Fixed Income Basics
In 2022, a customer buys 5 ABCD 10% debentures, M '50, at 85. The interest payment dates are Feb 1st and Aug 1st. The bonds are callable as of 2027 at 103. The current yield on the bonds is: A 10% B 10.81% C 11.76% D 12.43%
$100 $850 =11.76%
A customer holds a $250,000 portfolio invested solely in U.S. Government bonds. If the equities market were to rally because of the expectation of a growing economy, while market interest rates remained stable, the risk associated with holding the bond portfolio would be: A opportunity cost B default risk C liquidity risk D reinvestment risk
A. "Opportunity cost" is the return on investment that is forgone by choosing an underperforming asset class. By staying invested in T-Bonds, the customer will earn a lower rate of return as compared to the return that can be achieved from investing in equities in a bull market. For example, if the customer earns 4% on the T-Bonds, but equities grow by 10% over the same period, the opportunity cost is 6%. But, of course, T-Bonds are safe - they have no default risk and also no liquidity risk. Finally, any long-term investment that makes periodic interest or dividend payments has "reinvestment risk" - the risk that over a long-term investment time horizon, rates are dropping and reinvestment of these payments is made at lower and lower rates, reducing overall investment returns.
What rate would be used to find the present value of a TIPS? A Real Rate of Return at the time the bond was issued B Risk-Free Rate of Return at the time the bond was issued C Internal Rate of Return of the bond's cash flows D LIBOR
A. Finding the present value of a TIPS (Treasury Inflation Protection Security) is the same thing as calculating the market price of a TIPS using discounted cash flows. The coupon rate on a TIPS is the interest rate at issuance that will price the instrument at par. This is the same as the "real rate" of return at that point in time (the real rate has the current inflation deducted out, because there is no "inflation risk" on a TIPS). Assume that the 30-year Treasury Bond is issued with a 3% coupon rate when the inflation rate is 1%. The "real" rate of return is 2%, and this would be the interest rate on a 30-year TIPS issued at that time. Assuming that this interest rate is 2% for a 30 year TIPS. If there is no inflation, the annual cash flow received for each of the next 29 years will be 2% of $1,000 = $20; and in year 30, the customer will receive $1,020 ($1,000 principal without any inflation adjustment plus another $20 of interest). If these cash flows are discounted at the coupon rate of 2%, the price of the bond will be par. If there is inflation, then the principal amount is adjusted upwards in that year for the CPI increase, and the cash flow received in that year also increases, since the 2% coupon is applied against the increased principal amount. Because the cash flows are increasing due to inflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued above par. Conversely, if there is deflation, then the principal amount is adjusted downwards in that year for the CPI decrease, and the cash flow received in that year also decreases, since the 2% coupon is applied against the decreased principal amount. Because the cash flows are decreasing due to deflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued below par.
A customer who buys a 10 year zero coupon bond with the intention of holding it to maturity would be MOST concerned with: A inflation risk B liquidity risk C market risk D business risk
A. Bonds with low coupons and long maturities are most affected by interest rate risk and purchasing power risk (risk of inflation). If market interest rates rise (due to Fed policy actions or rising rates of inflation), then this bond's price would drop sharply. This is the major risk for a long term zero coupon obligation.
The disadvantage of owning a mutual fund that invests in common stocks is the risk of loss of: A principal B liquidity C diversification D income
A. Buying a mutual fund that invests in common stocks gives the benefit of diversification. Mutual fund shares can be redeemed daily, so liquidity is not an issue. Income from the investments in the fund flows through to the shareholders, so loss of income is not an issue either. However, market risk is still an issue. If the overall market falls, this fund's shares will fall as well. Thus, loss of principal is still a risk. Review
A customer buys a premium bond with 20 years to maturity that is callable at par at any time during its life. In which situation will the customer earn the lowest yield on the bond? A If the bond is called in 5 years B If the bond is called in 10 years C If the bond is called in 15 years D If the bond is redeemed by the issuer at maturity
A. If a customer buys a bond at a premium, he or she is paying more than par for the bond. This will happen if market interest rates have dropped after the bond was issued or if the bond's credit quality improves after issuance. The premium is "lost" as the bond is held, since the bond is redeemed at par at maturity. The yield to maturity formula takes this into account by taking an annual deduction for the pro-rata loss of the premium - this is called the annual amortization of the bond premium. If the bond is called early, this loss in compressed into a shortened time frame, and this reduces the yield. Thus, any premium bond will give the lowest yield if it is called at the earliest call date.
