The best answer is B.
As municipalities reached their debt limits with G.O. bond issuance, they found it harder and harder to get voter approval to raise limits to sell additional G.O. bonds (think of Proposition 13 in California that capped property taxes to almost no increase unless the property was sold). To get around this, the COP - Certificate of Participation - was invented and COP issuance is now greater than G.O. bond issuance in many states.
A COP is issued by a state entity where lease revenues are pledged to back the issue. The lease payments are received from a project such as a university dormitory, prison, municipal office building, municipal transit system, etc. The "difference" is that the lease payment is made based on the governing body making an annual appropriation from tax collections, and it is not "legally" obligated to do so, hence it is not really a bond. Rather, it is a security that gives the holder a share of "revenue" if the appropriation is made (which it will be, otherwise that issuer's credit rating would be trashed).
COP issuance has increased greatly over the years because they are easier to issue than G.O. debt (no pesky debt limits or voter approval to deal with) - but they are sold at a slightly higher yield, because they have more credit risk.
A municipality has floated a $100,000,000 revenue bond issue. The annual level debt service requirement is $20,000,000. In the first fiscal year, the municipality has collected revenues of $45,000,000. The "Coverage Ratio" is:
A. $20,000,000 / $100,000,000
B. $45,000,000 / $100,000,000
C. $45,000,000 / $20,000,000
D. $20,000,000 / $45,000,000
The best answer is B.
Auction Rate Securities are either preferred stock or bonds that have the dividend rate or interest rate reset at a weekly auction. In order to have a successful auction for anything, there must be bidders (buyers) for the securities offered. A lack of bids (or no bids) will result in no auction, making Choice I correct.
The auction is conducted as a "Dutch Auction," where bids are accepted in minimum $25,000 increments to buy the amount of securities offered. The bids are accepted from the lowest interest rate on up to the highest interest rate, and bids are accepted until the total amount offered is sold. The highest interest rate bid that is accepted to complete the sale of the issue is called the "clearing rate" and the entire offering gets this interest rate for the next week.
Note that there is usually a maximum interest rate set on bids (otherwise, the issuer could be forced to pay exorbitant interest rates if the only bids received were at excessively high interest rates).
If the interest rate bids received are at or below the maximum rate, then the auction is carried out as a Dutch Auction.
If the interest rate bids are above the maximum rate (this implies that the issuer's perceived credit quality has deteriorated or that market conditions are excessively volatile and buyers are demanding much higher interest rates), then the auction has "failed" and the sellers (holders) of the securities will carry the positions to the next week, during which they will receive the maximum interest rate on those securities. Then another auction will be attempted.
Thus, the risk for the holder of an ARS is not that interest will not be earned; rather it is that the holder may be forced to continue to hold the security when that customer really wants to dispose of the position. This occurs when there is either a lack or bids; or the bids received are at interest rates that are higher than the maximum or clearing rate (which is the same as saying that the clearing rate is below the interest rate bid).