Deck 13: Equity Valuation

Question 1

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. $$\begin{array} { c c } \text { Maturity (Years) } & \text { Price } \\\hline 1 & \$ 943.40 \\2 & \$ 881.68 \\3 & \$ 808.88 \\4 & \$ 742.09\end{array}$$
What is the yield to maturity on a 3-year zero coupon bond?

A) 6.37%
B) 9.00%
C) 7.33%
D) 10.00%
E) none of these

Answer 1

7.33%

Question 2

Suppose that all investors expect that interest rates for the 4 years will be as follows: $$\begin{array} { c r } \text { Year } & \text { Forward Interest Rate } \\0& \text { (today) } 5 \% \\1 & 7 \% \\2 & 9 \% \\3 & 10 \%\end{array}$$
What is the price of 3-year zero coupon bond with a par value of $1,000?

A) $863.83
B) $816.58
C) $772.18
D) $765.55
E) none of these

Answer 2

$816.58

Question 3

Suppose that all investors expect that interest rates for the 4 years will be as follows: $$\begin{array} { c r } \text { Year } & \text { Forward Interest Rate } \\\hline 0& \text { (today) } 5 \% \\1 & 7 \% \\2 & 9 \% \\3 & 10 \%\end{array}$$
What is the price of a 2-year maturity bond with a 10% coupon rate paid annually? (Par value = $1,000)

A) $1,092.97
B) $1,054.24
C) $1,000.00
D) $1,073.34
E) none of these

Answer 3

$1,073.34

Question 4

Given the following pattern of forward rates: $$\begin{array} { c c } \text { Year } & \text { Forward Rate } \\1 & 5 \% \\2 & 6 \% \\3 & 6.5 \%\end{array}$$
If one year from now the term structure of interest rates changes so that it looks exactly the same as it does today,what would be your holding period return if you purchased a 3-year zero coupon bond today and held it for one year?

A) 6%
B) 8%
C) 9%
D) 7%
E) none of these

Question 5

According to the "liquidity preference" theory of the term structure of interest rates,the yield curve usually should be:

A) inverted.
B) normal.
C) upward sloping
D) a and b.
E) b and c.

Question 6

The expectations theory of the term structure of interest rates states that

A) forward rates are determined by investors' expectations of future interest rates.
B) forward rates exceed the expected future interest rates.
C) yields on long-and short-maturity bonds are determined by the supply and demand for the securities.
D) all of these.
E) none of these.

Question 7

Suppose that all investors expect that interest rates for the 4 years will be as follows: $$\begin{array} { c r } \text { Year } & \text { Forward Interest Rate } \\\hline 0& \text { (today) } 5 \% \\1 & 7 \% \\2 & 9 \% \\3 & 10 \%\end{array}$$
What is the yield to maturity of a 3-year zero coupon bond?

A) 7.00%
B) 9.00%
C) 6.99%
D) 7.49%
E) none of these

Question 8

If forward rates are known with certainty and all bonds are fairly priced

A) all bonds would have the same yield to maturity.
B) all short-maturity bonds would have lower prices than all long-maturity bonds.
C) all bonds would have the same price.
D) all bonds would provide equal 1-year rates of return.
E) none of these.

Question 9

An inverted yield curve implies that:

A) Long-term interest rates are lower than short-term interest rates.
B) Long-term interest rates are higher than short-term interest rates.
C) Long-term interest rates are the same as short-term interest rates.
D) Intermediate term interest rates are higher than either short-or long-term interest rates.
E) none of these.

Question 10

The yield curve shows at any point in time:

A) The relationship between the yield on a bond and the duration of the bond.
B) The relationship between the coupon rate on a bond and time to maturity of the bond.
C) The relationship between yield on a bond and the time to maturity on the bond.
D) All of these.
E) None of these.

