Unit 2 - Series 65
One of the more popular money market instruments is the negotiable CD. To be considered a negotiable CD, a CD must have a face value of at least A) $100,000. B) $1 million. C) $25,000. D) $500,000.
A) $100,000. Explanation Negotiable CDs, sometimes referred to as jumbo CDs, have a minimum denomination of $100,000. They are unsecured, interest-bearing obligations of banks.
The current yield on a bond with a coupon rate of 7.5% currently selling at 105½ is approximately A) 6.50%. B) 7.11%. C) 7.50%. D) 8.00%.
B) 7.11%. Explanation A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 ÷ $1,055 = 7.109%, or approximately 7.11%.
If investors hold bonds until maturity, their realized rate of return, assuming all interim cash flows are reinvested at that same rate, would be equal to A) the coupon return. B) the yield to maturity. C) the price return. D) the income return.
B) the yield to maturity. Explanation The yield to maturity is an investor's total return if they purchase the bond at any point and then hold it until maturity, assuming all interim cash flows are reinvested at that same YTM. This takes into consideration any capital gain or loss; therefore, the yield to maturity will fluctuate with the bond's price.
Bond prices are quoted as a percentage of A) market value. B) conversion value. C) par value. D) stated value.
C) par value. Explanation Bond prices are quoted as a percentage of par value. On the exam, the par value of bonds is always $1,000.
Which of the following is not a money market instrument? A) Commercial paper B) Newly issued Treasury notes C) Banker's acceptances D) Treasury bills
B) Newly issued Treasury notes Explanation Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of one year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of two to 10 years and therefore would not be a money market instrument.
One of the advantages of owning a corporation's debentures is that you have prior claim over A) general creditors. B) employees. C) secured creditors. D) preferred stockholders.
D) preferred stockholders. Explanation Holders of a company's debentures are general creditors and, as such, have prior claim only over equity holders.
If an investor pays 95.28 for a Treasury bond, how much did the bond cost? A) $958.75 B) $9,528.00 C) $950.28 D) $95.28
A) $958.75 Explanation Treasury bonds are quoted as a percentage of par ($1,000) plus 32nds. In this case, the price is $950 plus 28/32 (i.e., ⅞) of $10, for a total of $958.75.
MNO is planning to raise capital through an offering of 30-year bonds. Which call price would be most beneficial to MNO? A) 102 B) 104 C) 110 D) 106
A) 102 Explanation MNO would benefit most from the ability to call bonds at the lowest possible price. The call feature enables MNO to buy the bonds before maturity to reduce their fixed interest costs. A call price of 102 requires the lowest call premium of the options shown.
Which of the following would you not expect to see issued at a discount? A) Bank jumbo CD B) Treasury bill C) Zero-coupon bond D) Commercial paper Explanation Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value.
A) Bank jumbo CD Explanation Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value.
Which of the following is a direct obligation of the U.S. government? A) Ginnie Maes B) Fannie Maes C) Government bond mutual funds D) Bank for cooperatives bonds
A) Ginnie Maes Explanation Ginnie Maes are backed by the full faith and credit of the United States. Other agencies have a moral, but not direct, government backing. Government bond mutual funds are not backed by the U.S. government.
Which of the following statements about municipal bonds is not true? A) Municipal bonds are generally considered riskier than corporate bonds. B) Municipal bonds generally carry lower coupon rates than corporate bonds of the same quality. C) The interest on municipal bonds is usually not subject to federal income tax. D) Municipal bonds are bonds issued by governmental units at levels other than the federal.
A) Municipal bonds are generally considered riskier than corporate bonds. Explanation Municipal bonds are generally considered second only to Treasury instruments in relative safety.
A corporation is likely to call eligible debt when interest rates are A) declining. B) rising. C) volatile. D) stable.
A) declining. Explanation A corporation generally calls in its debt when interest rates are declining, in order to replace old, higher interest rate debt with new, lower interest rate issues.
