STC Series 7 Chapter 6 Exam

A call notice is likely to be issued on a long-term CD if: A. It's trading at a premium to the call price B. It's trading at a discount to the call price C. The issuer needs to reduce revenue D. The issuer needs to increase reserves

A. It's trading at a premium to the call price Long-term CDs, also referred to as brokered CDs, are issued by banks and can be sold through broker-dealers. These CDs can be callable and will most likely be called if they're trading at a premium to their call price. The most likely reason for the CDs to be trading at a premium is because interest rates have fallen, which makes the call feature more attractive to the issuer.

The Barge Towing Corporation has announced in a tombstone ad that it will issue $500,000,000 of 6 1/2% convertible subordinated debenture bonds convertible into common stock at $10.50. The bonds will mature in November 2040 and are being issued at a $1,000 par value. If the bonds were subsequently trading in the market at $1,020, the market price of the common stock, to be on parity with the bond, will be: A. $9.54 B. $10.20 C. $10.74 D. $12.04

C. $10.74 The conversion price is given as $10.50. To find the conversion ratio, divide the par value ($1,000) of the bond by the conversion price of $10.50. This equals a conversion ratio of 95 to 1 ($1,000 divided by $10.50 equals 95). To find parity (equality in dollar value) for the stock, divide the market price of the bond by the conversion ratio. The market price of the bond is 102 ($1,020) and the conversion ratio is 95 to 1. Therefore, $1,020 divided by 95 equals approximately $10.74. This would be the parity price for the stock.

A type of security that is issued in the U.S. by foreign governments and corporations, trades in U.S. markets, and is denominated in U.S. dollars is called a: A. Global mutual fund B. Eurodollar bond C. Yankee bond D. Repurchase agreement

C. Yankee bond Yankee bonds are issued in the U.S. by foreign corporations and governments, are dollar-denominated securities, and trade in U.S. markets. Yankee bonds are normally issued by foreign entities when conditions in the U.S. are better than in the foreign country. Eurodollar bonds are issued by U.S. companies and sold to investors overseas and pay their interest in Eurodollars (dollars on deposit in banks outside the U.S.). Since Eurodollar bonds are not initially offered to investors in the U.S., they are exempt from SEC registration.

Eurodollars are primarily used in: A. International payments B. Arbitrage C. Funding investments in the United States D. Financing investments outside of the United States

D. Financing investments outside of the United States Eurodollars are defined as U.S. dollars on deposit in foreign banks, not just in Europe. Although they can be used for various purposes, Eurodollars are primarily used for financing investments outside of the United States.

Which of the following statements is NOT TRUE concerning a structured product offered by an RR? A. They are usually registered with the SEC B. The principal that the investor would receive may be based on the value of a stock traded on an exchange C. The principal the investor would receive may be based on the value of a foreign currency D. Since this product is usually sold by a bank, the principal will be protected by the FDIC

D. Since this product is usually sold by a bank, the principal will be protected by the FDIC Structured products may be linked to individual securities, commodities, foreign currencies, or indexes. These products are underwritten by most major financial services institutions and are usually registered as securities with the SEC. Structured products are not bank deposits and are not insured by the Federal Deposit Insurance Corporation (FDIC). This fact should be disclosed by an RR when offering this product to clients.

A bond is convertible into stock at $50 per share. The market price of the stock is 65. The market price of the bond is 120. To profit from this arbitrage opportunity, an investor should: Buy 5 bonds Buy 100 shares of stock Sell 5 bonds short Sell 100 shares of stock short AI and III I and IV CII and III DII and IV

Since the bond is convertible into 20 shares of stock ($1,000 par divided by $50) and the bond is priced at 120, the parity for the stock is $60 per share ($1,200 bond price divided by 20 shares). An arbitrage situation exists because the stock is selling at a 5-point premium to parity (65 market price versus 60 parity price). An investor can profit from this situation by purchasing bonds at 120 and shorting the stock at 65. Each bond may be converted into 20 shares of stock at a cost of $60 per share. These shares may then be used to cover the short sale, establishing a 5-point profit (65 short sale price - 60 cost).

