Finance exam #3

Under normal conditions, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par?

Adding a call provision

Treasury bonds

Bonds issued by the federal government

Why did Congress require that banks disclose the APR? If you were comparing the costs of loans from different lenders, could you use their APRs to determine the loan with the lowest effective interest rate? Explain.

Congress required that it be disclosed because the borrower should know what percentage they charged were by bank and other lender, so they cannot be cheated by banks and other lenders. The borrower must have transparency on the interest rate that they are depositing.

Default risk premium =

Corporate bond - Treasury bond - liquidity premium.

Par value

Face value of the bond

True or false Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

False

True or false Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise. Since floating-rate debt shifts price risk to companies, it offers no advantages to corporate issuers.

False

True or false If the discount (or interest) rate is positive, the present value of an expected series of payments will always exceed the future value of the same series.

False

True or false If a bank compounds savings accounts quarterly, the nominal rate will exceed the effective annual rate.

False

True or false As a result of compounding, the effective annual rate on a bank deposit (or a loan) is always equal to or less than the nominal rate on the deposit (or loan).

False

Bond

Long term debt instrument

What is inflation?

The amount by which prices increase over time

A 15-year bond with a face value of $1,000 currently sells for $850. What is correct about this statement?

The bond's yield to maturity is greater than its coupon rate.

Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return?

The required rate of return would increase because the bond would then be more risky to a bondholder.

Will the yield curve for interest rates be higher in 1 year or 5 year for terms to maturity?

The yield curve for interest rates will be higher in one year

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

The yield on a 10-year bond would be less than that on a 1-year bill.

Which of the following is correct?

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond

Would the yield spread on a corporate bond over a Treasury bond with the same maturity tend to become wider or narrower if the economy appeared to be heading toward a recession? Would the change in the spread for a given company be affected by the firm's credit strength?

The yield spread would expect to wider if the economy is heading towards recession. But if recession strikes, it will be difficult for the firm to repay the money. If the credit strength is good, spread will be narrower.

The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices. Is that statement true or false?

This statement is false. Because short term bonds are valued on short-term rates and longer term bonds are based on long term rates. Changes in short term rates do not necessarily impact changes in long-term rates. Longer term rates have more of an inflation expectation component.

What does it mean when it is said that the United States is running a trade deficit? What impact will a trade deficit have on interest rates?

Trade deficit means we are exporting less than we are importing. In other words. Higher imports lead to the trade deficit. Trade deficit leads to lower interest rates.

True or false The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things held constant.

True

True or false A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if market interest rates are below 10% and at a discount if interest rates are greater than 10%.

True

True or false If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve.

True

True or false The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp declines in the prices of outstanding bonds.

True

True or false The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.

True

True or false A bond that had a 20-year original maturity with 1 year left to maturity has more price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates, and they cannot be called.)

True

True or false As a general rule, a company's debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured.

True

True or false Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

True

True or false If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

True

True or false If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future.

True

True or false One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security. The higher the risk, the higher the security's required return, other things held constant.

True

True or false The present value of a future sum decreases as either the discount rate or the number of periods per year increases, other things held constant

True

Expected total return =

YTM = Expected CY + Expected CGY

When its semi annual

You double the years and divide by 2 for the interest rate and the payment

Call provision

a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date

Suppose a new and more liberal Congress and administration are elected. Their first order of business is to take away the independence of the Federal Reserve System and to force the Fed to greatly expand the money supply. What effect will this have: a. On the level and slope of the yield curve immediately after the announcement? b. On the level and slope of the yield curve that would exist two or three years in the future?

a. the yield curve becomes significantly steeper because the short term interest rates would decrease. This is due to the fact that the federal reserve deals mainly in the short term sector. b. If the government maintains this policy then the expanded money supply would cause inflation rates to rise. This leads to overall higher rates since inflation premiums would raise on securities.

Current yield =

annual coupon payment/current price

Yield to call =

annual rate

Capital gains yield =

change in price/beginning price

Par value =

future value

Coupon rate x future value =

payment

Yield to maturity

the rate of return earned on a bond if it is held to maturity

Yield to call

the rate of return earned on a bond when it is called before its maturity date

Coupon payment

the specified number of dollars of interest paid each year