Kate, age 59, has an investment portfolio exceeding $250,000. She considers herself a moderate to conservative investor. To generate additional income, she is anticipating adding bonds to her portfolio. She lives in a state that does not have an income tax and she is in the 28% federal income tax bracket. Which of the following bonds would be the best recommendation for her portfolio? A) Bond D, AAA rated Treasury note with a 2.55% coupon rate B) Bond A, A-rated corporate debenture with a 6.50% coupon rate C) Bond C, CCC rated corporate debenture with an 8.00% coupon rate D) Bond B, BBB rated municipal bond with a 3.75% coupon rate
B) Bond A, A-rated corporate debenture with a 6.50% coupon rate Explanation Even though Bond C has the highest after-tax rate of return, this bond would not be appropriate for Kate based on her risk tolerance. Therefore, Bond A would be the best choice. Calculations: Bond A: 6.5 × (1 - 0.28) = 4.68% Bond B: 3.75% Bond C: 8% × (1 - 0.28) = 5.76% Bond D: 2.55% × (1 - 0.28) = 1.84%
All the following securities are issued at a discount except A) zero-coupon bonds. B) CDs. C) Treasury bills. D) commercial paper.
B) CDs. Explanation CDs are interest-bearing debt instruments issued by banks at their face value. All of the others are issued at a discount. In truth, only about 85% of commercial paper is, but that's good enough for NASAA.
A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal? A) JKL Municipal Bond Fund B) DEF High-Yield Bond Fund C) ABC Growth and Income Fund D) GHI Index Fund
B) DEF High-Yield Bond Fund Explanation High-yield (junk) bonds, although carrying more risk, produce higher current income than other funds.
A bond with a par value of $1,000 and a coupon rate of 6% paid semiannually is currently selling for $1,200. The bond is callable in 15 years at 105. In the computation of the bond's yield to call, which of these would be a factor? A) Present value of $1,050 B) 15 payment periods C) Interest payments of $30 D) Future value of $1,200
C) Interest payments of $30 Explanation The yield to call (YTC) computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price, and the call price. A bond with a 6% coupon will make $30 semiannual interest payments. With a 15-year call, there are 30 semiannual payment periods, not 15. The present value is $1,200 and the future value is $1,050, which is the reverse of the numbers indicated in the answer choices.
The Straitened Corporation filed for bankruptcy. One of your clients held a mortgage secured by the corporation's building. When the building was sold, the proceeds were less than the mortgage balance, creating a deficiency balance. Where does this investor's claim stand? A) After the unsecured creditors B) There is no further claim once the building has been sold C) After the secured creditors D) As a general creditor on a pro rata basis
D) As a general creditor on a pro rata basis Explanation Secured creditors, such as those holding mortgage bonds, always have priority in a liquidation. If it happens, as in this question, that the assets securing the debt are insufficient to satisfy the claim, the balance is considered to be an unsecured debt. In that case, those bondholders are considered general creditors and share in any remaining assets proportionate to the amount of the deficiency. The Latin legal term for this is pari passu, but we don't expect you'd see that on the exam.
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? A) Expansion of an airport B) Municipal hospital C) Public golf course D) Public library
D) Public library Explanation Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through general obligation (GO) bond sales with the backing of taxes.
One of the likely consequences of a rating downgrade on a bond is A) the current yield will be reduced. B) an increase to the coupon by the issuer. C) the call feature will be employed. D) a reduction in the market price of the bond.
D) a reduction in the market price of the bond. Explanation If the rating agencies downgrade the quality of a bond, potential investors will look to compensate for the increased risk by demanding a greater yield on the issuer's bonds. This will inevitably result in a lower bond price. A change in rating is unlikely to lead to a call. In fact, with the reduction in the market price, the bond may be selling below par, giving the issuer the opportunity to retire the debt at a discount. Bonds are fixed-income securities because the coupon rate is fixed when the bond is issued and does not change.
A corporation has issued a 4% $60 par convertible stock with a conversion price of $20. With the preferred stock selling at $66 per share, an investor holding 100 shares of this stock will benefit by converting if the price of the common stock is A) above $20.00 per share. B) below $22.00 per share. C) above $18.20 per share. D) above $22.00 per share.
D) above $22.00 per share. Explanation With a conversion price of $20 and a par value of $60, this preferred stock is convertible into three shares of the company's common stock. We divide the current price of the preferred ($66) by the three shares to arrive at the parity price of $22. If the common stock is selling for more than the parity price, the investor can benefit by converting and selling the stock in the marketplace.
