Question 1

Because short-term interest rates are much more volatile than long-term rates,you would,in the real world,generally be subject to much more interest rate price risk if you purchased a 30-day bond than if you bought a 30-year bond.

Accepted Answer

Long-term bonds are generally more sensitive to interest rate changes than short-term bonds, meaning that their prices are more volatile in response to interest rate fluctuations. This is because the present value of the bond's future cash flows is more affected by changes in interest rates when those cash flows are further in the future.

Question 2

A bond that is callable has a chance of being retired earlier than its stated term to maturity.Therefore,if the yield curve is upward sloping,an outstanding callable bond should have a lower yield to maturity than an otherwise identical noncallable bond.

Accepted Answer

The callable bond will be called if rates fall far enough below the coupon rate,but it will not be called otherwise.Thus,the call provision can only harm bondholders.Therefore,callable bonds sell at higher yields than noncallable bonds,regardless of the slope of the yield curve.

Question 3

Other things equal,a firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

Accepted Answer

Subordinated debentures are lower in priority than second mortgage bonds in terms of repayment in case of bankruptcy, which increases the risk for investors. To compensate for this risk, firms typically offer a higher coupon rate on subordinated debentures.

Question 4

You have funds that you want to invest in bonds,and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800.The coupon rate is 10% (with annual payments),and there are 10 years before the bond will mature and pay off its $1,000 par value.You should buy the bond if your required return on bonds with this risk is 12%.

Accepted Answer

The bonds expected return (YTM)is 13.81%,which exceeds the 12% required return,so buy the bond.

Question 5

For bonds,price sensitivity to a given change in interest rates is generally greater the longer before the bond matures.

Accepted Answer

This is because the longer before the bond matures, the greater the number of future cash flows that are affected by changes in interest rates, and the greater the impact of those changes on the present value of those cash flows.

Question 6

Junk bonds are high risk,high yield debt instruments.They are often used to finance leveraged buyouts and mergers,and to provide financing to companies of questionable financial strength.

Accepted Answer

Junk bonds have a high risk of default and are therefore considered high risk, high yield debt instruments. They are often used in financing activities such as leveraged buyouts and mergers, as well as providing funding to companies that may have questionable financial strength.

Question 7

Income bonds pay interest only if the issuing company actually earns the indicated interest.Thus,these securities cannot bankrupt a company,and this makes them safer from an investor's perspective than regular bonds.

Accepted Answer

Income bonds pay interest only if the issuing company earns enough profit, which might make them seem safer for the company but not necessarily for the investor. Investors face higher risk since they might not receive interest payments if the company doesn't perform well. Regular bonds obligate the company to make interest payments regardless of its financial state, providing more predictable income for investors.

Question 8

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

Accepted Answer

Floating rates can benefit issuers if rates decline,so a company that thinks rates are likely to fall would want to issue such bonds.

Question 9

If the required rate of return on a bond (r_d)is greater than its coupon interest rate and will remain above that rate,then the market value of the bond will always be below its par value until the bond matures,at which time its market value will equal its par value.(Accrued interest between interest payment dates should not be considered when answering this question.)

Accepted Answer

This is because when the required rate of return is greater than the coupon rate, investors will demand a discount on the bond to make up for the lower interest payments. As a result, the bond's market value will be below par value until maturity, at which point the investor will receive the full par value plus the final interest payment.

Question 10

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

Accepted Answer

This statement is true. The value of an asset is determined by the future cash flows it is expected to generate, and these cash flows are then discounted back to their present value using a discount rate that reflects the risk inherent in the investment. This is the concept of present value.

Question 11

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

Accepted Answer

Both bonds have the same duration to maturity (1 year left), so their interest rate price risk is essentially the same, regardless of their original maturity lengths.

Question 12

There is an inverse relationship between bonds' quality ratings and their required rates of return.Thus,the required return is lowest for AAA-rated bonds,and required returns increase as the ratings get lower.

Accepted Answer

This statement is true. Bonds with higher quality ratings (such as AAA) are considered lower risk and therefore have lower required rates of return. As the quality ratings decrease, the perceived risk increases and the required rates of return increase accordingly.

Question 13

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

Accepted Answer

This statement accurately portrays the historical context in which the demand for floating-rate bonds emerged.

Question 14

If a firm raises capital by selling new bonds,it is called the "issuing firm," and the coupon rate is generally set equal to the required rate on bonds of equal risk.

Accepted Answer

This statement is true. The coupon rate on new bonds issued by a firm is usually set equal to the required rate on bonds of equal risk in order to attract investors and raise the necessary capital.

Question 15

A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially)at par.These bonds provide compensation to investors in the form of capital appreciation.

Accepted Answer

A zero coupon bond is a bond that pays no interest but is sold at a deep discount to its face value, providing compensation to investors through capital appreciation, not at par.

Question 16

You are considering 2 bonds that will be issued tomorrow.Both are rated triple B (BBB,the lowest investment-grade rating),both mature in 20 years,both have a 10% coupon,neither can be called except for sinking fund purposes,and both are offered to you at their $1,000 par values.However,Bond SF has a sinking fund while Bond NSF does not.Under the sinking fund,the company must call and pay off 5% of the bonds at par each year.The yield curve at the time is upward sloping.The bond's prices,being equal,are probably not in equilibrium,as Bond SF,which has the sinking fund,would generally be expected to have a higher yield than Bond NSF.

Accepted Answer

The sinking fund would give Bond SF a lower average maturity,and it would also lower its risk.Therefore,Bond SF should have a lower,not a higher,yield.

Question 17

A call provision gives bondholders the right to demand,or "call for," repayment of a bond.Typically,calls are exercised if interest rates rise,because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates.

Accepted Answer

A call provision gives the issuer of the bond the right, not the bondholder, to repay the bond before its maturity date, typically when interest rates fall, allowing the issuer to refinance at a lower cost.

Question 18

Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity.Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value.

Accepted Answer

Sinking funds are indeed used to retire bonds on a scheduled basis prior to their maturity, and companies can acquire bonds for a sinking fund through various means such as market purchases or lotteries administered by the trustee.

Question 19

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

Accepted Answer

This statement is generally true as mortgage bonds have collateral backing them, making them less risky for investors. Debentures, on the other hand, are unsecured and therefore require a higher interest rate to compensate for the increased risk. However, there may be exceptions where a debenture may have a lower interest rate than a mortgage bond depending on various factors such as the creditworthiness of the issuer and market conditions.

Question 20

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

Accepted Answer

The bond's coupon rate of $100/$1000 = 10% is the same as the market interest rate when interest rates are at 10%. If interest rates are below 10%, the bond's fixed coupon rate becomes more attractive, and demand for the bond increases, causing it to sell at a premium. If interest rates are above 10%, the bond's fixed coupon rate becomes less attractive, and demand for the bond decreases, causing it to sell at a discount.

Quiz 5: Bonds, bond Valuation, and Interest Rates