Question 1

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

This is because when interest rates are below 10%, investors will be willing to pay more for the bond to lock in the higher fixed annual interest payment of $100. Thus, the bond will sell at a premium (above its par value). Conversely, when interest rates are above 10%, investors can find bonds with better yields elsewhere, so the bond will be less attractive and will need to be priced at a discount (below its par value) to compensate for the lower interest rate.

Question 2

Income bonds pay interest only if the issuing company actually earns the indicated interestThus, 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

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

Bonds are debt instruments that represent a loan made by an investor to a borrower, typically a corporation or government. They are considered high risk, high yield because they offer a higher interest rate than other types of debt instruments, but also carry a higher risk of default. Leveraged buyouts and mergers are often financed with bonds because they allow the acquiring company to borrow a large amount of money at a relatively low cost. Companies of questionable financial strength may also issue bonds in order to raise capital, but these bonds will typically have a higher interest rate than bonds issued by more financially stable companies.

Question 4

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 5

the required rate of return on a bond (rd) 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 discount on the bond's market value to compensate for the lower interest payments. This will result in the market value being below its par value until the bond matures, at which point it will be redeemed at par value.

Question 6

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

The statement is incorrect. Floating-rate debt can offer advantages to issuers by allowing them to borrow at a lower initial interest rate compared to fixed-rate debt, and also by providing flexibility in adjusting the interest rate to market conditions.

Question 7

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

Zero coupon bonds are sold at a discount to their face value, not at par, and they provide compensation through capital appreciation as they mature to their face value.

Question 8

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. Investors demand a higher required rate of return as the quality of the bond decreases in order to compensate for the increased risk. AAA-rated bonds are considered the safest and least risky, so they have the lowest required rate of return.

Question 9

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

With only 1 year left to maturity, both bonds have similar interest rate risk, as the time to maturity is the primary factor affecting interest rate sensitivity, not the original maturity.

Question 10

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

Accepted Answer

This is a fundamental concept in finance known as duration. The longer the time until a bond matures, the more its price will be affected by changes in interest rates. This is because there is more time for interest rates to fluctuate and impact the bond's future cash flows.

Question 11

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, not the bondholder, the right to repay the bond before its maturity, typically exercised when interest rates fall, allowing the issuer to refinance at lower rates.

Question 12

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 market value of any asset can be estimated by determining its future cash flows and then discounting them back to the present. This is known as the discounted cash flow (DCF) analysis and is commonly used to value stocks, bonds, real estate, and other types of assets.

Question 13

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

The statement accurately describes the historical context that led to the increased usage of floating-rate bonds.

Question 14

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 have the option to acquire bonds through purchasing them in the market or selecting them through a lottery administered by the trustee.

Question 15

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 selling at a discount ($800 for a $1,000 bond), which means the effective yield (or required return) is higher than the coupon rate. If your required return is 12%, and you can purchase a bond with a 10% coupon rate for $800, then you should buy it because it provides a yield higher than your required return. Additionally, because the bond will mature in 10 years and pay off its par value, you will also receive the capital appreciation from the bond returning to its par value.

Question 16

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

The statement is true because mortgage bonds are secured by specific assets, which reduces the risk for investors, while debentures are unsecured and therefore carry a higher risk, resulting in higher required interest rates.

Question 17

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 a new bond issue is typically set equal to the required rate on bonds of similar risk as determined by the market. This ensures that the bond issue will be attractive to potential investors and that the issuing firm can raise the necessary capital at a reasonable cost.

Question 18

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 have a lower priority than second mortgage bonds, which means they have a higher risk of default. As a result, investors require a higher return and therefore, the firm will have to pay a higher coupon rate on its subordinated debentures than on its second mortgage bonds.

Question 19

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

A callable bond typically has a higher yield to maturity than a noncallable bond to compensate investors for the risk that the bond may be called before maturity, especially when the yield curve is upward sloping.

Question 20

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

Bond SF, which has the sinking fund, would generally be expected to have a lower yield than Bond NSF due to the additional security provided by the sinking fund. Therefore, if the prices of the bonds are equal, it is unlikely that they are in equilibrium.

Quiz 4: Bonds