An agent is discussing a specific bond that would be a good addition to the client's portfolio. The client comments that the nominal yield is lower than its current yield. The agent would explain that the bond is A) a high-yield bond B) selling at a premium C) issued by an unseasoned company, and the market hasn't yet realized how well secured the debt is D) selling at discount
D) selling at discount Explanation Anytime the current yield on a bond is higher than its nominal or coupon rate, the bond must be selling at a discount.
During the past year, the market price of Kapco common stock has increased from $47 to $50 per share. Over that period, Kapco's earnings per share (EPS) have increased from $2.00 to $2.50 per share, and their dividend payout ratio has decreased from 50% to 40%. Based on this information, the current yield on Kapco common stock is A) 4.26%. B) 2.00%. C) 2.13%. D) 6.34%.
B) 2.00%. Explanation The current yield on a stock is computed by dividing the annual dividend rate by the current market price. With EPS of $2.50 and a 40% payout ratio, the annual dividend is $1.00. This dollar divided by the current market price of $50.00 results in a current return of 2%.
Securities issued by which of the following issuers have the direct backing of the U.S Treasury? A) Federal Agricultural Mortgage Corporation (Farmer Mac) B) Government National Mortgage Association (Ginnie Mae) C) Federal National Mortgage Association (Fannie Mae) D) Federal Home Loan Mortgage Corporation (Freddie Mac)
B) Government National Mortgage Association (Ginnie Mae) Explanation Bonds issued or guaranteed by the Government National Mortgage Association (Ginnie Mae) are backed by the "full faith and credit of the U.S. government," just like U.S. Treasuries. Bonds issued by government-sponsored enterprises (GSE), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Agricultural Mortgage Corporation (Farmer Mac), are not backed by the same guarantee those issued by federal government agencies. Bonds issued by GSEs carry credit risk. The GSEs are publicly traded companies whose shares are registered with the SEC.
Which of the following expressions describes the current yield of a bond? A) Yield to maturity divided by par value B) Yield to maturity divided by current market price C) Annual interest payment divided by par value D) Annual interest payment divided by current market price
D) Annual interest payment divided by current market price Explanation The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond.
A client plans to purchase a home within the next three months and will require $100,000 for the down payment. The client has the money in her DDA and asks you for your recommendation as to the best place to put the money. Your recommendation would probably be for the client to A) purchase a GNMA for the monthly income. B) use the money to buy IPOs until the home is purchased. C) move the money into a 1-year CD. D) keep the money where it is.
D) keep the money where it is. Explanation DDA stands for demand deposit account, usually a checking account at a bank. Because this client cannot afford any risk to principal, and the bank account is covered by FDIC insurance, this is the most attractive option. The 1-year CD would offer more income, but there would likely be a penalty for early withdrawal. Even though the GNMA is directly backed by the U.S. government, it is subject to market fluctuation, a risk this client cannot take.
Which of the following statements regarding U.S. government agency securities is true? A) Interest received on agency securities is exempt from federal income tax. B) They are direct obligations of the U.S. government. C) They generally trade on the major stock exchanges. D) They generally offer higher yields than direct U.S. obligations.
D) They generally offer higher yields than direct U.S. obligations. Explanation In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk, and that means investors demand a higher return. They do not trade on any exchange. Their interest, like that of all U.S. government securities, is taxable on the federal level while being tax exempt on the state level.
One of the benefits of adding foreign debt securities to an investor's portfolio is A) potentially higher yields. B) reduced taxation. C) receiving income in foreign currency. D) potentially higher risk.
A) potentially higher yields. Explanation The interest rates paid on debt in many foreign countries, especially those in emerging economies, is higher than that available domestically. The tradeoff is higher risk. Receiving interest payments in foreign currency involves not only currency risk but the added expense of conversion into U.S. dollars. (ADRs are for equity, not debt securities.) In many cases, investors pay both foreign and U.S. tax on the interest.
Your client in the 28% federal income tax bracket currently owns some U.S. government bonds with a coupon yield of 6%. In order to receive the same income after taxes, she would need to buy municipal bonds with a coupon of A) 4.32%. B) 7.68%. C) 1.68%. D) 6.00%.
A) 4.32%. Explanation Because the 6% on the government bond is fully taxable on a federal basis, the client receives a net of 4.32% ($60 per bond less 28% in taxes [$16.80], or $43.20 per year). Interest on municipal bonds is tax free, so a 4.32% coupon will result in the same amount of after-tax income.