A corporation has $125,000,000 of convertible bonds outstanding. The conversion price is $50. The corporation refunds $75,000,000 of the bonds for nonconvertible bonds. How many additional shares of common stock will be outstanding if the remaining bonds are converted? A. 1,000,000 shares B. 1,500,000 shares C. 2,000,000 shares D. 2,500,000 shares

A. 1,000,000 shares After the refunding, $50,000,000 of convertible bonds will remain outstanding. If these bonds are converted, there will be an additional 1,000,000 shares of common stock outstanding ($50,000,000 of bonds / the conversion price of $50 = 1,000,000 shares of common stock).

A corporation has issued a bond with a 5% coupon that is convertible into common stock at $40. The stock is selling at $43.50 and the bond is selling at 109. The number of shares that will be received on conversion is: A. 25 B. 23 C. 22 D. 20

A. 25 The conversion price is $40. To find the conversion ratio (the number of shares of common stock received if the bond is converted), divide the par value of the bond ($1,000) by the conversion price ($40). This is equal to 25 ($1,000 divided by $40 equals 25). For every bond that is converted, the investor will receive 25 shares of common stock. The current price of the stock and bond are not relevant when calculating the conversion ratio.

A corporate bond is convertible at $25 and the underlying stock is currently selling at $30 per share. If the corporation indicates that the bond will be called at 115 ($1,150) on the next call date, what is the BEST advice to give to the bondholder? A. Convert the bond B. Let the bond be called C. Wait until the corporation makes a better offer D. Purchase additional bonds

A. Convert the bond The first step is to determine the conversion ratio. To calculate the conversion ratio, the bond's par value ($1,000) is divided by its conversion price ($25), which equals 40 shares. The conversion value is then found by multiplying the conversion ratio (number of shares received) by price per share, which is $1,200 (40 shares x $30 per share). The best advice to the bondholder is to convert the bond into stock (value of $1,200), rather than to allow the bond to be called (value of $1,150).

Which type of equity capital would have a delayed, diluted effect on a corporation? A. Convertible debt B. The sale of restricted stock under SEC Rule 144 C. A follow-on offering of common shares D. Nonconvertible deb

A. Convertible debt If the convertible debt is issued by a corporation and the securities are later converted, there will be more common shares outstanding, diluting the earnings of the shareholders. The sale of restricted stock under SEC Rule 144 is the sale of existing shares. It does not create additional shares. A follow-on offering of common shares has an immediate, not a delayed, dilutive effect. Nonconvertible bonds, also referred to as straight debt, do not produce a dilutive effect since no new common shares are issued.

Which TWO of the following choices are characteristics of reverse convertible securities? I. The coupon rate is usually above prevailing market rates II. The coupon rate is usually below prevailing market rates III. The investor may have an obligation to purchase shares of an equity security IV. The investor may have the right to sell shares of an equity security A. I and III B. I and IV C. II and III D. II and IV

A. I and III Reverse convertible securities are short-term notes issued by banks and broker-dealers that usually pay a coupon rate above prevailing market rates. They are considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value known as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of his principal. If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal.

A convertible bond has a conversion price of $50 and is currently selling in the market at $1,100. The conversion ratio is: A. 22 B. 20 C. 50 D. 55

B. 20 To find the conversion ratio of a convertible bond, the bond's par value ($1,000) is divided by the conversion price ($50). In this question, the conversion ratio is $20 ($1,000 ÷ $50). To calculate the conversion ratio, the market price of the bond is irrelevant.

A convertible bond is convertible at $25 and is selling in the market at 108. At what price should the common stock be selling for it to be at parity with the bond? A. 25 B. 27 C. 40 D. 43

B. 27 To find the number of shares the bond is convertible into (i.e., the conversion ratio), divide the conversion price into the par value ($1,000 divided by 25 = 40 shares). To be at parity, the 40 shares must be equal to the value of the bond which is 108 or $1,080. Dividing 40 shares into $1,080 gives the parity price of the stock of $27.

