Debt: Bond Basics
The yield to maturity of a bond: A. increases as bond market prices decline B. increases as bond market prices increase C. is unaffected by changes in market interest rates D. will vary with the earnings of the issuer
The best answer is A. (Annual interest + Annual Capital Gain) / ((Bond Cost + Redemption Cost) / 2) = Yield to Maturity for a Discount Bond Since both the Annual Interest and Annual Capital Gain are fixed, as the cost of the bond falls, the Yield to Maturity must rise. (Annual interest - Annual Capital Loss) / ((Bond Cost + Redemption Cost) / 2) = Yield to Maturity for a Premium Bond Since both the Annual Interest and Annual Capital Gain are fixed, as the cost of the bond rises, the Yield to Maturity must fall.
The lowest investment grade rating is: A. Baa B. Ba C. CCC D. C
The best answer is A. A bond's rating becomes speculative when it falls BELOW a BBB or Baa rating, so these are the lowest investment grades.
Which security is NOT subject to reinvestment risk? A. Zero coupon bonds B. Low coupon bonds C. Medium coupon bonds D. High coupon bonds
The best answer is A. A zero-coupon bond does not make periodic interest payments. The bond is purchased at a discount from par; makes no current interest payments; and matures at par. The implicit rate of return (the "interest" received) is built into the discount price and is not affected by reinvestment risk. Reinvestment risk for bondholders is the risk that interest rates drop after issuance of the bonds; and that as interest payments are received over the life of the issue, they cannot be reinvested at the same rate.
An investor who purchases a bond with a tender option at par is best protected from which of the following risks? A. Market risk B. Credit risk C. Legislative risk D. Call risk
The best answer is A. An investor who purchases a bond with a tender option at par is protected from market risk. If interest rates rise, the value of a typical bond without this option would drop. The option allows the bondholder to "put" the bond back to the issuer, receiving par for each bond. Therefore, the value of the bond cannot fall below par, even if market interest rates rise. Thus, in a period of rising interest rates, the holder of a "puttable" bond is protected from market risk once the option is exercisable.
When bonds are trading at a large discount, which of the following statements are TRUE? I The deeper the discount, the more volatile the bond's price movement in response to interest rate changes II The deeper the discount, the less volatile the bond's price movement in response to interest rate changes III Discount bonds with long maturities are more volatile than ones with short maturities IV Discount bonds with short maturities are more volatile than ones with long maturities A. I and III B. I and IV C. II and III D. II and IV
The best answer is A. As a general rule, the deeper the discount, the more volatile the bond's price movements in response to market interest rate changes. The deepest discount bond that can be purchased is a "zero coupon" bond. Such a bond has the most volatile price movements. Also, the longer the maturity, the more volatile the bond's price movements in response to market interest rate changes.
All of the following rate bonds for credit risk EXCEPT: A. Best's B. Fitch's C. Moody's D. Standard and Poor's
The best answer is A. Best's is a rating agency for insurers. Moody's, Standard and Poor's and Fitch's are the bond rating agencies, listed in order of market share.
An investor expects that interest rates will decline over the next 5 years. Which of the following are appropriate investments? I Non-callable 10 year bonds II 10 year bonds puttable at par in 5 years III 10 year bonds callable at par in 5 years IV Adjustable rate (reset) bonds, with an annual reset period A. I and II B. III and IV C. I, II, III D. I, III, IV
The best answer is A. If interest rates decline, it is likely that issuers will call in outstanding bonds and refund the issues at the lower current interest rates. An investor who expects interest rates to drop should avoid callable issues (Choice III) or issues with adjustable interest rates (since each year as interest rates drop, the rate on the bond is dropped). Non callable bonds are fine, as are bonds with put options. The put option will only be used if interest rates rise, decreasing the value of the bond. Then, the bondholder would exercise the option and "put" the bonds to the issuer at par.
An analysis of yield curves of U.S. Government and lower medium quality corporate bonds shows the yield spread to be widening over the last 4 months. Based upon investor expectations as evidenced by the widening of the yield spread, an appropriate investment is: A. U.S. Government bonds B. Medium quality corporate bonds C. Long term discount bonds D. Long term premium bonds
The best answer is A. If the yield "spread" between Government bonds and lower medium quality corporate bonds is widening, this means that yields on lower grade corporate bonds are higher than normal relative to yields on Government bonds. This occurs because an excess of investors are buying Governments, pushing their yields down; or an excess of investors are selling lower grade corporate bonds, pushing their yields up. This behavior is typical when investors expect a recession. When a recession is expected, there is a "flight to quality." Investors liquidate holdings that are vulnerable in a recession (low grade corporate bonds) and put the money into safe havens such as government bonds.