Which of the following will equal the face value of a bond? A The present value of the payments to be received from the issuer discounted by the bond coupon rate B The present value of the payments to be received from the issuer discounted by the market rate of interest C The future value of the payments to be received from the issuer discounted by the bond coupon rate D The future value of the payments to be received from the issuer discounted by the market rate of interest
A. If the annual interest payments and final principal repayment to be received from a bond are discounted back to present value using the coupon rate, the present value of those payments will be $1,000 = the face value of the bond.
An investor believes that interest rates will be flat or falling into the future; and that prices may deflate. The MOST appropriate investment is: A Long term U.S. Government bonds B Real estate C Gold D Large Capitalization stocks
A. In periods of deflation, interest rates fall. A fixed income security's price will go up as interest rates fall. Furthermore, since prices are deflating, the fixed interest payments received are able to buy more and more over time. This is the best investment choice. In times of deflation, real estate prices fall; as do gold prices. Stock prices tend to fall as well, since companies are forced to cut their prices to maintain sales volume.
A customer wishes to maximize liquidity and minimize interest rate risk. The BEST recommendation is: A bonds with short term maturities B bonds with long term maturities C callable bonds D non callable bonds
A. Short term bonds do not fluctuate much in value as interest rates move since they will be redeemed shortly at par. (The longer the maturity, the greater the price movement in response to market interest rate changes). Short term maturities are also the most liquid - that is, there is great market depth, making them easy to trade.
The Internal Rate of Return of an investment is the: A return which discounts the net cash flows to a present value of "0" B current yield of the investment C excess of return over the risk-free rate of return D expected return based on probability of investment outcomes
A. The IRR is the interest rate or rate of return that will discount the net cash flows to a present value of "0." It is the true yield of the investment. It is not the same as the current yield, which does not consider the time value of money. The excess of return over the risk-free rate of return defines the "risk premium." Expected return assigns probability percentages to potential investment outcomes and averages them.
A $1,000 par bond is issued with 3 years to maturity. The coupon rate on the bond is 2.50%. If the inflation rate for the next 3 years is 1.50%, the bond will be worth how much in 3 years? A $1,000 B $1,046 C $1,077 D $1,125
A. The bond matures in 3 years. At maturity, the bondholder receives par from the issuer. The 2.50% coupon ($25 in interest) is paid to the bondholder annually, divided into semi-annual payments. The inflation rate has nothing to do with this question
During a period of steep economic decline, equity investments fall out of favor with investors, who rotate their investments out of equities into safe investments such as Treasury Bills. This is an example of: A market risk B business risk C regulatory risk D opportunity cost
A. When investors like stocks, they buy them and stock prices rise. When investors don't like stocks, they either sell them or don't buy them and prices fall. This is market risk. Business risk is the risk that a negative event, bad management or bad products cause a company to become unprofitable. Regulatory risk is the risk of law change negatively affecting a company's operations. Opportunity cost is the return "lost" by making a suboptimal investment
A bond portfolio consists of: $100,000 par value of 1-year zero coupon bonds $100,000 par value of 3-year zero coupon bonds $100,000 par value of 5-year zero coupon bonds $100,000 par value of 9-year zero coupon bonds The duration of the portfolio is: A 1 year B 4.5 years C 5 years D 9 years
B. Duration is the number of years until the $1,000 par principal of a bond is paid back. Since a zero-coupon bond makes no interest payments, the entire $1,000 par principal amount is paid back at the maturity date, making the duration the same as the number of years to maturity. To calculate portfolio duration, the weighted average of the bond durations in the portfolio is calculated. In this example, each bond position has the exact same weight ($100,000 par), so taking the arithmetic average of the 4 maturities ( 1 + 3 + 5 + 9 = 18 / 4) gives a portfolio duration of 4.5.