A company that manufactures solar panels has approached an investment banker to help the firm raise capital for its new manufacturing plant in Colorado. The firm wants to raise capital in a private placement, and the CFO of the company wants to know the difference between convertible debt and debt with warrants attached. Which TWO of the following statements are TRUE? I. If convertible bonds are exchanged for common stock, the debt will no longer be part of the company's capital structure II. If the debt with warrants attached is exchanged for common stock, the debt will no longer be part of the company's capital structure III. If convertible bonds are exchanged for common stock, the company will raise additional capital IV. If the debt with warrants attached is exchanged for common stock, the company will raise additional capital A. I and III B. I and IV C. II and III D. II and IV

B. I and IV A convertible bond is a hybrid security consisting of a bond with an imbedded call option permitting the purchase of a share of common stock at a fixed price. If the bond is converted into common stock, the debt will no longer be part of the company's capital structure. If the debt with warrants attached is exchanged for common stock, the debt remains outstanding. It will still be part of the company's capital structure. If the debt with warrants attached is exchanged for common stock, the company will raise additional capital through the issuance of additional shares, based on the exercise of the warrants. No additional capital is raised when convertible bonds are exchanged for common stock.

Which TWO of the following statements are TRUE regarding Eurodollar bonds? I. They are denominated in U.S. dollars only II. They are denominated in foreign currencies only III. They are only traded outside of the U.S. IV. They are traded in the U.S. and international markets A. I and III B. I and IV C. II and III D. II and IV

B. I and IV Eurodollar bonds are issued by both U.S. and foreign companies and are denominated in U.S. dollars. Eurodollar bonds are actively traded in the U.S. after a seasoning period of 40 days. Eurodollar bonds are issued outside the U.S. to foreign investors and are exempt from SEC registration. Since they are not registered, they cannot be purchased as new issues in the U.S.

Which TWO of the following choices are characteristics of reverse convertible securities? I. They are short-term securities II. They are usually long-term securities III. The investor is guaranteed to receive his original principal back at maturity IV. The investor may receive less than the value of his original principal back at maturity A. I and III B. I and IV C. II and III D. II and IV

B. I and IV Reverse convertible securities are short-term notes issued by banks and broker-dealers that usually pay a coupon rate above prevailing market rates. They are considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value known as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of his principal. If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal.

Structured products may: I. Offer returns linked to equity securities II. Not offer returns linked to commodities III. Not offer returns linked to interest rates IV. Be formulated to provide principal protection A. I and III B. I and IV C. II and III D. II and IV

B. I and IV Structured products are prepackaged securities that often combine securities, such as a bond with a derivative. The structured security may be linked to equity securities, commodities, or interest rates. The products may also be structured to provide principal protection. Structured products are not bank deposits and are not insured by the Federal Deposit Insurance Corporation (FDIC). This fact should be disclosed by an RR when offering this product to clients.

Brawn subordinated debentures have a conversion price of $40. The bonds are selling in the market for 91% of par value. If the common stock is trading at $36, which TWO of the following statements are TRUE? I. The stock is selling at a discount to parity with the bond II. The stock is selling at a premium to parity with the bond III. A profitable arbitrage opportunity exists by liquidating the stock after converting the bond IV. Liquidating the stock after converting the bond would not be currently profitable A. I and III B. I and IV C. II and III D. II and IV

B. I and IV The conversion ratio, which is not given, is found by dividing the par value of the bond ($1,000) by the conversion price ($40). This equals 25 to 1 ($1,000 / $40). The market price of the common stock is $36 per share. The value of the stock upon conversion is $900 ($36 x 25); therefore, the stock is selling at a discount to parity with the bond. If the bonds were converted and the stock was then sold at the market price, the investor would have a loss.

ABC Corporation bonds are convertible at $50. If the bonds are selling in the market for 90 ($900) and the common stock is selling for $43, which TWO of the following statements are TRUE? I. The stock is selling at a discount to parity with the bond II. The stock is selling at a premium to parity with the bond III. Liquidating the stock after converting the bond would be currently profitable IV. Liquidating the stock after converting the bond would not be currently profitable A. I and III B. I and IV C. II and III D. II and IV

B. I and IV The conversion ratio, which is not given, is found by dividing the par value of the bond ($1,000) by the conversion price ($50). This equals 20 to 1 ($1,000 divided by $50 equals 20). The market price of the common stock is $43 per share. The stock is selling at a discount to parity with the bond ($43 stock x 20 shares = $860 which is below the $900 market price of the bond). If the bonds were converted and the stock was then sold at the market price, the investor would have a loss.