All of the following are true of negotiable, jumbo certificates of deposit except A) they are secured obligations of the issuing bank. B) they are usually issued in denominations of $100,000 to $1 million or more. C) they usually have maturities of one year or less. D) they are readily marketable.
A) they are secured obligations of the issuing bank. Explanation Negotiable CDs are general obligations of the issuing bank; they are not secured by any specific asset. They do qualify for FDIC insurance (up to $250,000), but that is not the same as stating that the bank has pledged specific assets as collateral for the loan.
Which of the following would be most likely to increase a bond's liquidity? A) No call protection B) A higher rating C) A lower rating D) A longer maturity
B) A higher rating Explanation Liquidity risk is the risk that when an investor wishes to dispose of an investment, no one will be willing to buy it or that a very large purchase or sale would not be possible at the current price. The available pool of purchasers for bonds with a low credit rating is much smaller than for those with investment-grade ratings. (Many institutions are only able to purchase bonds with higher credit ratings.) As a result, the lower the credit rating is, the greater the chance is of the bond having liquidity issues. Similarly, bonds with short-term maturities attract many more investors than those with long-term maturities, causing the long-term bonds to be less liquid. The absence of call protection is negative to many investors, thus limiting the number of potential investors.
The owner of a convertible debt issue A) generally expects a higher current return than with a nonconvertible bond of the same quality and maturity. B) is a creditor of the issuer. C) is generally in a senior position to other bondholders. D) has the choice of receiving the bond's interest or dividends on the underlying stock, whichever is higher.
B) is a creditor of the issuer. Explanation The owner of any bond is a creditor of the issuer. Dividends are paid only on stock, and the investor will have to convert in order to be a stockholder. Because of the growth potential of the common stock, holders of convertible securities invariably accept a lower coupon rate resulting in a lower current yield (return). In almost all cases, convertible debt securities are debentures and, therefore, junior to secured bonds.
Which of the following are general characteristics of negotiable jumbo CDs? A) Typically pay interest on a monthly basis B) Trade only in the primary market C) Issued in amounts of $100,000 to $1 million D) Always mature in one to two years with a prepayment penalty for early withdrawal
C) Issued in amounts of $100,000 to $1 million Explanation Negotiable jumbo CDs are issued for $100,000 to $1 million and trade in the secondary market. Most jumbo CDs are issued with maturities of one year or less. Being negotiable in the secondary market, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly.
All of the following statements regarding bonds selling at a discount are correct except A) they can indicate that interest rates have risen. B) they will appreciate more than comparable bonds selling at a premium if interest rates fall. C) they are more likely to be called than comparable bonds selling at a premium. D) they can indicate that the issuer's credit rating has fallen.
C) they are more likely to be called than comparable bonds selling at a premium. Explanation Issuers tend to call bonds with higher coupons. Bonds trading at a premium have higher coupons than those trading at a discount (and are more likely to be called—wouldn't you pay off your high-interest debt before the low-interest debt?). The longer the duration, the more volatile the bond's price. Lower coupon rates mean a longer duration. If rates rise, prices fall. If a bond's rating falls, so does its price.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years? A) $1,240 B) $1,344 C) $1,300 D) $1,267
D) $1,267 Explanation The unique feature of a TIPS bonds is its semiannual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semiannual periods in 4 years). Be sure to stop at 4 years—the question doesn't ask for the ending value for the 5th year. If this math is too challenging, there is a simple method that always works. That simple method has you take the annual inflation rate (6% = $60) for 4 years ($240) and add that to the original $1,000 face value. That is $1,240, and the correct answer on the exam will always be the next higher number ($1,267 in this case). This simple step means you are calculating the simple interest while the bond's principal growth is actually compounding.
Probably the most significant characteristic of municipal bonds for investors is A) their exemption from federal income tax. B) their exemption from registration on the state and federal level. C) that their coupon yields are higher than comparably rated corporate issues. D) their safety.
A) their exemption from federal income tax. Explanation Municipal bonds are unique in that their interest is not subject to federal income tax. As a result, their coupon yields are generally lower than corporate bonds with a similar rating; you get to keep all of the interest instead of paying taxes on it. The fact that they are exempt from registration with state and federal agencies is of little, if any, consequence to the typical investor. Although they tend to be quite safe, if safety is the primary concern, the investor would turn to U.S. Treasuries or government agency securities.