What rate would be used to find the present value of a TIPS? A Risk-Free Rate B Coupon Rate of TIPS C Inflation Rate D LIBOR
B. Finding the present value of a TIPS (Treasury Inflation Protection Security) is the same thing as calculating the market price of a TIPS using discounted cash flows. The coupon rate on a TIPS is the interest rate at issuance that will price the instrument at par. Assume that this interest rate is 2% for a 30 year TIPS. If there is no inflation, the annual cash flow received for each of the next 29 years will be 2% of $1,000 = $20; and in year 30, the customer will receive $1,020 ($1,000 principal without any inflation adjustment plus another $20 of interest). If these cash flows are discounted at the coupon rate of 2%, the price of the bond will be par.
A customer buys a 2-year maturity, 10% coupon bond at par. If market interest rates rise to 12%, then the bond's price will fall by approximately: A 1.7% B 3.4% C 8.8% D 9.7%
B. The customer bought this 2-year bond at par with a coupon rate of 10%. If market interest rates rise to 12%, then the present value of the bond's cash flows will fall as follows (rounded): Year 1:$100 / 1.12 = $89.29Year 2:$1,100 / (1.12)2 = $876.91 Total Present Value = $89.29 + $876.91 = $966.20 The bond will fall in price by $33.80 from $1,000 par, for a fall of 3.4%.
A customer buys a 3-year maturity, 6% coupon bond at par. If market interest rates rise to 8%, then the bond's price will fall by: A 2% B 5% C 10% D 25%
B. The customer bought this 3-year bond at par with a coupon rate of 6%. If market interest rates rise to 8%, then the present value of the bond's cash flows will fall as follows: Year 1:$60 / 1.08 = $55.55Year 2:$60 / (1.08)2 = $51.44Year 3:$1,060 / (1.08)3 = $841.46 Total Present Value = $55.55 + $51.44 + $841.46 = $948.45 The bond will fall in price by $51.55 from $1,000 par, for a fall of 5.155%.
A $1,000 par zero coupon bond with 5 years to maturity can be purchased for $750. How is the bond's rate of return calculated? A Find the Internal Rate of Return that discounts that bond's final payment to "0" in 5 years B Find the Internal Rate of Return that discounts the bond's final payment to $750 in 5 years C Multiply the initial cost of the bond by the discount rate D Divide the $1,000 redemption price of the bond by the discount
B. To find the bond's yield, the interest rate must be found that takes the $750 purchase price and grows it to $1,000 in 5 years. This interest rate is about 6%. This is the bond's yield to maturity (which is also the Internal Rate of Return for a zero coupon bond). $750 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 = $1,004 Conversely, if the $1,000 payment to be received in 5 years is discounted by the rate of return that will bring its present value to $750, that is the bond's yield. This would be: $1,000 / (1.06 x 1.06 x .1.06 x 1.06 x 1.06)
A $1,000 par TIPS is issued with 3 years to maturity. The coupon rate on the bond is 2.50%. If the inflation rate for the next 3 years is 1.50%, the bond will be worth how much in 3 years? A $1,000 B $1,046 C $1,077 D $1,125
B. A TIPS is a Treasury Inflation Protection Security. Aside from receiving the 2.50% coupon ($25 annual interest) paid to the bondholder, the principal is adjusted upwards by the inflation rate each year, and at maturity, the holder receives the inflated principal amount. $1,000 inflated by 1.50% annually equals: $1,000 x 1.015 x 1.015 x 1.015 = $1,046. (Note, while in reality the principal gets adjusted semi-annually, to simplify the calculation, we are adjusting the principal annually.)
Bond A and Bond B both have an 8% coupon. Bond A matures in 2 years, while Bond B matures in 10 years. If market interest rates rise: A the price of both bonds will fall at the same rate B the price of Bond B will fall faster than the price of Bond A C the price of both bonds will rise at the same rate D the price of Bond B will rise faster than the price of Bond A
B. As market interest rates rise, the prices of fixed income securities fall, but not at equal rates. As market interest rates rise, the longer the maturity of the bond, the faster the price will fall; and the lower the coupon rate, the faster the price of the bond will fall. Since the coupon is the same for both bonds, the price of the longer maturity bond (B) will fall faster as market interest rates rise.
What represents business risk? A The risk that a company presents fraudulent financial statements B The risk of buying a single stock C The risk of investing in an enterprise that does not have a government backing D The risk is making an investment commitment when prices are peaking
B. Business risk is simply making an investment in a business that runs into problems, such as falling sales, bad management, bad market environment, bad product line, that cause business results to deteriorate. On this one, we are down to a 50/50 choice - either Choice A or Choice B. Since business risk really does not take "fraud" into account. Choice B is the best answer. As more stocks are added to a portfolio, diversification reduces business risk. A single stock portfolio will have a high level of business risk.