As it relates to convertible bonds, which of the following provides an arbitrage opportunity? A. Stock trading at a discount to parity. B. Stock trading at a premium to parity. C. Stock trading at parity. D. Bond trading at a premium to parity.

B. Stock trading at a premium to parity. Parity exists when a convertible security is trading at a price that's equal to the total value of the stock into which it's convertible. If the stock is trading at a premium to the parity price, the bond can be converted into the stock and then sold at the higher price. This results in an arbitrage opportunity. Conversely, if the stock is trading at or below the parity price, nothing can be gained through conversion. Finally, if the convertible bond is trading at a premium to parity, there's no reason to convert it into the stock.

A bond convertible at $40 is selling in the market for 120. If the stock has a current market price of $50, the parity price for the bond is: A. $960 B. $1,200 C. $1,250 D. $1,500

C. $1,250 It is necessary to find the conversion ratio to solve this problem. The bond is convertible at $40. $1,000 divided by $40 equals the conversion ratio of 25 shares of stock to one bond, or 25 to 1. To find the parity price of the bond, multiply the market price of the stock of $50 by the conversion ratio of 25 ($50 x 25 = $1,250). This means that the bond must sell for $1,250 to be equal in value to the stock when the stock has a market value of $50 per share.

XYZ convertible debentures are convertible into 20 shares of XYZ Corporation common stock. If the bonds were selling in the market at $960, what would the common stock need to be selling for to be on parity? A. $19.20 B. $20 C. $48 D. $50

C. $48 To find the stock's parity price, divide the current market price of the bond ($960) by the conversion rate (ratio) which is given as 20 shares. This equals $48.

The Barge Towing Corporation has announced in a tombstone ad that it will issue $500,000,000 of 6 1/2% convertible subordinated debenture bonds convertible into common stock at $10.50. The bonds will mature in November 2040 and are being issued at a $1,000 par value. The conversion ratio of the bonds is approximately: A. 75 to 1 B. 85 to 1 C. 95 to 1 D. 100 to 1

C. 95 to 1 The conversion price is given as $10.50. To find the conversion ratio, divide the par value ($1,000) of the bond by the conversion price of $10.50. This equals a conversion ratio of 95 to 1 ($1,000 divided by $10.50 equals 95).

A corporation's long-term debt would most likely be called when interest rates: A. Rise above the bond's nominal yield B. Rise above the bond's yield to maturity C. Fall below the bond's nominal yield D. Fall below the bond's yield to maturity

C. Fall below the bond's nominal yield The indenture between the issuer and bondholder for long-term debt often contains a call provision that allows the issuer, at its option, to redeem the bonds before maturity. Call provisions usually benefit the issuer, which has the option of calling in the bonds when interest rates decline. The issuer may then refinance the debt at a lower rate of interest. For instance, if an issuer's outstanding bond is paying a coupon rate (nominal yield) of 9% at a time when similar bonds are paying only 5%, it can reduce its interest costs by calling in the 9% bonds and issuing new ones at 5%. As rates decline, the bond's yield to maturity, or yield to call, also would decline.

A company that manufactures solar panels has approached an investment banker to help the firm raise capital for its new manufacturing plant in Colorado. The firm wants to raise capital in a private placement, and the CFO of the company wants to know the difference between convertible debt and debt with warrants attached. Which TWO of the following statements are TRUE? I. Both convertible debt and debt issued with warrants attached will trade as one unit each II. Convertible debt trades as one unit, but debt issued with warrants attached trades as two separate units III. Both convertible debt and debt issued with warrants attached have a potential dilutive effect on the common stockholders IV. Convertible debt has a dilutive effect on common shares, but debt issued with warrants does not A. I and III B. I and IV C. II and III D. II and IV

C. II and III A convertible bond is a hybrid security consisting of a bond with an imbedded call option permitting the purchase of a share of common stock at a fixed price. A convertible bond trades as one unit. A bond issued with warrants attached will trade as two separate units. When the bond is issued, the warrants are detached from the bond and will trade as a separate unit. An event that will reduce the proportionate claim of common stockholders to the earnings of a corporation is considered to be dilutive. The conversion of convertible securities into common stock and the issuance of additional shares of common stock (e.g., based on the exercise of warrants) will each result in additional shares owned by new shareholders.