Municipal dollar bonds are generally: A. term bonds B. series bonds C. serial bonds D. short term maturities
The best answer is A. Municipal dollar bonds (quoted on a percentage of par basis) are term bonds. Municipal bonds quoted in basis points (yield quotes) are serial bonds.
Regarding bonds with put options, which of the following statements are TRUE? I Exercise of the put is at the option of the bondholder II Exercise of the put is at the option of the issuer III Yields on bonds with put options are lower than similar bonds without this feature IV Yields on bonds with put options are higher than similar bonds without this feature A. I and III B. I and IV C. II and III D. II and IV
The best answer is A. Put options are exercisable at the option of the bondholder (not the issuer). Because the put option removes some of the market risk from the bond, this feature is valued by bondholders, who will accept lower yields on bonds having this option.
A 12%, $1,000 par corporate bond is trading at $1,100. What is the current yield? A. 10.9% B. 12.0% C. 12.6% D. 13.3%
The best answer is A. Since the bond is trading at a premium, its current yield must be lower than its coupon. The formula to find the current yield is: Annual Interest / Market Price = Current Yield $120 / $1,100 = 10.9%
The obligor on a municipal bond issue is the: A. borrower of the bond proceeds B. lender of the bond proceeds C. guarantor of the payment of debt service on the bond issue D. fiduciary acting for the benefit of the bondholders
The best answer is A. The "obligor" on a bond issue is the party having the obligation to pay the debt service on the bonds. This is the "legal" name for the borrower or debtor.
The current yield of a bond will: I increase as bond prices fall II decrease as bond prices rise III remain unchanged as bond prices fall IV remain unchanged as bond prices rise A. I and II B. III and IV C. I and IV D. II and III
The best answer is A. The current yield is the stated rate of interest as a percentage of the bond's market value. As bond prices fall, the current yield increases; as bond prices rise the current yield decreases.
The yield curve shows the yields of: A. different maturities of the same type of security B. different types of securities with the same maturity C. different risk classes of securities with the same maturity D. different maturities of securities with different risk classes
The best answer is A. The yield curve compares the yields of all maturities for the same type of security (e.g., the yields for all maturities of U.S. Government securities; the yields for all maturities of AAA rated corporate securities, etc.)
For bonds trading at a discount, rank the yield measures from lowest to highest? I Nominal II Current III Basis A. I, II, III B. III, II, I C. II, I, III D. I, III, II
The best answer is A. When bonds are trading at a discount, the stated (nominal) yield will be lowest. The current yield will be higher, since it is based on the discounted market price - not par value. The yield to maturity will be the next highest, since it includes the portion of the discount earned annually as part of the annual return in addition to the interest received.
During a period when the yield curve is inverted: A. short term rates are more volatile than long term rates B. long term rates are more volatile than short term rates C. short term and long term rates are equally volatile D. no relationship exists between short term and long term rate volatility
The best answer is A. Whether the yield curve is ascending (normal), flat or inverted, the true statement always is that short term rates are more volatile than long term rates. Short term rates are susceptible to Federal Reserve influence, and move much faster than do long term rates. Long term rates respond more slowly; and reflect longer term expectations for inflation and economic growth, among other factors.
A bond issue where every bond has the same issue date, interest rate, and maturity is a: A. term bond offering B. series bond offering C. serial bond offering D. combined serial and term bond offering
The best answer is A. A term bond issue is one where every bond has the same issue date, interest rate and maturity. Corporate issues and U.S. Government bond issues are typically term bonds.
A declining rate of inflation would lead to: A. higher bond prices and higher bond yields B. higher bond prices and lower bond yields C. lower bond prices and lower bond yields D. lower bond prices and higher bond yields
The best answer is B. A declining rate of inflation will lead to lower interest rates. If interest rates drop, then bond prices will rise.
Which of the following ratings applies to commercial paper? A. MIG 1 B. P3 C. Bb D. A+
The best answer is B. Commercial paper is rated P1, P2, P3, NP (highest to lowest) by Moody's. P stands for prime. NP means "not prime" and is the lowest rating. The "ABC" ratings are used for long term corporate and municipal bonds. The MIG ratings are used for municipal short term notes.
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
The best answer is 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.
