SB Chapter 7: Interest rates and bon valuation

True or false: The real rate of return will generally be higher than the nominal rate of return.

False

What are three important features of Treasury notes and bonds?

Highly liquid Default-free Taxable

In general, a corporate bond's coupon rate ____,

In general, a corporate bond's coupon rate ____,

What is a real rate of return?

It is a rate of return that has been adjusted for inflation.

True or false: A bond's value is not affected by changes in the market rate of interest.

false

True or false: The inflation premium will be higher if the rate of inflation is low.

false

Which one of these correctly specifies the relationship between the nominal rate and the real rate?

(1 + R) = (1 + r) × (1 + h)

What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year?

10%

A bond pays annual interest payments of $50, has a par value of $1,000, and a market price of $1,200. How is the coupon rate computed?

50/1000

What is a premium bond?

A bond that sells for more than face value

As an investor in the bond market, why should you be concerned about changes in interest rates?

Changes in interest rates cause changes in bond prices.

Which of these are required to calculate the current value of a bond?

Coupon rate Time remaining to maturity Par value Applicable market rate

What is a bond's current yield?

Current yield = Annual coupon payment/Current price

Which six factors determine the yield on a bond?

Default risk Expected future inflation Taxability Liquidity Interest rate risk Real rate of return

What is a discount bond?

Discount bonds are bonds that sell for less than the face value

The discounted payback period has which of these weaknesses?

Loss of simplicity as compared to the payback method Exclusion of some cash flows Arbitrary cutoff date

Which one of the following is the most important source of risk from owning bonds?

Market interest rate fluctuations

Which of the following variables are required to calculate the value of a bond?

Market yield Coupon rate Remaining life of bond

Which is the largest security market in the world in terms of trading volume?

The U.S. Treasuries market

What does a bond's rating reflect?

The ability of the firm to repay its debt and interest on time

Why does a bond's value fluctuate over time?

The coupon rate and par value are fixed, while market interest rates change.

What does the clean price for a bond represent?

The quoted price, which excludes interest accrued since the last coupon date.

Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?

Treasury bonds are issued by the US government while corporate bonds are issued by corporations. Treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer. Treasury bonds are considered free of default risk while corporate bonds are exposed to default risk.

The main reason it is important to distinguish between debt and equity is that the benefits and risks _____.

are different

Secondary markets in sukuk are extremely illiquid because most sukuk are:

bought and held to maturity

A corporate bond's yield to maturity ____.

can be greater than, equal to, or less than the bond's coupon rate changes over time

A bond with exotic features is often called a _____ bond.

cat

the ______ yield is the bond's annual coupon divided by its price

current

With _______-rate bonds, the coupon payments are adjustable.

floating

One of the main disadvantages of the discounted payback period rule is that the cutoff is arbitrarily set and cash flows beyond that point are:

ignored

What will happen to the default risk premium during periods of economic uncertainty?

increase

The written agreement between the corporation and the lender detailing the terms of the debt issue is the

indenture

The U.S. Treasuries market is the _____ in the world in terms of trading volume.

largest

If a $1,000 par value bond is trading at a discount, it means that the market value of the bond is ______ $1,000.

less than

A zero coupon bond is a bond that ____.

makes no interest payments

If a given set of cash flows is expressed in ___________ terms and discounted at the _______________ rate, the resulting present value will be the same as if the cash flows were expressed in real terms and discounted at the real rate.

nonminal, nominal

The amount of time needed for the cash flows from an investment to pay for its initial cost is the _____ period.

payback

Within the context of financial markets, complete the following equation: Bid − Ask = Bid-Ask

spread

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

suggests accepting

Bond ratings are based on the probability of default risk, which is the risk that ___.

the bond's issuer may not be able make all the required payments

The Fisher effect decomposes the nominal rate into:

the inflation rate and the real rate

If you own corporate bonds, you will be concerned about interest rate risk as it affects ____.

the market price of the bonds

The degree of interest rate risk depends on ____.

the sensitivity of the bond's price to interest rate changes

If a $1,000 par value bond is trading at a premium, the bond is _____.

trading for more than $1,000 in the market

True or false: Equity represents an ownership interest.

true

True or false: Interest earned on Treasury notes and bonds is taxable

true

True or false: The major difference between Western financial practices and Islamic law is that Islamic law does not permit charging or paying interest.

true

True or false: The price you actually pay to purchase a bond will generally exceed the clean price.

true

Which of the following is not one of the six factors used to determine the yield on a bond?

voting rights

Most of the time, a floating-rate bond's coupon adjusts ____.

with a lag to come base rate

Which of the following is not a difference between debt and equity?

Equity is publicly traded while debt is not

As a general rule, which of the following are true of debt and equity?

Equity represents an ownership interest The maximum reward for owning debt is fixed

What are the cash flows involved in the purchase of a 5-year zero coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.

Pay $800 today and receive $1,000 at the end of 5 years

When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities that are generically called

Bond

Match each one of these bonds with their characteristic. CAT bond Convertible Bond put bond structured bond

CAT bond - Protects insurance companies from natural disasters Convertible bond -Can be exchanged for shares of stock Put bond - owner can force issuer to repay prior to maturity at a stated price Structured note - based on financial securities, commodities, or currencies

Which of the following are usually included in a bond's indenture?

The total amount of bonds issued The repayment arrangements

The relationship between bond prices and the market rate of interest is ____. Multiple choice question.

inverse; if the market rate of interest rises, bond prices will fall

Which of the following is true about interest rate risk?

All else equal, the longer the time to maturity, the greater the interest rate risk. All else equal, the lower the coupon rate, the greater the interest rate risk.

How is investing in U.S. Treasury bonds different from investing in corporate bonds?

Treasury issues have no default risk. Interest from U.S. Treasuries is exempt from taxes at the state level but corporate interest is not.

What are some reasons why the bond market is so big?

Various state and local governments also participate in the bond market. Federal government borrowing activity in the bond market is enormous. Many corporations have multiple bond issues outstanding.

What is a corporate bond's yield to maturity (YTM)?

YTM is the expected return for an investor who buys the bond today and holds it to maturity. YTM is the prevailing market interest rate for bonds with similar features.

When interest rates in the market rise, we can expect the price of bonds to ____.

decrease

Which of these risks is addressed by bond ratings?

default risk

The inflation_______________, Correct Unavailable premium is the portion of a nominal interest rate that represents compensation for expected future___________

inflation inflation

The federal government can raise money from financial markets to finance its deficits by ___.

issuing bods

The default risk premium refers to the extra compensation demanded by investors for the possibility that the issuer might ____.

not make all the promised payments

If a given set of cash flows is expressed in nominal terms and discounted at the nominal rate, the resulting present value will be the same as if the cash flows were expressed in real terms and discounted at the ____ rate.

real