XYZ Corporation has a 6 1/2% convertible bond outstanding that is convertible into 40 shares of common stock. The bond is currently selling in the market at 85 ($850) and the common stock is selling at 21. The XYZ Corporation is offering its existing bondholders a new straight (nonconvertible) bond paying 6 1/2% that matures at the same time as the convertible bond. The effect of the successful completion of the proposal would be to: I. Reduce interest costs II. Reduce potential dilution III. Have no effect on interest costs IV. Increase dilution A. I and III B. I and IV C. II and III D. III and IV

C. II and III Prior to the refunding, if all of the bonds were converted into common stock, outstanding shares would increase causing earnings per share to decrease (dilute). The effect of the successful completion of the proposal (refunding) would be to reduce potential dilution because the conversion provision is being eliminated. There would be no reduction in interest costs since the new bonds are paying the same rate of interest as the old bonds (6 1/2%).

An advantage a corporation receives when it issues a convertible bond is that: A. It's able to offer bonds with a higher rate of interest to investors B. It's able to offer bonds with a longer maturity to investors C. It's able to borrow money at a lower rate of interest D. It's able reduce the number of shares that it has outstanding

C. It's able to borrow money at a lower rate of interest Convertible bonds allow corporations to borrow money at a lower rate of interest (lower coupon) since the convertible feature is an attraction for investors. Investors are willing to accept the lower interest rate in exchange for the opportunity to convert the bonds into common stock. In addition, the investor has some downside protection because, even if the price of the stock falls, the convertible bond still has inherent value as a bond.

A husband has three accounts at Liberty Bank, one containing $125,000, another with $75,000, and the third with $50,000. His wife has one account at Freedom Bank which contains $125,000. The couple also has a joint account at Freedom Bank which contains $500,000. Which accounts are fully covered by the FDIC? A. Only the husband's three accounts at Liberty Bank are fully covered. B. Neither the husband's three accounts at Liberty Bank nor the wife's account at Freedom Bank are fully covered. C. The husband's three accounts at Liberty Bank and the wife's account at Freedom Bank are fully covered. D. Only the wife's account at Freedom Bank is fully covered.

C. The husband's three accounts at Liberty Bank and the wife's account at Freedom Bank are fully covered. The Federal Deposit Insurance Corporation (FDIC) provides insurance of up to $250,000 per depositor. The husband's three accounts at Liberty Bank total $250,000 and are fully covered. The wife's single account at Freedom Bank totals $125,000 and is fully covered. Although not referenced in any of the answers, the couple's joint account at Freedom Bank is also fully covered since each tenant in the account is provided coverage of up to $250,000.

Which of the following choices BEST describes Eurodollars? A. U.S. dollars on deposit in U.S. banks B. U.S. dollars on deposit in European banks C. U.S. dollars on deposit in foreign banks D. European currency on deposit in U.S. banks

C. U.S. dollars on deposit in foreign banks Eurodollars are defined as U.S. dollars on deposit in foreign banks, not just in Europe.

A corporation has issued a bond with a 5% coupon that is convertible into common stock at $40. The bond is selling currently trading at par and the stock is selling at $39.00. If the bond increased in value by 20 points, what is parity of the stock? A. $25.00 B. $30.00 C. $40.60 D. $48.00

D. $48.00 If the bond increased by 20 points over its par value of $1,000, it would be selling for $1,200. The parity price for the stock is found by dividing the market value of the bond ($1,200) by the conversion ratio of 25 ($1,000 or par value ÷ $40). This is equal to $48 ($1,200 ÷ 25 = $48). The current price of the stock is not relevant.

During a period of stable interest rates, which bond has the most potential to show a significant change in price? A. A 7%, 30-year U.S. Treasury Bond B. An 8%, 5-year high-grade corporate bond C. A 6%, 6-month Revenue Anticipation Note D. A 7 1/2%, 10-year convertible subordinated debenture

D. A 7 1/2%, 10-year convertible subordinated debenture The key to this question is to recognize that if interest rates are stable, then most bond prices will experience little movement. However, to identify the bond that is still expected to fluctuate the most, find the answer that is the most unique. In this question, the convertible debenture may still experience a significant change in price based on the changing value of the underlying equity (i.e., the security into which the bond may be converted). For example, if the value of the underlying stock increases, the value of the bond will also increase to keep the bond's price in the vicinity of conversion parity. Parity is achieved when the value of the bond is equal to the value of the common stock which is able to be obtained at conversion.