Two 20-year corporate bonds are issued at par, with stated interest rates of 10%. One issue is puttable at par in 5 years, while the other is puttable at par in 10 years. If interest rates rise by 200 basis points shortly after issuance, which statement is TRUE? A. The bond puttable in 5 years will depreciate more than the bond puttable in 10 years B. The bond puttable in 10 years will depreciate more than the bond puttable in 5 years C. Both bonds will depreciate by equal amounts D. The rate of depreciation depends on the credit rating of the bonds
The best answer is B. If a bond is puttable at par in the near future, any price decline due to rising interest rates will be suppressed since the holder is able to put the bond back to the issuer sooner. Thus, the bond puttable in 10 years will depreciate more than the bond that is puttable in 5 years if interest rates rise.
In 2019, a customer buys 5 GE 10% debentures, M '39. The interest payment dates are Feb 1st and Aug 1st. The current yield on the bonds is 11.76%. The bonds are callable as of 2029 at 103. The bond is trading: A. at a premium B. at a discount C. at par D. in the money
The best answer is B. If the bond's current yield (11.76%) is higher than the coupon yield (10%), the bond is trading at a discount. In order for the yield to rise above the stated fixed coupon rate, the price of the bond must drop in the market.
Which characteristics make a security least subject to liquidity risk? I Short term maturity II Long term maturity III Low credit rating IV High credit rating A. I and III B. I and IV C. II and III D. II and IV
The best answer is B. Liquidity risk is the risk that a security can only be sold by incurring large transaction costs. The easiest securities to sell (meaning the most readily marketable) are those with high credit ratings and short term maturities.
Which statements are TRUE regarding market risk for bondholders? I As interest rates rise, the price of long term bonds falls faster than that of short term bonds II As interest rates rise, the price of short term bonds falls faster than that of long term bonds III To avoid market risk, a customer would invest in bonds with long term maturities IV To avoid market risk, a customer would invest in bonds with short term maturities A. I and III B. I and IV C. II and III D. II and IV
The best answer is B. Market risk for a bondholder is the risk of rising interest rates forcing the price of a bond to drop. As interest rates rise, the price of a long term bond falls faster than that of a short term bond. To avoid market risk, a bondholder would want to invest in the shortest maturity possible.
Most of the value of a bond is established by the: A. present value of the first payment B. present value of the last payment C. expected volatility of the bond's price D. expected volatility of market interest rates
The best answer is B. The actual dollar price of a bond is computed by taking the yearly income stream and principal repayment at maturity and discounting it back to today's "present value" based on the current market interest rate. Most of the value of the bond comes not from the yearly interest payments, but rather from the final payment when the principal is being returned.
A corporation has issued 7% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 8%. Which of the following are TRUE statements about the outstanding 7% 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
The best answer is B. The bond was issued with a coupon of 7%. Currently, the yield for a similar issue is 8%. Therefore, interest rates have risen subsequent to the issuance of the bond; or the credit quality of the bond has deteriorated. 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 municipal dealer quotes a 4 year, 4% term revenue bond at 98. The yield to maturity is: A. 4.25% B. 4.55% C. 4.75% D. 5.00%
The best answer is B. The formula for yield to maturity is: Annual Income + Annual Capital Gain (Discount Bond) / Average Bond Value = Yield to Maturity This bond has a coupon rate of 4% = 4% of $1,000 par = $40 of annual income. The bond is purchased at 98% of $1,000 par = $980; and will mature at $1,000 in 4 years, Thus, the $20 capital gain is earned over 4 years for an annual gain of $20 / 4 = $5 per year. The bond is purchased at $980 and matures at $1,000, for an average value of $980 + $1,000 / 2 = $990. The YTM is: $40 + $5 $990 = 4.545% = 4.55%
Which bond will exhibit the greatest price volatility? A. 8-year bond; 6% coupon; 7% yield; duration of 6.41 B. 7-year bond; 0% coupon; 7% yield; duration of 7.00 C. 3-year bond; 2% coupon; 3% yield; duration of 2.93 D. 2-year bond; 1% coupon; 3% yield; duration of 1.98
The best answer is B. The longer the expiration, the more volatile a bond's price movements, which narrows the Choices to either A or B. The lower the coupon, the more volatile the bond's price movements, with the lowest coupon being "0." A 7-year zero coupon bond will actually be more volatile in price movements than a slightly longer maturity bond (8 years) with a fairly high coupon (6% in this case). The higher coupon means that more of the bond's value is represented by the interest stream than comes in early and this stabilizes the bond's price as market interest rates move. Duration is a concept that is tested as a "basic" idea on Series 7. It represents the amount of time that it will take for an investor to recoup his or her purchase price. The longer the duration, the longer it will take for an investor to get his or her money back and longer term bonds are more volatile. So the higher the duration number, the greater the bond volatility, and duration is often used as a measure of bond price volatility.
