finance exam 2
nominal interest rate including default premium (not treasury) and maturity risk premium
r = r* + h + dp + mp
the fisher effect equation
r* + h + (r* x h)
what are the three major components of interest rates?
real rate, inflation premium, the default premium
treasuries are considered..
risk free
What is the EAR if the APR is 5% and compounding is quarterly?
slightly above 5.09%
"Junk" bonds are a street name for ________ grade bonds.
speculative
effective annual rate (EAR) / annual percentage yield (APY)
the compounded rate of interest per year
As the rating of a bond increases (for example, from A, to AA, to AAA), it generally means that ________.
the credit rating increases, the default risk decreases, and the required rate of return decreases
fisher effect
the equation that shows the relationship between the real rate (r*), the inflation rate (h), and the nominal interest rate (r).
in constructing a yield curve, you place interest rate on the - and time to maturity on the -
vertical axis: horizontal axis
real interest rate
the reward for waiting
Suppose you invest $1,000 today, compounded quarterly, with the annual interest rate of 8.00%. What is your investment worth in one year?
1082.43
maturity date
the expiration date of the bond on which the final interest payment is made as well as the principal repayment
nominal interest rate
the interest rate composed of a real interest rate plus the inflation rate
coupon rate
the interest rate for the bond coupons, expressed in annual percentage terms
periodic interest rate
the interest that the financial institution pays each compounding period
default premium (dp)
the portion of the borrowing rate that compensates the lender for the higher risk of default.
coupon
the regular interest payment of a bond
The Fisher Effect involves which of the items below?
Nominal rate, the real rate, and inflation
how is EAR/APY calculated?
(1 + APR/m)^m - 1
Suppose the market is efficient and there is no risk. Five years ago, the market interest rate was 10% and Simpson Warehouses Inc. issued twenty-five-year annual par value coupon bonds. Since then, the interest rates in general have risen. The price today for a Simpson bond is $850.61. If you use a buy-and-hold strategy, what is the expected return (%) on Simpson bonds today?
12
The First Common Bank has advertised one of its loan offerings as follows: "We will lend you $100,000 for up to 3 years at an APR of 8.5% (interest compounded monthly." If you borrow $100,000 for 1 year, how much interest will you have paid and what is the bank's APY?
8,839.09 explanation: Nominal annual rate = APR = 8.5% Frequency of compounding = C/Y = m = 12 Periodic interest rate = APR/m = 8.5%/12 = 0.70833% APY or EAR = (1.0070833)12 - 1 = 1.08839 - 1 =8.839%Total interest paid after 1 year = .08839*$100,000 = $8,839.09
Creative Solutions Inc. has issued 10-year $1,000 face value, 8% annual coupon bonds, with a yield to maturity of 9.0%. The annual interest payment for the bond is ________.
80 The annual interest or coupon payment is equal to the coupon rate multiplied by the par value of the bond. Here that is (0.08) × ($1,000) = $80.
Big House Nursery Inc. has issued 20-year $1,000 face value, 8% annual coupon bonds, with a yield to maturity of 10%. The current price of the bond is ________.
829.73
On March 1st, 2016, Thompson Warehouses Inc. issued twenty-five-year coupon bonds with a 10% coupon rate and $1,000 face value each. The first coupon date is 1-Sep-2016 and the second is made on 1-Mar-2017. Since then, interest rates in general have risen and the yield to maturity on the Thompson bonds is now 12% on September 1st, 2020. Given this information, what is the current price for a Thompson bond?
848.62
The ExecUfind Corporation has issued 20-year semiannual coupon bonds with a face value of $1,000. If the annual coupon rate is 10% and the current yield to maturity is 12%, what is the firm's current price per bond?
849.54
The Fisher Effect states the relationship between the nominal rate (r), the real rate (r*), and inflation (h). Suppose r*= 5% and h = 4%. What is the precise value of the nominal rate (%) ?
9.2 explanation: .05 + .04 + (.05 * .04) = 9.2
Which of the following statements about the relationship between yield to maturity and bond prices is TRUE?
A bond selling at a discount means that the coupon rate is less than the yield to maturity. When the yield to maturity and coupon rate is the same, the bond is called a par value bond. A bond selling at a premium means that the coupon rate is greater than the yield to maturity.
Assume that you are willing to postpone consumption today and buy a certificate of deposit (CD) at your local bank. Your reward for postponing consumption implies that at the end of the year ---.
you will be able to buy more goods or services
Jim needs to borrow $50,000 for a business expansion project. His bank agrees to lend him the money over a 5-year term at an APR of 9% and will accept either annual, quarterly, or monthly payments with no change in the quoted APR. Calculate the periodic payment under each alternative and compare the total amount paid each year under each option.
annual: 12,854.62 quarterly: 12528.41 monthly: 12455.04
The ________ is the expiration date of the bond.
maturity date
Treasury ________ and ________ are semiannual bonds, while Treasury ________ are zero-coupon instruments
notes; bonds; bills
key components of a bond
par value, coupon rate, coupon, maturity date, and yield to maturity
coupon rate > par value
premium bond
The ________ is a market derived interest rate used to discount the future cash flows of the bond.
yield to maturity
The ________ is the yield an individual would receive if the individual purchased the bond today and held the bond to the end of its life.
yield to maturity
You pay 20% down on a home with a purchase price of $180,000. Your bank will loan the remaining balance at 7% APR. You have an option to make annual payments or monthly payments on the loan. Both options have a 30-year payment schedule. What is the difference between the annuity payment paid under the annual plan and that under the monthly plan?