Which bond will decrease the most in price, if interest rates rise by 50 basis points? A A bond with low duration B A bond with high duration C A bond with low credit risk D A bond with high credit risk
B. Duration is a measure of bond price volatility. Bonds with low coupons have large duration numbers; as do bonds with long maturities. Thus, the bonds with the biggest durations are those that are most volatile in price.
Two 20-year corporate bonds are issued at par, with stated interest rates of 10%. One issue is callable at par in 5 years, while the other is callable at par in 10 years. If interest rates drop by 200 basis points shortly after issuance, which statement is TRUE? A The bond callable in 5 years will appreciate more than the bond callable in 10 years B The bond callable in 10 years will appreciate more than the bond callable in 5 years C Both bonds will appreciate by equal amounts D The rate of appreciation depends on the credit rating of the bonds
B. If a bond is callable at par in the near future, any price rise due to falling interest rates will be suppressed since the issuer is likely to call in the debt and refund at lower interest rates. Thus, the bond callable in 10 years will appreciate more than the bond callable in 5 years if interest rates fall.
Which security is MOST affected by interest rate risk? A Common stock B Preferred stock C Treasury bill D Commercial paper
B. Preferred stock is a fixed income security, with a perpetual life - there is no stated maturity. Thus, this is the longest term fixed income security available, and its price is greatly affected by interest rate risk (remember, longer maturities and lower coupon rate issues are most susceptible to interest rate risk). Common stock prices are not directly influenced by interest rate movements - the connection is indirect at best. Common stock prices are directly influenced by expectations regarding future earnings, sales, dividends, etc. Treasury bills and commercial paper are money market instruments with very short maturities - interest rate risk has little impact on these issues.
Which security's price would fluctuate the MOST due to a change in interest rates? A 10 year GNMA with an 8% coupon and a 9% yield to maturity B 10 year zero-coupon Treasury Note with a 7% yield to maturity C 10 year AA rated corporate bond with an 8.5% coupon and a 9.3% yield to maturity D 10 year junk-rated corporate bond with a 9% coupon and a 10% yield to maturity
B. Since all of these securities have the same time to maturity, this is not a factor in deciding which would have the greatest duration (duration is price volatility for a given change in market interest rates). Generally speaking, the longer the maturity, the greater the duration; and the lower the coupon, the greater the duration. The zero-coupon bond is the lowest coupon and would exhibit the most volatile price changes as market interest rates move.
A corporation has issued 10% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 12%. Which are TRUE statements about the outstanding 10% issue? I The current yield will be higher than the nominal yield II The current yield will be lower than the nominal yield III The dollar price of the bond will be at a premium to par IV The dollar price of the bond will be at a discount to par A I and III B I and IV C II and III D II and IV
B. The bond was issued with a coupon of 10%. Currently, the yield for a similar issue is 12%. Therefore, interest rates have risen. When interest rates rise, yields on bonds already trading must also rise. What causes this is a drop in the dollar price of the issue - the bond now trades at a discount.
A 5% coupon bond is being offered on a 6% basis. If interest rates for similar bonds fall below 6%, the basis for this bond will: A increase B decrease C be unaffected D be volatile
B. This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
A U.S. based client purchases 10,000 yen for $110. If the yen drops to $.01, the purchase of 10,000 yen will now cost: A $90 B $100 C $110 D $120
B. This question requires you to sharpen up your 6th grade math skills! Since 10,000 yen were purchased for $110, each yen has a value of $.011. If the yen falls to $.01, 10,000 x $.01 = $100 for the purchase.
