Question 1

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 market interest rates are below 10% and at a discount if interest rates are greater than 10%.

Accepted Answer

The bond has a fixed annual interest payment of $100, which represents a 10% yield when the bond is priced at its par value of $1,000. If market interest rates (i.e. the yield on bonds with similar risk characteristics) are below 10%, investors will be willing to pay more than $1,000 for the bond in order to obtain a higher yield than what is available in the market. This will cause the bond to sell at a premium. Conversely, if market interest rates are above 10%, investors will require a higher yield than what the bond offers, and will only be willing to purchase the bond at a discount (i.e. for less than $1,000) in order to compensate for the lower yield.

Question 2

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 3

A bond that had a 20-year original maturity with 1 year left to maturity has more 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

False

Question 4

The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds,other things held constant.

Accepted Answer

High-coupon bonds make larger coupon payments, which means that investors receive more income from these bonds. This income acts as a cushion against potential losses in the bond's value due to changes in interest rates. As a result, high-coupon bonds tend to have lower interest rate risk and be less sensitive to changes in interest rates than low-coupon bonds.

Question 5

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

Accepted Answer

The coupon rate on new bonds issued by a firm is typically set equal to the required rate of return for bonds of similar risk. The term "issuing firm" is also commonly used to refer to a company that is selling bonds to raise capital.

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 higher risk of default but also offer a higher yield than investment-grade bonds. They are commonly used in leveraged buyouts and mergers and are issued by companies with lower credit ratings or questionable financial strength.

Question 7

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 reflects the historical context that led to the increased usage of floating-rate bonds.

Question 8

The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity.

Accepted Answer

This is known as "duration" and it measures a bond's sensitivity to interest rate changes. Bonds with longer maturities have longer durations and therefore are more sensitive to changes in interest rates.

Question 9

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

Accepted Answer

Floating-rate debt does offer advantages to corporate issuers as they can issue debt at a lower initial interest rate and benefit from potentially lower interest payments if market rates fall. It also allows them to diversify their debt portfolio and manage interest rate risk. However, it does shift the price risk to companies if market rates rise.

Question 10

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

Accepted Answer

The answer of A zero coupon bond is a bond...

Question 11

A call provision gives bondholders the right to demand,or "call for," repayment of a bond.Typically,companies call bonds if interest rates rise and do not call them if interest rates decline.

Accepted Answer

The answer of A call provision gives bondholders the right...

Question 12

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

When the required rate of return on a bond is greater than its coupon interest rate, investors will demand a lower price for the bond in order to achieve their required rate of return. As a result, the market value of the bond will be below its par value until it matures and reaches its face value.

Question 13

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

Debentures are unsecured bonds and are not backed by any specific assets, so they have a higher required interest rate to compensate for the greater risk to investors. Mortgage bonds, on the other hand, are secured by specific assets and have a lower interest rate as a result.

Question 14

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 is a commonly used method of valuing assets, known as discounted cash flow analysis. It involves estimating the future cash flows that an asset is expected to generate, and then using a discount rate to determine their present value. This approach is used in a range of industries, from finance to real estate to art collecting.

Question 15

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 price risk if you purchased a 30-day bond than if you bought a 30-year bond.

Accepted Answer

The answer of Because short-term interest rates are much more...

Question 16

Sinking funds are provisions included in bond indentures that require companies to retire bonds on a scheduled basis prior to their final maturity.Many indentures allow the company to acquire bonds for sinking fund purposes by either (1)purchasing bonds on the open market at the going market price or (2)selecting the bonds to be called by a lottery administered by the trustee,in which case the price paid is the bond's face value.

Accepted Answer

This statement accurately describes sinking funds and the options available to companies for retiring bonds early.

Question 17

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 bond is currently selling at a discount ($800 instead of $1000), which means that its yield to maturity is higher than its coupon rate of 10%. If the buyer's required return on bonds with this risk is 12%, then the bond's yield to maturity is higher than their required return, indicating that it would be a good investment. Therefore, they should buy the bond.

Question 18

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

Since both bonds have the same credit rating, maturity, and coupon, they should have the same yield. The presence of a sinking fund should not affect the yield, as it is a mandatory repayment schedule that does not add any additional credit risk. Therefore, the bond prices should be equal and in equilibrium.

Question 19

Restrictive covenants are designed primarily to protect bondholders by constraining the actions of managers.Such covenants are spelled out in bond indentures.

Accepted Answer

Restrictive covenants are indeed included in bond indentures to protect bondholders by limiting the actions of managers.

Question 20

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. Higher quality bonds, such as those with AAA ratings, are considered less risky and therefore require a lower rate of return. Lower quality bonds, such as those with lower ratings, are considered more risky and therefore require a higher rate of return to compensate investors for that risk.

Quiz 7: Bonds and Their Valuation