The nominal yield of a bond will: I increase as bond prices fall II decrease as bond prices rise III remain unchanged as bond prices fall IV remain unchanged as bond prices rise A. I and II B. III and IV C. I and IV D. II and III
The best answer is B. The nominal yield is the stated rate of interest as a percentage of par value. It does not change as bond prices move. However, the current yield and yield to maturity will be affected by changes in bond prices.
If a callable bond is purchased at a premium, and is then called at par which of the following is TRUE? A. The yield to call is higher than the nominal yield B. The yield to call is lower than the nominal yield C. The yield to call is the same as the nominal yield D. The yield to call moves inversely to the nominal yield
The best answer is B. The yield to call will be lower than the yield to maturity if the bond was purchased at a premium (which will be lost faster if the bond is called early). Since the bond is purchased at a premium, both yield to call and yield to maturity must be lower than the nominal yield.
A wealthy customer has $2,000,000 to invest and wishes to create a bond portfolio that maximizes expected income, and is willing to assume a reasonable level of risk of default to achieve this objective. The registered representative recommends diversifying by investing $400,000 among 5 different corporate bond issues in different industries. Below are 4 possible portfolios for the customer: Expected Annual Rate of Return Default Risk Over 10 Years Portfolio A 10% 5% Portfolio B 11% 10% Portfolio C 12% 40% Portfolio D 14% 50% The best portfolio to meet the customer's investment objective and risk tolerance level is: A. Portfolio A B. Portfolio B C. Portfolio C D. Portfolio D
The best answer is B. This one is "interesting." The "default risk" represents the loss of return that is likely due to making higher risk investments. If Portfolio A has an expected annual rate of return of 10% over 10 years; but there is the probability that of the $2,000,000 invested, 5% of those bonds will default, so the net return will be 95% of 10% = 9.5%. If Portfolio B has an expected annual rate of return of 11% over 10 years; but there is the probability that of the $2,000,000 invested, 10% of those bonds will default, so the net return will be 90% of 11% = 9.9%. If Portfolio C has an expected annual rate of return of 12% over 10 years; but there is the probability that of the $2,000,000 invested, 40% of those bonds will default, so the net return will be 60% of 12% = 7.2%. If Portfolio D has an expected annual rate of return of 14% over 10 years; but there is the probability that of the $2,000,000 invested, 50% of those bonds will default, so the net return will be 50% of 14% = 7.0%.
An investor buys a bond at a discount. Later in the year, the bond is trading at a premium. This is termed: A. Amortization B. Appreciation C. Accretion D. Accumulation
The best answer is B. When an asset increases in value, this is termed appreciation.
For bonds trading at a premium, rank the yield measures from lowest to highest? I Nominal II Current III Basis IV Yield to Call Basis A. I, II, III, IV B. IV, III, II, I C. II, I, III, IV D. I, III, II, IV
The best answer is B. When bonds are trading at a premium, the yield to call will be the lowest measure since the annual return is reduced by the annual amortized portion of the premium that will be "lost" over the life of the bond to the call date. The next highest yield will be the yield to maturity, since the premium will be lost over a longer "life" than if the bond is called early. Current yield will be higher than yield to maturity, since it does not include the annual premium loss. Stated yield will be the highest since it is the return based on par value.
When the yield curve is inverted: I short term rates are higher than long term rates II long term rates are higher than short term rates III the Federal Reserve is loosening credit IV the Federal Reserve is tightening credit A. I and III B. I and IV C. II and III D. II and IV
The best answer is B. When short term rates are higher than long term rates, this is an inverted or descending yield curve. If the Federal Reserve sharply tightens credit, it exerts its influence at the short end of the yield curve, driving up short term rates. If the Fed really "tightens," then short term rates can be driven above long term rates. Long term rates are indirectly influenced by Fed actions - what drives long term rates are long term expectations about economic growth and inflation.