What happens to the rate of return calculation on a non-callable bond if the rate of interest stays the same and the time intervals are changed? I Shortening the time intervals will increase the rate of return II Shortening the time intervals will decrease the rate of return III Lengthening the time intervals will increase the rate of return IV Lengthening the time intervals will decrease the rate of return A I and III B I and IV C II and III D II and IV
B. When the question is stating that the "time intervals shorten," this means that the time period between each interest payment received shortens. When the question is stating that the "time intervals lengthen," this means that the time period between each interest payment received lengthens.For example, assume that a 10% bond will pay interest semi-annually, instead of annually. At the end of each 6 months, $50 of interest will be received, instead of receiving $100 every 12 months. Because the first $50 interest payment received can immediately be reinvested over the next 6 months until the second $50 payment is received, this will produce a higher rate of return than receiving the $100 payment at the end of the year. Thus, the actual rate of return will increase if time intervals shorten, because the interest is actually being received more quickly, and can be reinvested faster, increasing the rate of return. Conversely, if the time intervals lengthen, because the actual interest payments are being received more slowly and are reinvested more slowly, the rate of return declines.
A customer who is retired wants to select an investment that is marketable, and that provides the highest rate of return. The BEST choice would be to recommend: A Treasury Bills B Treasury Notes C Investment Grade Preferred Stock D Certificates of Deposit
C. Certificates of Deposit are non-negotiable - they are non-marketable, so this does not meet the client's needs. Preferred stock is marketable, and Treasury securities are extremely marketable, so any of these meet this requirement. However, investment grade preferred stock issued by a top-shelf corporation will provide a higher investment return than ultra-safe Treasury securities, making this the best choice.
If an investor believes that inflation rates will be rising in the foreseeable future, he might rebalance his portfolio to include: A Fixed annuities B 5 year certificates of deposit C Tangible assets D U.S. Government bonds
C. In times of inflation, interest rate levels rise, so bond prices fall; and stock prices fall as well, since companies typically cannot raise prices to consumers fast enough to cover their increasing costs, causing profits to suffer. In times of inflation, any security that gives a fixed return, such as fixed annuities and certificates of deposit, are a bad bet. The payout on these instruments remains fixed over time, yet costs are rising. Tangible assets, such as real estate, collectibles, etc. tend to keep pace with inflation; as overall prices inflate, their prices inflate as well. This is the best choice of the ones offered.
All of the following risks are essentially equivalent for long term corporate bonds EXCEPT: A Interest rate risk B Market risk C Default risk D Inflation risk
C. Interest rate risk is the risk that market interest rates rise, forcing bond prices down. This is the same as market risk for bonds. In an inflationary environment, market interest rates rise, so bond prices are forced down. Thus, these 3 risks are very similar for bonds. Default risk is specific to each corporate bond issuer, so it is the exception in this question.
A TIPS is issued with a 3.5% coupon rate and a 5 year maturity. If inflation runs at 4% per year for the 5-year life of the bond, the redemption value of the bond at maturity will be approximately: A $1,000 B $1,051 C $1,219 D $1,445
C. TIPS are Treasury Inflation Protection Securities. The bonds are issued at par with a lower interest rate than conventional Treasury bonds. In return, the principal amount is adjusted upwards for inflation, with the inflated principal amount paid at maturity. The inflation adjustment is made semi-annually when the interest payment is made. Thus, if inflation runs at 4% annually for the 5-year life of the bond, the principal amount will have been adjusted upwards 10 times, at a 2% increase per adjustment. After the 1st year, the bond's value is $1,000 x 1.02 x 1.02 = $1,040.40 After the 2nd year, the bond's value is $1,040.40 x 1.02 x 1.02 = $1,082.43 After the 3rd year, the bond's value is $1,082.43 x 1.02 x 1.02 = $1,126.16 After the 4th year, the bond's value is $1,126.16 x 1.02 x 1.02 = $1,171.66 After the 5th year, the bond's value is $1,171.66 x 1.02 x 1.02 = $1,218.99
At which Standard and Poor's rating is a bond first considered to be speculative ("junk bond")? A AA B BBB C BB D C
C. The top 4 ratings are "investment grade" - AAA, AA, A, and BBB. Bonds below these ratings are speculative. The best (i.e. first) speculative rating is, therefore, BB.