Which of the following best describes a guaranteed bond? A. A bond where the trustee pays interest and principal. B. A bond on which the U.S. Treasury promises to pay interest and principal if necessary. C. A bond that's insured by SIPC. D. A bond for which another corporation promises to pay interest and principal if necessary.

D. A bond for which another corporation promises to pay interest and principal if necessary. A guaranteed bond is one that, along with its primary form of collateral, is secured by a guarantee of another corporation. The other corporation promises that it will pay interest and principal if necessary. A typical example is a parent company guaranteeing a bond that's issued by a subsidiary company.

A tombstone ad states that Southern California Gas is issuing 8 3/4% first mortgage bonds at a price of 96.35% of their par value. The payment of interest and principal on the bond is secured by: A. The general credit of the state of California B. The mortgages on property owned by the state of California C. The state of California D. A lien on property owned by Southern California Gas

D. A lien on property owned by Southern California Gas The tombstone ad states the bonds are first mortgage bonds, which means they are secured by a lien on property owned by the Southern California Gas Company. The company is a publicly owned corporation. Therefore, the bonds are not secured by property owned by the state of California.

A bond secured by other bonds and securities is referred to as a: A. Collateralized mortgage obligation B. Guaranteed bond C. Mortgage bond D. Collateral trust bond

D. Collateral trust bond A bond issued by a corporation that is secured by other bonds and securities is called a collateral trust bond. A CMO is backed by mortgages that were purchased from banks and other lenders who originated loans to homeowners.

A security that pays a fixed amount twice a year, and also allows the holder to profit if the common stock rises, is known as a: A. Warrant B. Right C. Convertible preferred stock D. Convertible bond

D. Convertible bond A convertible bond pays interest on a semiannual basis (twice a year). Preferred stock pays a dividend to shareholders on a quarterly basis. A convertible security (bond or preferred stock) would allow an investor to convert the security into shares of the company's common stock, at a predetermined ratio. If a security is convertible into common stock, the price of the security will tend to move with the price of the stock.

A corporation with an excellent earnings record has several issues of bonds outstanding. During a period of stable interest rates, which of the following securities are expected to fluctuate the most? A. Mortgage bonds B. Commercial paper C. Debenture bonds D. Convertible bonds

D. Convertible bonds The convertible bonds will fluctuate the most because they are convertible into common stock. The price fluctuates with the price movements of the common stock. The fact that interest rates are stable is another reason why convertible bonds is the best answer. If the question had stated that interest rates were moving sharply upward or downward, then all other bonds would fluctuate sharply in price to bring yields in line with interest rates. However, the question asks what will happen in a period of stable interest rates. Given that statement, the best answer is that convertible bonds will fluctuate the most.

Which TWO of the following statements concerning convertible bonds are TRUE? I. Coupon rates are usually higher than nonconvertible bonds of the same issuer II. Convertible bondholders are considered creditors of the corporation III. Convertible bonds are usually issued by companies with strong credit ratings IV. It is possible that a convertible bond will sell at a price based solely on its inherent value as a bond A. I and III B. I and IV C. II and III D. II and IV

D. II and IV Convertible bondholders are considered creditors of a corporation and provide investors with the ability to convert their bonds into shares of common stock of the same issuer at a set price (conversion price). This feature links these types of bonds to the equity markets and the price of a convertible bond is affected by the price of the underlying stock. However, if the price of the underlying stock declines to the point where there is no advantage to the conversion feature, the bond may sell at a price based on its inherent value as a bond, disregarding the convertible feature. Moreover, convertible bonds are issued by companies with weaker credit ratings and allow the issuer to sell debt at a lower cost. Since the conversion feature is a benefit to the bondholder, convertible bonds will have a lower coupon than similar nonconvertible bonds.

