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Finance Chapter 5
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Terms in this set (124)
The tax-ability premium is the additional compensation demanded on _____.
Taxable bonds
How has TRACE improved transparency in corporate bond market?
Corporate bond dealers are now required to report trade information through TRACE.
A Treasury yield curve depicts the _____
Yields for different maturities of Treasury securities.
A note is debt with an original maturity of ___ year(s) or less.
10
What is the least important component of the nominal rate of return?
Inflation loss on investment earnings
Nominal rate
(1 + R) = (1 + r) X (1 + h)
What is a TIPS?
Treasury Inflation Protected Securities.
A treasury yield curve depicts the _____.
Yields for different maturities of Treasury securities.
In a bankruptcy, the holder of a ____ is most apt to be paid first while the holder of a ____ will be paid last.
Senior debt security; common stock
The Fisher effect hypothesizes that real rate of return ____.
Is invariant to the rate of inflation
The interest rate premium is the additional compensation demanded by investors for holding _____ bonds.
Longer-term
If you were classified as a high income/high tax bracket investor, you might find municipal bond attractive investment because
Income from municipal bonds is exempt from federal taxes
The relationship between bond prices and the market rate of interest is:
Inverse; if the market rate of interest rises, bond prices will fall.
If a bond is rated Baa by Moody's and BB by Standard & Poor's, the bond will be regarded as a(n) ____ bond.
Crossover
The liquidity premium compensates investors based on a bond's _____.
Degree of marketability
What is the difference between a premium bond and a discount bond?
Premium bonds sell for more than the par value while discount bonds sell for less than the par value
The bid-ask spread represents the _____.
Dealers profit.
What does historical data suggest about nature of short-term and long-term interest rates?
Sometimes short-term rates are higher and sometimes long-term rates are higher.
What is the difference between a bond's "clean price" and its "dirty price"?
The clean price excludes accrued interest, while the dirty price includes accrued interest.
A bond has a "make-whole' call provision. The call price will be approximately equal to the ___.
Market price at the time of the call
Which is the largest security market in the world in terms of trading volume?
The U.S. Treasuries market
When using trial and error to compute the yield to maturity (YTM) for a 6 percent coupon bond that trades at a premium, the process can be shortened if the initial guess is ____ 6 percent.
Lower than
The term structure of interest rates examines the
Relationship between short-term and long-term interest rates
What are the federal income tax implications of receiving $50 in interest income from a municipal bond versus a corporate bond?
Only the interest on the corporate bond will be taxed.
Break even rate
1 - (current yields / comparable yield)
At what tax rate will you be indifferent between a muni that yields 7 percent and a comparable corporate bond yield 9 percent.
22.22%
The coupon rate on an original issue discount will be ___.
Very low
Assume a bond has a $1,000 par value, a coupon rate of 6 percent, annual interest payments and 7 years to maturity. If the yield on similar bonds is 8 percent what is the current market value of this bond?
$895.87
How is an original issue discount bond (OID) different from a zero coupon bond?
An OID has a very low coupon rate.
Most of the time, a floating-rate bond's coupon adjusts ___.
With a lag to some base rate
What are "fallen angel" bonds?
Bond that have dropped from investment grade to junk bond status
If you invest in a $1,000 corporate bond that has a 9 percent coupon and makes semi-annual payments, you can expect to receive ___ each six months.
$ 45 every 6 months
A corporation issues 50,000 bonds at $1,000 each. The bonds mature in 5 years and have a coupon rate of 7 percent. What will the total annual interest expense be for the corporation?
$3.5 Million
When an investor sells a bond, the price received is always the ____.
Bid Price
A bond's yield to maturity considers the interest earning and the change in the bond's price while the current yield considers ______.
Interest earnings only
How significant is the real rate of return in determining the shape of the term structure of interest rates?
• Not very significant
• Less significant than inflation
If market interest rates rise the present value of a zero coupon will ______.
Decrease.
What are some reasons why the bond market is so big?
• Various state and local governments also participate in the bond market
• Many corporations have multiple bond issues outstanding
• Federal government borrowing activity in the bond market is enormous.
As a general rule, which of the following are true of debt and equity?
• The maximum reward for owning debt is fixed
• Equity represents an ownership interest
How is the real rate of return different from the nominal rate of return?
The real rate of return adjusts the nominal rate to remove the effects of inflation.
Party Time, Inc. has a 6% coupon bond that matures in 11 years. The bond pays interest semiannually. What is the market price of a $1,000 face value bond if the yield to maturity is 12.9%?
$600.34
The value of a 20 year zero-coupon bond with a $1,000 face value when the market required rate of return of 8% (semiannual) is ___.
