face value. Which of the following features currently apply to this bond? I. discounted price II. premium price III. yield to maturity that exceeds the coupon rate IV. yield to maturity that is less than the coupon rate.

II. premium price IV. yield to maturity that is less than the coupon rate

Which two of the following factors cause the yields on a corporate bond to differ from those on a comparable treasury security? I. Inflation risk II. Interest rate risk III. Taxability IV. Default risk

III. Taxability IV. default risk

Real rates are defined as nominal rates that have been adjusted for which one of the following?

Inflation

which one of the following risks would a floating rate bond tend to have less of as compared to a fixed-rate coupon bond?

Interest rate risk

A treasury yield curve plots treasury interest rates relative to which one of the following?

Maturity

Bond value

PV of coupons + PV of par PV of annuity + PV of lump sum

A deferred call provision is which one of the following?

Prohibition which prevents bond issuers from redeeming callable bonds prior to a specified date.

Which one of the following statements concerning bond ratings is correct?

Split rated bonds are called crossover bonds

Which one of the following statements is correct? ...

The NYSE is a publicly owned corporation that sells trading licenses to exchange members

Which one of the following statements is correct?

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

Currently, the bond market requires a return of 11.6% on the 10-year bonds issued by Winston Industries. The 11.6% is referred to as which one of the following?

Yield to maturity

A bond that has only one payment, which occurs at maturity, defines which one of the following?

Zero coupon bond

All else constant, a bond will sell at ______ when the coupon rate is ----- the yield to maturity.

a discount; less than

Current yield

annual coupon/ price

Bonds issued by the U.S. government

are considered to be free of default risk