Two similar companies issue bonds at the same time. One company issues convertible bonds and the other issues nonconvertible bonds. Which two of the following statements are TRUE? I. The convertible bonds will probably offer a higher coupon rate. II. The convertible bonds will probably offer a lower coupon rate. III. The convertible bonds will probably have a higher current yield. IV. The nonconvertible bonds will probably have a higher yield to maturity. A I and III B. I and IV C. II and III D. II and IV

D. II and IV Convertible bonds normally have a lower coupon rate than nonconvertible securities. The convertible bonds pay less interest and offer lower yields because the convertible feature gives individuals the ability to become stockholders at their discretion. Since the issuer is giving bondholders this advantage, it can offer a lower coupon rate.

A corporation is NOT considered to be in default if it fails to pay interest on which of the following bonds? A. Mortgage bond B. Debenture C. Convertible bonds D. Income bond

D. Income bond For an income (adjustment) bond, an issuer is only expected to pay interest if it has sufficient income. However, on all of the other debt securities, interest must be paid regardless of the corporation's income. The mortgage bond is secured, but both the debenture and convertible bonds are unsecured. Although the claims of debenture holders come after those of the mortgage bondholders, the corporation is considered to be in default if it fails to make the required interest payments.

If an issuer's convertible bonds are converted by bondholders, what is the effect on the issuer's outstanding common stock? A. It will no have no effect. B. It will decrease the number of outstanding shares. C. It will provide existing shareholders with a larger dividend. D. It will increase the number of outstanding shares.

D. It will increase the number of outstanding shares. If an issuer's convertible bonds are converted into stock, the immediate impact is an increase to the number of outstanding shares. The conversion of the bonds does not change the dividend payment being made to existing shareholders.

A company currently has $125,000,000 of 3 1/4% convertible bonds. The company is going to offer bondholders $125,000,000 of 3 1/4% nonconvertible bonds plus cash of $15,000,000 for the convertible bonds. How will this transaction, if successful, affect the company's financial status? A. It will reduce the cash and debt position and reduce the potential dilutive effect on the common stock B. It will reduce the cash position and increase the debt position C. It will increase the cash position and reduce the potential dilutive effect on the common stock D. It will reduce the cash position and the potential dilutive effect on the common stock

D. It will reduce the cash position and the potential dilutive effect on the common stock The effect of the transaction will be to reduce the cash position and the potential dilutive effect on the common stock. The company is paying out cash and is also issuing nonconvertible bonds in place of convertible bonds (which could have been converted into common stock). This will reduce the cash position and the potential dilutive effect on the common stock.

A 7% convertible bond has a conversion ratio of 40. The bond has a nondilutive feature and the common is selling at $43 a share. If the company distributes a 10% stock dividend, which of the following statements is TRUE regarding the convertible bond? A. The conversion ratio remains at 40, but the conversion price is reduced B. The conversion ratio increases to 45.50 and the conversion price remains constant C. The conversion price decreases to $22.73 and the conversion ratio remains the same D. The conversion price decreases to $22.73 and the conversion ratio increases to 44

D. The conversion price decreases to $22.73 and the conversion ratio increases to 44 A nondilutive feature requires that the conversion features be adjusted should there be a stock split or stock dividend. The conversion ratio will be increased and the conversion price will be reduced. The new conversion ratio will be 44 [the old ratio (40) plus the old ratio times the percentage dividend (40 x 10% = 4)]. The new conversion price will be the par value of the bond divided by the new conversion ratio ($1,000 divided by 44 equals $22.73).

Which of the following statements is TRUE concerning reverse convertible securities? A. An investor will receive a coupon rate below prevailing market rates. B. An investor is anticipating a decrease in the value of the underlying asset. C. They are suitable for an investor who wants to own shares of the underlying asset. D. The investor is anticipating that the price of the underlying asset would be above the knock-in value.

D. The investor is anticipating that the price of the underlying asset would be above the knock-in value. Reverse convertible securities are short-term notes that are issued by banks and broker-dealers and usually pay a coupon rate that's above prevailing market rates. They are considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security that's unrelated to the issuer, a basket of stocks, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value, which is referred to as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of her principal (the most beneficial option). If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal. Since the investor is not able to participate in any increase in the value of the underlying asset, the investor is anticipating that its price will remain stable. Reverse convertibles are unsuitable for investors who want to own the underlying asset, since being obligated to buy those securities is an undesirable outcome.