$208.29
A 12-year, 5% coupon bond pays interest annually. The bond has a face value of $1,000. What is the change in the price of this bond if the market yield rises to 6% from the current yield of 4.5%?
12.38% decrease
The Lo Sun Corporation offers a 6% bond with a current market price of $875.05. The yield to maturity is 7.34%. The face value is $1,000. Interest is paid semiannually. How many years is it until this bond matures?
16 years
Wine and Roses, Inc. offers a 7% coupon bond with semiannual payments and a yield to maturity of 7.73%. The bonds mature in 10 years. What is the market price of a $1,000 face value bond?
$949.8
Winston Enterprises has a 15-year bond issue outstanding that pays a 9 % coupon. The bond is currently priced at $894.60 and has a par value of $1,000. Interest is paid semiannually. What is the yield to maturity?
10.40%
A General Co. bond has an 8 % coupon and pays interest annually. The face value is $1,000 and the current market price is $1,020.50. The bond matures in 20 years. What is the yield to maturity?
7.79%
Consider a bond which pays 7% semiannually and has 8 years to maturity. The market requires an interest rate of 8% on bonds of this risk. What is this bond's price?
$941.74 (Hint find PV)
A bond with a 7% coupon that pays interest semi-annually and is priced at par will have a market price of _____ and interest payments in the amount of _____ each.
$1000; 35
Why does a bond's value fluctuate over time?
The coupon rate and par value are fixed, while market interest rates change.
Which of the following are usually included in a bond's indenture?
• The repayment arrangements
• The total amount of bonds issued
How much can a corporation expect to receive per bond if it sells 10-year zero coupon bonds with a face value of $1,000 if the market rate of interest is 9 percent?
414.64/ Hint find PV
Which of the following institutions issue bonds that are traded in the bond market?
• The federal government
• State governments
• Public corporations
According to the approximation formula for the nominal rate of return(R), the nominal rate will ____ if inflation (h) increases.
Increase
CAT bond
Protects insurance companies from natural disasters.
Convertible bond
Can be exchanged for shares of stock
Put bond
Owner can force issuer to repay prior to maturity at a stated price
Structured note
Based on financial securities, commodities, or currencies
What is the present value of annual interest payments on a 10 year, $ 1000 par value bond with a coupon rate of 10 percent annually, if the yield on similar bonds is 9 percent.
$641.77
Annuity Present Value
Coupon Pmt * (1 - (1/(1+IR^years))/IR
Present Value with non-annuity
FV/1+IR^years
True or False; If you invest in a bond that is rated AAA by S&P, you can be reasonably assured that your investment has very little default risk.
True
A 10-year AAA corporate bond is most apt to have a yield that ____ the yield on a 10-year AAA state government bond.
Exceeds
What is the coupon rate on a bond that has a par value of $1000, a market value of $1,100, and a coupon interest payment of $100 per year.
10%
Coupon Rate
Par value/Interest Payment per year
Which three of the following are common shapes for the term structure of interest rates?
• Upward sloping
• Humped
• Downward sloping
If an investment appreciates by 7 percent while the rate is 2 percent, what is the nominal rate of return?
7%
Which of the following are features of municipal bonds?
• They are issued by state and local governments
The interest on municipal bonds is exempt from federal taxes.
The federal government can raise money from financial markets to finance its deficits by ____.
Issuing bonds
What are the three important features of Treasury notes and bonds?
• Default-free
• Taxable
• Highly liquid
A zero-coupon bond is a bond that ____.
Makes no interest payments.
Which of these are required to calculate the current value of a bond?
• Time remaining to maturity
• Applicable market rate
• Coupon
• Par Value
True or False: A bond's value is not affected by changes in the market rate of interest.
False
Effective Annual Rate
[1 +( IR/#of interest payments per year ) ]^ #of interest payments per year - 1
What is the effective annual rate for a bond with a 7 percent yield to maturity that makes semi-annual interest payments?
7.12
What is the bid price?
The bid is the price at which a dealer is willing to buy securities
If you own corporate bonds, you will be concerned about interest rate risk as it affects ____.
The market price of the bonds
What is a discount bond?
Discount bonds are bonds that sell for less than the face value.
Which is more transparent, the stock market or the bond market?
The stock market is more transparent.
In an inflationary environment, the nominal rate will be _____ the real rate.
Greater than
A sinking fund ____
• Has its terms spelled out in the bond's indenture
• Is a mechanism for repaying the bonds prior to maturity
ABC Co. issued 1 million 6 percent annual coupon bonds that mature in 10 years. The face value is $1,000 per bond. What are the expected cash flows from one of these bonds?