Question 11

Suppose that all investors expect that interest rates for the 4 years will be as follows: $$\begin{array} { c r } \text { Year } & \text { Forward Interest Rate } \\\hline 0& \text { (today) } 5 \% \\1 & 7 \% \\2 & 9 \% \\3 & 10 \%\end{array}$$
If you have just purchased a 4-year zero coupon bond,what would be the expected rate of return on your investment in the first year if the implied forward rates stay the same? (Par value of the bond = $1,000)

A) 5%
B) 7%
C) 9%
D) 10%
E) none of these

Question 12

Which of the following theories state that the shape of the yield curve is essentially determined by the supply and demands for long-and short-maturity bonds?

A) Liquidity preference theory.
B) Expectations theory.
C) Market segmentation theory.
D) All of these.
E) None of these.

Question 13

An upward sloping yield curve is a(n)_______ yield curve.

A) normal.
B) humped.
C) inverted.
D) flat.
E) none of these.

Question 14

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. $$\begin{array} { c c } \text { Maturity (Years) } & \text { Price } \\\hline 1 & \$ 943.40 \\2 & \$ 881.68 \\3 & \$ 808.88 \\4 & \$ 742.09\end{array}$$
You have purchased a 4-year maturity bond with a 10% coupon rate paid annually.The bond has a par value of $1,000.What would the price of the bond be one year from now if the implied forward rates stay the same?

A) $808.88
B) $1,108.88
C) $1,000
D) $1,042.78
E) none of these

Question 15

Which of the following is not proposed as an explanation for the term structure of interest rates:

A) The expectations theory.
B) The liquidity preference theory.
C) The market segmentation theory.
D) Modern portfolio theory.
E) A,b,and c.

Question 16

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. $$\begin{array} { c c } \text { Maturity (Years) } & \text { Price } \\\hline 1 & \$ 943.40 \\2 & \$ 881.68 \\3 & \$ 808.88 \\4 & \$ 742.09\end{array}$$
What is,according to the expectations theory,the expected forward rate in the third year?

A) 7.00%
B) 7.33%
C) 9.00%
D) 11.19%
E) none of these

Question 17

The term structure of interest rates is:

A) The relationship between the rates of interest on all securities.
B) The relationship between the interest rate on a security and its time to maturity.
C) The relationship between the yield on a bond and its default rate.
D) All of these.
E) None of these.

Question 18

The market segmentation theory of the term structure of interest rates

A) theoretically can explain all shapes of yield curves.
B) definitely holds in the "real world".
C) assumes that markets for different maturities are separate markets.
D) a and b.
E) a and c.

Question 19

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. $$\begin{array} { c c } \text { Maturity (Years) } & \text { Price } \\\hline 1 & \$ 943.40 \\2 & \$ 881.68 \\3 & \$ 808.88 \\4 & \$ 742.09\end{array}$$
What is the price of a 4-year maturity bond with a 12% coupon rate paid annually? (Par value = $1,000)

A) $742.09
B) $1,222.09
C) $1,000.00
D) $1,141.84
E) none of these

Question 20

According to the expectations hypothesis,a normal yield curve implies that

A) interest rates are expected to remain stable in the future.
B) interest rates are expected to decline in the future.
C) interest rates are expected to increase in the future.
D) interest rates are expected to decline first,then increase.
E) interest rates are expected to increase first,then decrease.

Question 21

The market segmentation and preferred habitat theories of term structure

A) are identical.
B) vary in that market segmentation is rarely accepted today.
C) vary in that market segmentation maintains that borrowers and lenders will not depart from their preferred maturities and preferred habitat maintains that market participants will depart from preferred maturities if yields on other maturities are attractive enough.
D) a and b.
E) b and c.

Question 22

Forward rates ____________ future short rates because ___________.

A) are equal to;they are both extracted from yields to maturity.
B) are equal to;they are perfect forecasts.
C) differ from;they are imperfect forecasts.
D) differ from;forward rates are estimated from dealer quotes while future short rates are extracted from yields to maturity.
E) are equal to;although they are estimated from different sources they both are used by traders to make purchase decisions.

Question 23

Statistical estimation of the yield curve contains apparent pricing error.These error terms are probably a result of

A) tax effects.
B) call provisions.
C) out of date price quotes.
D) all of these.
E) none of these.