107.96 explanation: annually: (30; 7; 144000; ?; 0) monthly: (360; 7/360; 144000, ?, 0)
You put 20% down on a home with a purchase price of $250,000. The down payment is thus $50,000, leaving a balance owed of $200,000. The bank will loan the remaining balance at 3.91% APR. You will make annual payments with a 30-year payment schedule. What is the annual annuity payment under this schedule?
11439.96
RadicaL CREATIONS Inc. just issued zero-coupon bonds with a par value of $1,000. If the bond has a maturity of 15 years and a yield to maturity of 10%, what is the current price of the bond if it is priced in the conventional manner (semiannual compounding)?
231.37
Lucy is tempted to buy 200 apples, with each one costing $2. However, she realizes that if she saves the money in a bank account she should be able to buy 240 apples. If the cost of the an apple increases by the rate of inflation, i.e. 8%, according to the Fisher equation, how much would the nominal rate (%) of the return on the bank account have to be?
28% explanation: nominal interest rate= real interest + inflation As in the above case the real interest rate = (240 - 200)/200 = 0.2 Real interest rate = 20% inflation = 8% so nominal interest rate = 20% + 8% nominal interest rate = 28%
Suppose you postpone consumption and invest at 6% when inflation is 2%. What is the approximate real rate of your reward for saving?
4% We can see that an inflation rate of 2% is 4% less than our 6% investment rate. Thus, 4% is the real rate of your reward for saving.
Rogue Recovery Inc. wishes to issue new bonds but is uncertain how the market would set the yield to maturity. The bonds would be 20-year, 7% annual coupon bonds with a $1,000 par value. The firm has determined that these bonds would sell for $1,050 each. What is the yield to maturity for these bonds?
6.54%
You invest $25,000 at an annual rate of 7.25% for one year. What is the difference in interest earned if you compound this money on a daily basis instead of an annual basis?
67.13 explanation: annually: (1 + .0725)^1 - 1 = .0725 * 25,000 = 1812.50 daily: (1 + .0002)^365 - 1 = .0752 * 25,000 = 1879.63 1879 - 1812.50
Which of the statements below is FALSE?
The prices of goods and services tend to decrease over time because of inflation.
Which of the following are issued with the shortest time to maturity?
Treasury bills
par value bond
a bond for which the current price equals the par value of the bond
premium bond
a bond for which the price is above par
discount bond
a bond for which the price is below par
bond
a long-term debt instrument in which a borrower promises to pay back the principal with interest on specific dates in the future
treasury notes
a u.s. government bond with a maturity of 2-10 years
When the ________ is less than the yield to maturity, the bond sells at a/the ________ the par value.
coupon rate; discount to
The ________ compensates the investor for the additional risk that the loan will not be repaid in full.
default premium
coupon rate < par value
discount bond
bonds are sometimes called ...
fixed income securities
Bonds are sometimes called ________ securities because they pay set amounts on specific future dates.
fixed-income
junk bonds
is the label given to bonds that are rated below BBB. these bonds are considered speculative in nature
fallen angels
is the label given to bonds that have their ratings lowered from investment to speculative grade
A bond is a ________ instrument by which a borrower of funds agrees to pay back the funds with interest on specific dates in the future.
long-term debt
To determine the interest paid each compounding period, we take the advertised annual percentage rate and simply divide it by the ________ to get the appropriate periodic interest rate.
number of compounding periods per year
A basis point is ________.
one-hundredth of a percentage point
basis point
one-hundredth of a percentage point
The ________ is the face value of the bond.
par value
coupon rate = par value
par value bond
maturity risk premium
the portion of the nominal interest rate that compensates the investor for the additional waiting time to receive payment in full
pay value
the principal amount to be repaid at the maturity of the bond
the rate of return on a treasury bill includes ...
the real rate of interest and the inflation premium
nominal risk-free rate of interest
the return on a risk-free asset
Suppose you deposit money in a certificate of deposit (CD) at a bank. Which of the following statements is TRUE?
The bank is technically renting money from you with a promise to repay that money with interest.
The greater the frequency of payments made per year, the --- the total amount paid
lower
yield to maturity (YTM)
the return the bondholder receives on the bond if held to maturity
how is periodic interest rate calculated?
apr/compounding periods per year
annual percentage rate (APR)
the yearly uncompounded rate of interest.
Which of the following statements is FALSE?
Although an APR is quoted on an annual basis, interest can be paid monthly but never daily.
MicroMedia Inc. $1,000 par value bonds are selling for $1,265. Which of the following statements is TRUE?
The bond market currently requires a rate (yield) less than the coupon rate. The bonds are selling at a premium to the par value. The coupon rate is greater than the yield to maturity.
Which of the statements below is TRUE?
The frequency of bankruptcy for a high-tech up-start firm is higher than for a blue-chip firm, so we see higher borrowing rates for start-ups than for mature firms.
treasury bills
a u.s. government bond with a maturity of less than one year
treasury bonds
a u.s. government bond with a maturity of more than 10 years
yield curve
a yield curve is a graphical depiction of the relationship between the interest rate and the maturity date of a financial interest
When interest rates are stated or given for loan repayments, it is assumed that they are ________ unless specifically stated otherwise. Correct!
annual percentage rate
The ________ is the regular interest payment of the bond.
coupon
The ________ is the interest rate printed on the bond.
coupon rate
classifications of bonds:
treasury, corporate, municipal, securitized
most yield curves tend to be ---, they can also take on various other shapes.
upward sloping