In 2019, a customer buys 1 ABC 10%, $1,000 par debenture, M '34, at 100. The interest payment dates are Jan 1st and Jul 1st. The nominal yield on the bond is: A. 5.00% B. 10.00% C. 12.00% D. 15.00%
The best answer is B. The nominal yield is the stated rate of interest on the bond, based on par value: Annual Interest / Par = Nominal Yield $100 / $1,000 = 10%
A declining rate of inflation would lead to: I lower bond prices II higher bond prices III lower bond yields IV higher bond yields A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. A declining rate of inflation will lead to lower interest rates. If interest rates drop, then bond prices will rise.
Bonds quoted on a yield to maturity basis are generally: A. term bonds B. series bonds C. serial bonds D. short term maturities
The best answer is C. Bonds quoted in basis points (yield quotes) are serial bonds - this is the usual case for municipal bonds. Bonds quoted on a percentage of par basis are term bonds.
If interest rates rise dramatically, which investment would be LEAST adversely affected? A. A discount bond with 5 years to maturity B. A 7-year zero coupon bond C. A premium bond with 5 years to maturity D. A 9-year zero coupon bond
The best answer is C. If market interest rates rise, bond prices fall. Discount bonds fall faster than premium bonds; and long-term bond prices fall faster than short-term bond prices. Zero coupon bonds (which are the deepest discount bonds) with long maturities will fall the fastest of all. The only choice given that is not a discount bond is Choice C - a premium bond. Premium bonds have higher coupon rates, and this higher level of income coming in sooner softens the bond's fall in price as market interest rates rise.
Which statements are TRUE? I Most of the value of a bond is established by the present value of the first payment II Most of the value of a bond is established by the present value of the last payment III The longer the maturity of a bond, the greater the bond's price volatility IV The shorter the maturity of a bond, the greater the bond's price volatility A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. The actual dollar price of a bond is computed by taking the yearly income stream and principal repayment at maturity and discounting it back to today's "present value" based on the current market interest rate. Most of the value of the bond comes not from the yearly interest payments, but rather from the final payment when the principal ($1,000 par) is being returned. From a present value standpoint, if a bond has a long maturity, the present value of the final principal payment is greatly affected by interest rate movements, since many years of compounding are applied to get the present value of the last $1,000 payment. On the other hand, if the bond has a short maturity, the present value of the final $1,000 principal payment is not affected much at all by market interest rate movements, because the basic truth is that the bond will be redeemed shortly at par, so the value of the payment cannot vary much from par.
Which statements are TRUE regarding interest rate movements and their effect on bond prices? I As interest rates move, the price of short term maturities will change faster than long term obligations II As interest rates move, the price of long term maturities will change faster than short term obligations III As interest rates move, the price of low coupon issues will change faster than high coupon issues IV As interest rates move, the price of high coupon issues will change faster than low coupon issues A. I and III B. I and IV C. II and III D. II and IV
The best answer is C. The basic truths about interest rate movements and their effect on bond prices are: The longer the maturity, the greater the change in price for a given change in interest rates; The lower the coupon, the greater the change in price for a given change in interest rates.
A corporation has issued 8% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 7%. Which are TRUE statements about the outstanding 8% 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
The best answer is C. The bond was issued with a coupon of 8%. Currently, yield for a similar issue is 7%. Therefore, interest rates have fallen subsequent to the issuance of the bond; or the credit quality of the bond has improved. When interest rates fall, yields on bonds already trading must also fall. What causes this is a rise in the dollar price of the issue - the bond now trades at a premium.
In 2019, a customer buys 1 GE 10%, $1,000 par debenture, M '34, at 115. The interest payment dates are Jan 1st and Jul 1st. The yield to maturity on the bond is: A. 6.96% B. 8.00% C. 8.37% D. 10.23%
The best answer is C. The formula for yield to maturity for a premium bond is: (Annual interest - Annual Capital Loss) / ((Bond Cost + Redemption Cost) / 2) = Yield to Maturity for a Premium Bond 100 - (150 premium /15 years to maturity) / ((1150 + 1000) / 2) = 100 - 10 / 1075 = 90 / 1075 = 8.37%
At which Standard and Poor's rating is a bond considered to be speculative ("junk bond")? A. AA B. BBB C. BB D. C
The best answer is C. The top 4 ratings are "investment grade" - AAA, AA, A, and BBB. Bonds below these ratings are speculative. The best speculative rating is, therefore, BB.