Question 24

Investors can use publicly available financial date to determine which of the following?
I)the shape of the yield curve
II)future short-term rates
III)the direction the S&P/TSX composite index is heading
IV)the actions to be taken by the Bank of Canada

A) I and II
B) I and III
C) I,II,and III
D) I,III,and IV
E) I,II,III,and IV

Question 25

The concepts of spot and forward rates are most closely associated with which one of the following explanations of the term structure of interest rates.

A) Segmented Market theory
B) Expectations Hypothesis
C) Preferred Habitat Hypothesis
D) Liquidity Premium theory
E) None of these

Question 26

Interest rates might decline

A) because real interest rates are expected to decline.
B) because the inflation rate is expected to decline.
C) because nominal interest rates are expected to increase.
D) a and b.
E) b and c.

Question 27

The yield curve

A) is a graphical depiction of term structure of interest rates.
B) is usually depicted for Canada bonds in order to hold risk constant across maturities and yields.
C) is usually depicted for corporate bonds of different ratings.
D) a and b.
E) a and c.

Question 28

The most recently issued Treasury securities are called

A) on the run.
B) off the run.
C) on the market.
D) off the market.
E) none of these

Question 29

An upward sloping yield curve

A) is an indication that interest rates are expected to increase.
B) incorporates a liquidity premium.
C) reflects the confounding of the liquidity premium with interest rate expectations.
D) all of these.
E) none of these.

Question 30

Given the yield on a 3 year zero-coupon bond is 7.2% and forward rates of 6.1% in year 1 and 6.9% in year 2,what must be the forward rate in year 3?

A) 7.2%
B) 8.6%
C) 6.1%
D) 6.9%
E) none of these.

Question 31

If you have just purchased a 4-year zero coupon bond,what would be the expected rate of return on your investment in the first year if the implied forward rates stay the same? (Par value of the bond = $1,000)

A) 5%
B) 3%
C) 9%
D) 10%
E) None of these is correct.

Question 32

The pure yield curve can be estimated

A) by using zero-coupon bonds.
B) by using coupon bonds if each coupon is treated as a separate "zero."
C) by using corporate bonds with different risk ratings.
D) by estimating liquidity premiums for different maturities.
E) a and b.

Question 33

The "break-even" interest rate for year n that equates the return on an n-period zero-coupon bond to that of an n-1-period zero-coupon bond rolled over into a one-year bond in year n is defined as

A) the forward rate.
B) the short rate.
C) the yield to maturity.
D) the discount rate.
E) None of these.

Question 34

Consider two annual coupon bonds,each with two years to maturity.Bond A has a 7% coupon and a price of $1,000.62.Bond B has a 10% coupon and sells for $1,055.12.Find the two one-period forward rates that must hold for these bonds.

A) 6.97%,6.95%
B) 6.95%,6.95%
C) 6.97%,6.97%
D) 6.08%,7.92%
E) 7.00%,10.00%
1,000.62 = d₁X 70 + d₂ X 1,070;
1,055.12 = d₁X 100 + d₂ X 1,100;
2620.36 = 3000 d₂;

Question 35

Assuming the forecasts implicit in a yield curve come to pass,an inverted yield curve would be most favorable for

A) short-term borrowers.
B) long-term borrowers.
C) short-term lenders.
D) long-term lenders.
E) nobody-Neither a borrower nor a lender be.

Question 36

An inverted yield curve is one

A) with a hump in the middle.
B) constructed by using convertible bonds.
C) that is relatively flat.
D) that plots the inverse relationship between bond prices and bond yields.
E) that slopes downward.

Question 37

When computing yield to maturity,the implicit reinvestment assumption is that the interest payments are reinvested at the:

A) Coupon rate.
B) Current yield.
C) Yield to maturity at the time of the investment.
D) Prevailing yield to maturity at the time interest payments are received.
E) The average yield to maturity throughout the investment period.

Question 38

Which one of the following statements is true?