Which investment cash flows for an investment with a 3 year time horizon would have the highest net present value? A Year 1 - $500; Year 2 - $1,000; Year 3 - $1,500; Total = $3,000 B Year 1 - $1,000; Year 2 - $1,000; Year 3 - $1,000; Total = $3,000 C Year 1 - $1,000; Year 2 - $500; Year 3 - $1,500; Total = $3,000 D Year 1 - $1,500; Year 2 - $1,000; Year 3 - $500; Total = $3,000
D. Each of these investments is returning $3,000 over a 3-year time frame. Net present value discounts these annual cash flows to today's value (the reverse of compound interest). Using net present value, the investment that returns the cash earlier is more valuable - Choice D. To illustrate this, assume that the market rate of interest is 10%. The net present value of Choice A's cash flows is: Year 1Year 2Year 3$500(1.1)+$1,000(1.1)2+$1,500(1.1)3= $5001.1+$1,0001.21+$1,5001.331= $2,408 The net present value of Choice D's cash flows is: Year 1Year 2Year 3$1,500(1.1)+$1,000(1.1)2+$500(1.1)3= $1,5001.1+$1,0001.21+$5001.331= $2,566
What rate would NOT be used to find the present value of a TIPS? A Real Rate of Return at the time the bond was issued B Nominal Rate of the bond C Coupon Rate of the bond D Internal Rate of Return of the bond's cash flows
D. Finding the present value of a TIPS (Treasury Inflation Protection Security) is the same thing as calculating the market price of a TIPS using discounted cash flows. The coupon rate (nominal rate) on a TIPS is the interest rate at issuance that will price the instrument at par. This is the same as the "real rate" of return at that point in time (the real rate has the current inflation deducted out, because there is no "inflation risk" on a TIPS). Assume that the 30-year Treasury Bond is issued with a 3% coupon rate when the inflation rate is 1%. The "real" rate of return is 2%, and this would be the interest rate on a 30-year TIPS issued at that time. Assuming that this interest rate is 2% for a 30 year TIPS. If there is no inflation, the annual cash flow received for each of the next 29 years will be 2% of $1,000 = $20; and in year 30, the customer will receive $1,020 ($1,000 principal without any inflation adjustment plus another $20 of interest). If these cash flows are discounted at the coupon rate of 2%, the price of the bond will be par. If there is inflation, then the principal amount is adjusted upwards in that year for the CPI increase, and the cash flow received in that year also increases, since the 2% coupon is applied against the increased principal amount. Because the cash flows are increasing due to inflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued above par. Conversely, if there is deflation, then the principal amount is adjusted downwards in that year for the CPI decrease, and the cash flow received in that year also decreases, since the 2% coupon is applied against the decreased principal amount. Because the cash flows are decreasing due to deflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued below par.
Which recommendation is suitable for an investor who believes that the economy will experience an extended period of inertial inflation? A Growth equities B Value equities C Long Term Government Bonds D Real Estate
D. Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation.
Which risks are unique to mortgage backed securities? I Interest rate risk II Contraction risk III Credit risk IV Extension risk A I and III B I and IV C II and III D II and IV
D. Mortgage backed securities pass through the monthly mortgage payments to the certificate holders. Because the homeowners have the right to prepay their mortgages without penalty, when market interest rates drop, the homeowners refinance their mortgages, and these early principal repayments are passed-through to the certificate holders. Thus, the certificates pay off much earlier than expected as the expected maturity shortens (this is also called contraction risk or call risk). The certificate holders that receive the early principal payments will now have to reinvest them in new MBSs, which will be yielding less because market interest rates have declined
All of the following terms relating to mortgage backed securities are synonymous EXCEPT: A Call risk B Contraction risk C Prepayment risk D Extension risk
D. Mortgage backed securities pass through the monthly mortgage payments to the certificate holders. Because the homeowners have the right to prepay their mortgages without penalty, when market interest rates drop, the homeowners refinance their mortgages, and these early principal repayments are passed-through to the certificate holders. Thus, the certificates pay off much earlier than expected as the expected maturity shortens (this is also called contraction risk or call risk). The certificate holders that receive the early principal payments will now have to reinvest them in new MBSs, which will be yielding less because market interest rates have declined. Extension risk is an opposite risk. If market interest rates have risen after a mortgage pool is created, the homeowners sit tight and don't move. Thus, the anticipated rate of prepayments built into the security slows down and the maturity extends. The certificate holder winds up earning a lower than market rate of interest for much longer than he or she ever expected!