A customer has purchased a 20-year maturity corporate bond with a 5% coupon at par. The bond is callable in 10 years @ 103. The customer intends to hold the bond to maturity. If market interest rates rise to 7%, which statement is TRUE? A. The bond is likely to be called in 10 years, and the customer's yield to call will be higher than the 5% coupon B. The bond's yield to maturity will be 7% for this customer C. The market value of the bond shown on the customer's account statement will be less than par D. The customer will receive less than par at maturity
The best answer is C. This question is cute. We know that if market interest rates rise, bond prices will fall - the customer's bond will show at a depreciated value on his or her account statement. As long as this bond is held to maturity (it will not be called by the issuer if interest rates rise), this customer's yield to maturity will be the 5% coupon. The customer will not experience any loss of principal, unless the bond is sold prior to maturity.
Which of the following would cause the yield curve to be ascending? A. An increase in demand for long term bonds from investors B. An increase in the laddering of bond portfolios by investors C. The Federal Reserve pursuing a tight monetary policy D. Short term yields declining at the same time as long term yields are increasing
The best answer is D. An ascending yield curve is a normal curve - short term yields are normally lower than long term yields. Choice D describes an ascending curve. If there is an increase in demand for long term bonds, then long term bond prices rise and their yields fall. This can cause their yields to fall below short term rates - an inverted yield curve - making Choice A wrong. If the Federal Reserve is pursuing a tight money policy, this will raise short term rates (the Fed exerts its influence at the short end of the yield curve). Again, this can cause the curve to invert - making Choice C wrong. Finally, a "laddered" bond portfolio is one that has maturities staggered at roughly even intervals - say 5, 10, 15, 20, 25 and 30 years out. Thus, every 5 years, bonds are maturing and if rates have been rising, the proceeds are reinvested at higher current rates. This gives some protection to the value of the portfolio in a period of rising interest rates. Because purchases are being made at even intervals across the yield curve, laddering should not distort the shape of the yield curve - making Choice B wrong.
A customer has heard about the explosive growth in China and wants to make investments in Chinese companies. The customer should be informed about which risks? I Political risk II Exchange Rate risk III Marketability risk IV Default risk A. I and II only B. III and IV only C. I, II, III D. I, II, III, IV
The best answer is D. How about telling the customer about all of these risks! Political risk is the risk of investing internationally in countries that have weak political systems. Thus, the bondholder has very little in the way of legal protection. Another consideration is exchange rate risk. This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening). When the "weakened" foreign currency is converted back into its value in U.S. dollars, it buys "fewer" U.S. dollars, so the value of the investment in terms of U.S. dollars, declines. In addition, any bond purchaser incurs some level of marketability risk and some level of default risk.
Which of the following will increase the marketability risk of a bond? I Active trading in that security II Inactive trading in that security III Round lot size transaction amount IV Large block size transaction amount A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. Marketability risk is the risk that a security will be difficult to sell. The easiest securities to trade are "round lots" of actively traded issues. For example, a round lot of stock is 100 shares; a round lot of bonds is 5 bonds. Large blocks are more difficult to market; and it is more difficult to sell thinly traded securities than actively traded securities.
Market uncertainty regarding future interest rate levels would indicate that the yield curve should be: A. ascending B. descending C. inverted D. flat
The best answer is D. Under the "market expectations" theory of yield curves, when investors expect interest rates to rise in the future, the yield curve will have an upward slope. Conversely, when investors expect interest rates to fall in the future, the yield curve will have a downward slope. If investors are uncertain as to the future direction of market interest rates, then the yield curve will be flat.
Exchange rate risk is a factor to consider when investing in debt issues: I within the U.S. II outside the U.S. III that are denominated in U.S. dollars IV that are denominated in a foreign currency A. I and III B. I and IV C. II and III D. II and IV
The best answer is D. When an investment is made outside the U.S. that is denominated in a foreign currency, the investor assumes exchange rate risk. This is the risk that the foreign currency weakens against the U.S. dollar (which is the same as the U.S. dollar strengthening). For example, assume that an investment is made in $100,000 of bonds denominated in Japanese Yen when the Yen is trading at 100 to the U.S. dollar. Thus, $100,000 x 100 Yen per U.S. dollar = 1,000,000 Yen being spent. Also assume that each bond costs 10,000 Yen, so 100 bonds are purchased at $100 each. Now assume that the bonds do not move in price, but the Yen weakens to 200 Yen to the U.S. dollar (each U.S. dollar now "buys" 200 Yen instead of 100 Yen). This means that 100 bonds are still priced at 10,000 Yen each in Japan. However, because each U.S. dollar is worth 200 Yen, the bonds are now worth 10,000 Yen / 200 Yen per U.S. dollar = $50 each. Thus, the bonds are now worth 1/2 of what was paid for them, solely due to the movement in currency exchange rates.