A bond issued by the GEMCO Corporation has been rated BBB by a major bond-rating organization. This bond would be considered A) callable. B) secured. C) an investment-grade corporate bond. D) a high-yield corporate bond.
C) an investment-grade corporate bond. Explanation An investment-grade bond has a bond rating between AAA and BBB. Lower-rated bonds are considered high-yield bonds and are often referred to as junk bonds. The bond may or may not be secured; the rating does not indicate that fact.
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of A) equipment trust certificates. B) secured income notes. C) collateral trust certificates. D) guarantee trust bonds.
C) collateral trust certificates. Explanation When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.
A bond is selling at a premium over par value. Therefore, A) its yield to maturity is greater than its current yield. B) its nominal yield is less than its current yield. C) its current yield is less than its nominal yield. D) none of these are correct.
C) its current yield is less than its nominal yield. Explanation Any bond selling at a premium will yield less than the coupon rate (nominal yield). Conversely, of course, a bond trading at a discount will certainly yield more. Remember, there is an inverse relationship between bond prices and bond yields.
The GHIJ Corporation has a 3% convertible debenture outstanding with a conversion price of $40. The bond's current market price is 126. The most probable reason for this is A) GHIJ's earnings have risen since the debenture was issued. B) the current market price of the GHIJ common stock is approximately $35 per share. C) the current market price of the GHIJ common stock is approximately $50 per share. D) interest rates have risen since the debenture was issued.
C) the current market price of the GHIJ common stock is approximately $50 per share. Explanation With a conversion price of $40, the bond is convertible into 25 shares. Convertible securities generally sell at a slight premium to their parity price, which—at $1,260—would be $50.40 per share.
Your client in the 35% federal income tax bracket currently owns some corporate bonds with a coupon yield of 7%. In order to receive the same income after taxes, he would need to buy municipal bonds with a coupon of A) 7.00%. B) 9.45%. C) 2.45%. D) 4.55%.
D) 4.55%. Explanation Because the 7% on the corporate bond is fully taxable, the client receives a net of 4.55% ($70 per bond less 35% in taxes [$24.50], or $45.50 per year). Interest on municipal bonds is tax free, so a 4.55% coupon will result in the same amount of after-tax income.
A money market mutual fund would be least likely to invest in which of the following assets? A) Jumbo CDs B) Repurchase agreements C) Newly issued U.S. Treasury bills D) Newly issued U.S. Treasury notes
D) Newly issued U.S. Treasury notes Explanation A money market mutual fund typically invests in money market instruments—those with a maturity date not exceeding 397 days. Treasury notes are issued with maturity dates of 2-10 years.
Your customer owns 1,000 shares of the XYZ $100 par 5½% callable convertible preferred stock convertible into four shares of XYZ common stock at $25. What should she be advised to do if the board of directors were to call all the preferred at 106 when the XYZ common stock is trading at $25.50? A) Hold the preferred stock to continue the 5½% yield. B) Place irrevocable instructions to convert the preferred stock into common stock and sell short the common stock immediately. C) Convert her preferred stock into common stock because it is selling above parity. D) Present the preferred stock for the call because the call price is $4 above the parity price.
D) Present the preferred stock for the call because the call price is $4 above the parity price. Explanation If the preferred stock is called, the client will receive $106 per share or $106,000. Tendering the preferred stock will provide the highest value. The value of converting the preferred stock into four shares of common is worth $102 (4 × $25.50 = $102), which is less than the call value of $106. On the 1,000 shares, this is a $4,000 difference. The dividends will cease on the call date if the preferred stock is held beyond the call date.
A bond's yield to maturity is A) determined by dividing the coupon rate by the bond's current market price. B) set at issuance and printed on the face of the bond. C) the annualized return of a bond if it is held to call date. D) the annualized return of a bond if it is held to maturity.
D) the annualized return of a bond if it is held to maturity. Explanation The yield to maturity is the annualized return of a bond if it is held to maturity. The computation reflects the internal rate of return and is frequently referred to as the market required rate of return for a debt security. The rate set at issuance and printed on the face of the bond is the nominal or coupon rate. Dividing the coupon rate by the current market price of the bond provides the current yield. The return of a bond if it is held to the call date is the YTC.