$60 in interest at the end of each year for 10 years and $1,000 repayment of principal at the end of 10 years.
What affects a bond's yield to maturity?
• Par value
• Current price
• Coupon rate
If the rate of inflation is 3 percent and the real rate of return is 5 percent, the nominal rate is approximately _____ percent.
8
Nominal rate
r(real rate) + h(inflation rate)
What will your after-tax yield be on a corporate bond that is currently priced to yield 7% percent if you are in the 25 percent tax bracket?
5.25%
When interest rates in the market rise, we can expect the price of bonds to ____.
Decrease
If you are in the 15 percent tax bracket, what will be your aftertax yield on a U.S. Treasury bond that is currently priced at par yielding 5 percent?
4.25%
U.S. Treasury notes and bonds have initial maturities ranging from _____ years.
2 to 30
What is the principal amount of a loan if the monthly payment on a 30 year mortgage is $1,600? Assume an annual interest rate of 6 percent, compounded monthly.
$266,866.58
What allows a company to repurchase a bond?
Call provision
What are three components determine the shape of the term structure of interest rates?
• Inflation premium
• Interest rate risk premium
• Real interest rate
As an investor in the bond market, why should you be concerned about changes in interest rates?
Changes in interest rates cause changes in bond prices.
If the term structure of interest rates is upward-sloping, then ____.
Long-term rates are higher than short-term rates.
How significant is the inflation premium on the shape of the term structure of interest rates?
• Very significant
• More significant than the real rate of return
True or false: The inflation premium will be higher if the rate of inflation is low.
False
What is a bond's current yield?
Annual coupon payment/Current Price
What are the three components of the Treasury yield curve?
• Interest rate risk premium
• Real rate of return
• Expected inflation
What is the asked price?
The asked price is the price at which a dealer is willing to sell.
All else held constant, the yield on highly liquid bond will be ___ the yield to an illiquid bond.
Lower than
What are the three components of the nominal rate of return?
• Compensation for inflation effect on the investment earnings
• Real rate of return
• Compensation for the inflation effect on the original investment
What is a bond's yield to maturity (YTM)?
YTM is the expected return on a bond that is held until it matures
The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables?
• Time to maturity
• Coupon rate
What is accrued interest?
It is the interest that has been earned but not yet received.
What are six factors that determine the yield on a bond?
• Real rate of return
• Default risk
• Interest rate risk
• Expected future inflation
• Liquidity
• Taxability
What is true about a multi-year typical bond's coupon?
It is a fixed annuity payment.
A bond's YTM will exceed its current yield when the bond is selling at ____
A discount.
What are the positive protective covenants:
• The firm must periodically provide audited financial statements to the lender
• The firm must maintain working capital that equals or exceeds a specified level.
If you invest in a corporate bond, how many times can you expect, in general, to receive interest?
Twice a year
The default risk premium refers to the extra compensation demanded by investors for the possibility that the issuer might ___.
Not make all the promised payments
What are the two unique features of a U.S. federal government bond?
• Exempt from state income taxes
• Are considered to be default-free
What is a premium bond?
A bond that sells for more than face value.
What are some features of the OTC market for bonds?
• The OTC has no designated physical location
• OTC dealers are connected electronically.
What is the real rate of return if the nominal rate is 7 percent and the rate of inflation is 2 percent?
4.90%
Real Rate of Return
[(1+nominal rate)/(1+h)] - 1
Suppose you own a 30-year bond issued by GE and a 2-year bond issued by PG with identical coupon rates and par values. Which bond will you lose more money on as interest rates rise?
The GE bond will lose more because it has a longer maturity.
Why did Disney issue 100-year bonds, dubbed "Sleeping Beauty" bonds, in the 1990's?
To lock-in historically low interest rates for a long time
What is the clean price of a $1,000 par value bond with a 12 percent coupon, payable semiannually, if the bond's dirty price is $1,050 and the next semiannual coupon payment is due in 4 months?
$1,030
If a $1,000 face value U.S. Treasury bond is quoted at 99.5, then the bond can be purchased _____.
At 99.5 percent of face value plus any accrued interest.
True or False: The price you pay to purchase a bond will generally exceed the clean price.
True.
What does the dirty price represent?
It includes the quoted price and accrued interest.
What is the price of a U.S. Treasury bond listed at 122 if the par value is $5,000.
$6,100
A humped term structure of interest rates indicates that interest rates are expected to ____ as the time to maturity increases.
Increase and then decline
As the time to maturity increases, the interest rate risk premium ______.
...
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