An investor buys a $30,000, 10% corporate bond maturing in 2047 for $24,000. The bond is callable starting in the year 2022. What is the most appropriate measure for calculating yield? A Total Return B Current Yield C Yield to Call D Yield to Maturity
D. This investor is paying $24,000 for a 10% bond with a face value of $30,000. Thus, the investor is paying 20% less than par for the bond. Because of the discount, these bonds are currently yielding 12.5% ($100 annual interest received / $800 purchase price per bond = 12.5%). This issuer would not call these bonds, since the issuer is only paying 10%; yet if the issuer were to sell new bonds in the current market, it would have to pay 12.5%. This bond is not likely to be called, so using the call date is not the appropriate time frame. Rather, this bond will probably remain outstanding until its maturity, and this is the time frame that should be used to compute the yield on the bond.
A customer with $50,000 to invest needs $100,000 in 10 years to pay for his child's college education. The minimum interest rate needed to meet this goal is: A 10.8% B 9.4% C 8.6% D 7.2%
D. This question is basically asking the "Rule of 72." This is a "rule of thumb" method to determine how long it takes to double one's money. By dividing the rate of return earned on an investment into 72, the length of time needed to double one's investment value can be roughly determined. 72= 10 years to double investment value7.2%
All of the following are required to find the rate of return offered by a zero coupon bond EXCEPT: A Par value at redemption B Years to redemption C Purchase price D Discount rate
D. To find the yield of a zero coupon bond, the purchase price, redemption price and years to maturity are needed. Assume that a customer buys a 5 year zero coupon bond for $750, and it will mature in 5 years at $1,000 par.
A blue chip corporation is making a bond offering that is rated AAA. During the issue's first year of trading, what is the greatest potential risk that a bondholder assumes? A Inflation risk B Liquidity risk C Marketability risk D Interest rate risk
D. Because this is a bond offering that is rated AAA, it will be highly marketable. The bond will be easy to sell, so marketability risk is minimal. Liquidity risk is closely aligned with marketability risk. It is the risk that selling will incur high transaction costs, which is typical of illiquid investments. That is not the case with a AAA-rated bond. So we are left with either inflation risk or interest rate risk as the correct answer. Most corporate bond issues are 30-year bonds. If this is the bond's first year of trading, it probably has 29 years of life left. If market interest rates rise (which is typical in an expanding economy), long-term bonds are impacted more than short term bonds, and their price will fall dramatically. This is the greatest potential risk. The risk of inflation is also very real because it leads to higher interest rates, but this is generally a slower moving phenomenon than rising interest rate levels in an improving economy.
Which of the following risks is the primary concern when investing in a municipal bond? A purchasing power risk B market risk C credit risk D legislative risk
D. Legislative (regulatory) risk is the risk of law changes; primarily the risk of tax law changes. Since the interest income from municipal bonds is exempt from Federal income tax, the main risk associated with these securities is that the Federal government may attempt to tax their interest income (this has already happened with certain types of municipal bonds). Also note that these securities are subject to purchasing power risk, market risk, and credit risk; but this is not the "primary" concern with these investments.
To determine the present value of an investment, which of the following is NOT considered? A The interest rate to be used to discount the annual payments received B The amount of cash expected to be generated each year by the investment C The time horizon of the expected investment returns D The required sum needed at the end of the investment's life
D. Present value takes the annual cash flows that are expected to be generated by an investment and discounts them at the market rate of interest to their "present value." Thus, the present value formula determines what those cash flows are worth today. In contrast, future value takes the cash flows generated by an investment and compounds them at the market rate of interest to their value at a set future date.
The closest approximation of the internal rate of return on a bond is the bond's: A coupon rate B current yield C duration D yield to maturity
D. The internal rate of return on a bond is the interest rate that will discount the bond's cash flows to the purchase price of the bond. It is the same as the bond's yield to maturity.
Investment A requires a $13,000 initial investment with a 3 year investment time horizon. It is expected to generate $5,000 of positive cash flow in Year 1, $5,000 of positive cash flow in Year 2, and $5,000 of positive cash flow in Year 3. Assuming that the market rate of return for investments of similar risk and investment time horizon is 10%, the NPV of this investment is: A -$565.75 B +$666.66 C +$2,000.00 D +$3,000.00
Net Present Value takes the cash flows from an investment and discounts them back to today's present value. The "Net" part of the formula, is that the initial investment outlay ($13,000 in this case) is deducted from the present value of the positive future cash flows. If the NPV is positive, this is a good investment. In this example, in Year 0, -$13,000 is the initial cash outlay.