The interest from which of the following bonds is exempt from federal income tax? I. State of California bonds II. City of Anchorage bonds III. Treasury bonds IV. GNMA bonds A) I and II B) I and III C) II and IV D) III and IV
A) I and II Explanation Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax.
Which of the following debt instruments generally presents the least amount of default risk? A) Municipal general obligation bonds B) High-yield corporate bonds C) Convertible senior debentures D) Municipal revenue bonds
A) Municipal general obligation bonds Explanation Because the full taxing power of the municipality backs a general obligation municipal bond, it will exhibit the least amount of default risk. A corporate debenture is an unsecured bond with a potentially greater degree of risk, as is a junk or high-yield corporate bond.
Your client is interested in investing in preferred stocks in an effort to receive dividend income. The client's target goal is a 6% current return on investment (ROI). If the RIF Series B preferred stock is paying a quarterly dividend of $0.53, your client's goal will be achieved if the RIF can be purchased at A) $50.00. B) $8.83. C) $22.55. D) $35.33.
D) $35.33. Explanation First, take the quarterly dividend and annualize it (4 × $0.53 = $2.12). Dividing that number by 6% gets you $35.3333, which rounds down to $35.33. Alternatively if you wish (but which takes more time), multiply each of the choices by 6% to see which of them equals $2.12.
Which of the following statements represents an advantage of a municipal general obligation (GO) bond over a revenue bond? A) Only a facility's users pay for a GO bond. B) A GO bond is not charged against the municipality's borrowing limits. C) A GO bond issuer is required to conduct a feasibility study. D) A GO bond generally involves less risk to the investor.
D) A GO bond generally involves less risk to the investor. Explanation GO bonds are generally less risky than revenue bonds because they are backed by taxes rather than revenues. GO debt is charged against the borrowing limits (similar to the credit limit on your credit cards). That is a benefit to the investor because that limit protects against the municipality getting into debt over its head. It is the revenue bond that needs a feasibility study and collects user fees.
In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is A) greater risk. B) shorter maturities. C) higher yields. D) increased liquidity.
D) increased liquidity. Explanation Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral—often U.S. Treasury zero-coupon bonds—thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors. These benefits cause the yields to be lower—less risk, less reward. There is nothing unique about the maturities of Brady bonds.
The term Eurodollars refers to A) a worldwide currency system that is expected to someday replace existing currency systems. B) European currency held in U.S. banks. C) American dollars held by banks in other countries, especially in Europe. D) obsolete currency that was formerly backed by the gold standard.
C) American dollars held by banks in other countries, especially in Europe. Explanation American dollars held in international banks, especially—but not exclusively—in Europe, are known as Eurodollars.
Which of the following are characteristics of negotiable jumbo CDs? I. Issued in amounts of $100,000 to $1 million or more II. Typically pay interest on a monthly basis III. Always mature in one to two years with a prepayment penalty for early withdrawal IV. Trade in the secondary market A) II and IV B) I and III C) I and IV D) II and III
C) I and IV Explanation Negotiable jumbo CDs are issued for $100,000 to $1 million or more and trade in the secondary market. Most jumbo CDs are issued with maturities of one year or less. Being negotiable, there is no prepayment penalty. These CDs generally pay interest on a semiannual basis, not monthly.
Which of the following is a characteristic of an investment-grade general obligation municipal bond? A) The bond retains a direct claim on specific property. B) The bond's main source of investment risk is financial risk. C) The taxing authority of the issuing government or municipality backs the issue's repayment. D) The bond's periodic interest is paid to investors only when sufficient revenue is collected by the municipality.
C) The taxing authority of the issuing government or municipality backs the issue's repayment. Explanation General obligation bonds are backed by the full faith and credit of the government issuing the debt and are repaid through taxes collected by the government body. The main source of investment risk for a municipal security is interest rate risk. General obligation bonds do not retain a claim on specific property. The government issuing the bonds uses its taxing authority to pay the interest and repay the principal. Revenue bonds, not general obligation bonds, are dependent on revenue collected from the financed project.