A) The expectations hypothesis indicates a flat yield curve if anticipated future short-term rates exceed the current short-term rate.
B) The basic conclusion of the expectations hypothesis is that the long-term rate is equal to the anticipated long-term rate.
C) The liquidity preference hypothesis indicates that,all other things being equal,longer maturities will have lower yields.
D) The segmentation hypothesis contends that borrows and lenders are constrained to particular segments of the yield curve.
E) None of these.

Question 39

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. $$\begin{array} { | l | l | } \hline \text { Maturity (Years) } & \text { Price } \\\hline 1 & \$ 925.16 \\\hline 2 & \$ 862.57 \\\hline 3 & \$ 788.66 \\\hline 4 & \$ 711.00 \\\hline\end{array}$$
What is,according to the expectations theory,the expected forward rate in the third year?

A) 7.23
B) 9.37%
C) 9.00%
D) 10.9%
E) None of these is correct.

Question 40

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. $$\begin{array} { | l | l | } \hline \text { Maturity (Years) } & \text { Price } \\\hline 1 & \$ 925.16 \\\hline 2 & \$ 862.57 \\\hline 3 & \$ 788.66 \\\hline 4 & \$ 711.00 \\\hline\end{array}$$
What is the price of a 4-year maturity bond with a 10% coupon rate paid annually? (Par value = $1,000)

A) $742.09
B) $1,222.09
C) $1,035.66
D) $1,141.84
E) None of these is correct.

Question 41

Discuss the two prevailing theories of the term structure of interest rates.Include in your discussion the differences in the theories,and the advantages/disadvantages of each.

Question 42

Explain what the following terms mean: spot rate,short rate,and forward rate.Which of these is(are)observable today?

Question 43

Term structure of interest rates is the relationship between what variables? What is assumed about other variables? How is term structure of interest rates depicted graphically?

Question 44

Answer the following questions that relate to bonds.
• A 2-year zero-coupon bond is selling for $890.00.What is the yield to maturity of this bond?
• The price of a 1-year zero coupon bond is $931.97.What is the yield to maturity of this bond?
• Calculate the forward rate for the second year.
• How can you construct a synthetic one-year forward loan (you are agreeing now to loan in one year)? State the strategy and show the corresponding cash flows.Assume that you can purchase and sell fractional portions of bonds.Show all calculations and discuss the meaning of the transactions.

Question 45

A liquidity premium

A) compensates long-term investors for the uncertainty about future selling prices.
B) compensates short-term investors for the uncertainty about future selling prices.
C) compensates long-term investors for the lack of liquidity in bond markets.
D) compensates short-term investors for the lack of liquidity in bond markets.
E) is almost never observed in the markets.

Question 46

The Liquidity Preference Theory states that

A) Stocks are preferred to bonds because they are generally more liquid.
B) Treasury Bonds are preferred to corporate bonds because they are more liquid.
C) The liquidity premium is expected to be positive because short-term investors dominate the market.
D) Bonds of large corporations are preferred because they have the highest liquidity.
E) Liquidity premiums can be measured precisely.

Question 47

Which of the following combinations will result in a sharply increasing yield curve?

A) increasing expected short rates and increasing liquidity premiums
B) decreasing expected short rates and increasing liquidity premiums
C) increasing expected short rates and decreasing liquidity premiums
D) increasing expected short rates and constant liquidity premiums
E) constant expected short rates and increasing liquidity premiums

Question 48

Which of the following is a reason that bond prices do not conform exactly to the present value of the bond's cash flows?
I)A call feature affects the bond's price.
II)After-tax cash flows may be different for different investors.
III)Canada Customs and Revenue Agency may impute a "built-in" interest payment.
IV)Some investors might choose to sell the bond before its maturity date.

A) I and II
B) I,II,and III
C) I and IV
D) I,II,and IV
E) I,II,III and IV

Question 49

The yield curve is a component of

A) the Dow Jones Industrial Average
B) the consumer price index
C) the index of leading economic indicators.
D) the producer price index
E) the inflation index

Question 50

Although the expectations of increases in future interest rates can result in an upward sloping yield curve;an upward sloping yield curve does not in and of itself imply the expectations of higher future interest rates.Explain.