Which of the following debt instruments does not make periodic interest payments? A) T-bills B) T-bonds C) T-notes D) TIPS
A) T-bills Explanation Treasury bills are always issued at a discount from their face value. At maturity, the investor receives the face value. The other choices pay interest semiannually. What makes TIPS different from the others is that the principal adjusts for inflation every six months. That means the fixed interest rate is paid on a varying principal.
A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? I. Bought it at a discount II. Bought it at a premium III. Sold it at a discount IV. Sold it at a premium A) I and III B) II and III C) I and IV D) II and IV
C) I and IV Explanation The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain.
Which of the following statements regarding convertible bonds is not true? A) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature. B) Convertible bondholders are creditors of the corporation. C) The conversion rate is set at issuance and does not change. D) Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
D) Coupon rates are usually higher than nonconvertible bond rates of the same issuer. Explanation Because convertible debentures offer investors the opportunity to gain from increases in the issuer's common stock, those investors are willing to accept a lower coupon (interest rate) than debt securities without the convertible feature. Debentures are debt securities, making their holders creditors of the issuer. At the time the debenture is issued, the bond indenture indicates the conversion rate. That rate is fixed and does not change over the life of the security. In general, the conversion feature will be exercised only if the market price of the underlying stock has risen to the point where the investor is better off owning the stock than the debenture. One of the benefits of owning this security is that, as a debt instrument, if the stock price falls below the conversion price, the debenture will trade in the market like a comparable nonconvertible issue. That is, it will trade at a market price offering a yield similar to nonconvertible debt securities of the same quality and maturity.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is A) $125.00 per share. B) $100.00 per share. C) $64.00 per share. D) $156.25 per share.
B) $100.00 per share. Explanation What does parity mean? It means that two things have equal value. What two things do we have here? We have the convertible bond, and because it is convertible, it can be converted into common stock. There is a number where the value of the bond and the value of the stock are the same; this price is the parity price. The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP's stock at $125 per share. However, that conversion is not based on a market price, which can fluctuate every day; it is based on the amount of money initially borrowed—the $1,000 par value of the bond. DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares. Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 ÷ 8 = $100 per share. That means that if the stock is selling for $100 per share and we decide to convert the bond, we'll have the same $800 in value. Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then to be equal, the stock must be selling at 80% of the conversion value (80% × $125 = $100).
You are meeting with a relatively unsophisticated investor who doesn't understand very much about stocks and bonds. The investor asks, "Can you list the advantages of owning common stock as compared to bonds?" Among other reasons, you could reply that A) there is limited liability. B) bonds have priority over any equity security in the event of liquidation. C) income payments are more reliable. D) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired.
D) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired. Explanation One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of bonds; if the company goes under, the bondholder's maximum loss is the investment. Even then, because of the seniority of bonds, it is less likely that the entire investment will be lost.
An investor purchasing 10 corporate bonds at a price of 102¼ each will pay A) $1,020.25. B) $10,225.00. C) $10,202.50. D) $1,022.50.
B) $10,225.00. Explanation At 102¼, each bond costs $1,022.50 (102 = 1,020 and ¼ of $10 = $2.50). There are 10 bonds, so the total is $1,022.50 × 10 = $10,225.
A $1,000 bond with a nominal yield of 8% will pay how much interest each year? A) $40 B) $80 C) $800 D) $160
B) $80 Explanation The nominal yield (or coupon rate) is the interest rate stated on the bond and is the rate the bondholder promises to pay on the bond until the bond matures. A $1,000 bond with an 8% nominal yield will pay $80 per year in interest.
Money market instruments are A) long-term equity. B) intermediate debt. C) short-term debt. D) long-term debt.
C) short-term debt. Explanation Money market instruments are high-quality debt securities with maturities that do not exceed one year.
Which of the following indicates a bond selling at a discount? A) 5% coupon yielding 5% B) 7% coupon yielding 6.5% C) 7% coupon yielding 7.5% D) 10% coupon yielding 9%
C) 7% coupon yielding 7.5% Explanation Whenever the yield is higher than the coupon, the bond is selling at a discount from the par value. When the question says "yielding," it is generally referring to the yield to maturity. However, whether referring to the YTM or the current yield, the answer here is the same: the yield is higher than the coupon.
Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond? A) Inflation risk B) Interest rate risk C) Currency risk D) Default risk
C) Currency risk Explanation Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident.
