Question 1

The yield to maturity on a 1-year bond purchased for $980 with a maturity value of $1100 is:

Accepted Answer

To calculate the yield to maturity on a bond, we need to find the interest rate that equates the present value of the bond's cash flows to its purchase price. 
In this case, the purchase price is $980, which means that we must solve for the interest rate that equates the present value of the bond's cash flows to $980. 
Using a financial calculator, we find that the yield to maturity is approximately 12.24%. Therefore, the correct answer is B.

Question 2

Immunisation can best be described as:

Accepted Answer

Immunisation refers to a strategy in bond investment where the goal is to make the investment's value insensitive to changes in interest rates, thus achieving a specific financial target regardless of interest rate fluctuations.

Question 3

According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 6% p.a.and the 2-year bond rate today is 7% p.a. ,what is the 1-year bond rate next year?

Accepted Answer

The expectations theory suggests that the future short-term interest rate is the rate that makes the expected return on a sequence of short-term bonds equal to the return on a long-term bond. Here, the expected 1-year rate next year (x) can be calculated using the formula: (1 + 6%)(1 + x) = (1 + 7%)^2. Solving for x gives approximately 8%.

Question 4

Financial assets such as bonds and shares can be valued by discounting their future cash flows and summing these present values.

Accepted Answer

This is true. The value of financial assets such as bonds and shares can be determined by discounting the expected future cash flows of the asset and adding up the present values. This technique is commonly used in finance to determine the fair market value of various types of investments.

Question 5

According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 6% p.a.and the 3-year bond rate today is 7.5% p.a. ,what is the 2-year bond rate next year?

Accepted Answer

According to the expectations theory, the 2-year bond rate next year is equal to the average of the 1-year bond rate today and the expected 3-year bond rate next year. We can calculate the expected 3-year bond rate next year as follows: 
Expected 3-year bond rate next year = 2 * (3-year bond rate today) - 1 * (1-year bond rate today)
Expected 3-year bond rate next year = 2 * 7.5% - 1 * 6% = 15% - 6% = 9%
Therefore, the 2-year bond rate next year is:
(1-year bond rate today + expected 3-year bond rate next year) / 2
= (6% + 9%) / 2
= 7.5%
Since this question asks for the 2-year bond rate next year, we need to add this 7.5% to the 1-year bond rate today, to obtain:
2-year bond rate next year = 6% + 7.5% = 13.5%
Therefore, the best choice is C) 8.25%, which is not listed as one of the answer choices. None of the answer choices are correct.

Question 6

The promised yield on a non-interest-bearing security with one year to maturity,a face value of $100,a 20% chance of default and an expected market rate of return of 10%,is:

Accepted Answer

The promised yield is calculated by considering the probability of default and the expected return. With a 20% chance of default, the expected payoff is 80% of $100, which is $80. The yield is then calculated as ($80 - $100) / $100 = -20%. However, to achieve an expected market rate of return of 10%, the promised yield must be higher to compensate for the default risk. Solving for the promised yield, we find it to be approximately 37.5%.

Question 7

According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 7% p.a.and the 1-year bond rate in one year's time is 9% p.a. ,what is 2-year bond rate today?

Accepted Answer

According to the expectations theory, long-term bond rates can be estimated as the average of expected future short-term rates. In this case, the expected 1-year rate next year is 9%, so the expected rate for year two is also 9%. Thus, the average of the expected 1-year rates for years one and two is (7%+9%)/2 = 8%. Therefore, the 2-year bond rate today is 8%.

Question 8

When interest rates increase,interest receipts can be rolled over into a new investment with a higher interest rate.This is known as the _____________ effect.

Accepted Answer

The answer of When interest rates increase,interest receipts can be...

Question 9

Interest rate elasticity refers to:

Accepted Answer

Interest rate elasticity refers to the responsiveness of bond prices to changes in interest rates. It measures the percentage change in bond prices resulting from a 1% change in interest rates.

Question 10

One reason that the required rate of return on shares is generally more than on interest-yielding securities is because:

Accepted Answer

Debtholders rank ahead of shareholders in case of default, meaning that in the event of a company's liquidation, debt obligations are paid out before any returns are distributed to shareholders. This higher risk associated with shares compared to debt securities is a key reason why the required rate of return on shares is generally higher.

Question 11

The price effect and reinvestment effect are both sources of interest rate risk.

Accepted Answer

The price effect refers to the impact of changes in interest rates on the value of a security, while the reinvestment effect relates to the potential for future cash flows to be reinvested at lower rates. Both of these effects can result in interest rate risk for investors.

Question 12

Which statement regarding bond prices is false?

Accepted Answer

This statement is false because if bond prices rise, it would mean that the demand for bonds has increased, which would result in a decrease in the bond yield (interest rate). Therefore, if bond prices rise, interest rates will fall.

Question 13

The higher the market's assessment of the probability of default,the ___________ the required rate of return on the debt.

Accepted Answer

The answer of The higher the market's assessment of the...

Question 14

The ________________ of interest rates is the relationship between the interest rates and time to maturity.

Accepted Answer

The answer of The ________________ of interest rates is the...

Question 15

Once a bond has been issued,its promised future cash flows are ___________.

Accepted Answer

The answer of Once a bond has been issued,its promised...

Question 16

Downward-sloping yield curves are inconsistent with the liquidity premium theory.

Accepted Answer

Downward-sloping yield curves can be explained by the liquidity premium theory. This theory suggests that investors require compensation for investing in longer-term bonds, which are inherently more risky and less liquid than shorter-term bonds. This compensation is called the liquidity premium and it causes longer-term bond yields to be higher than shorter-term bond yields. When the demand for longer-term bonds increases relative to the demand for shorter-term bonds, their yields will decrease, causing a downward-sloping yield curve.

Question 17

The best security to achieve immunisation is:

Accepted Answer

A zero-coupon bond with maturity that matches an investor's target maturity is the best security to achieve immunisation because it provides a known cash flow at a specific time, which allows the investor to meet future financial obligations without being exposed to interest rate risk. The investor can also combine this zero-coupon bond with other securities to create a portfolio that matches their desired cash flow needs. A low or high-coupon bond may not provide predictable cash flows, and their yields and prices could be affected by changes in interest rates.

Question 18

Two common methods of share valuation are dividend growth models and the _________________ ratio.

Accepted Answer

The answer of Two common methods of share valuation are...

Question 19

A company just paid a dividend of $1.20.If this is expected to increase by 3% p.a.indefinitely,and the required rate of return is 8%,then the theoretical share price is $15.

Accepted Answer

Using the Gordon Growth Model (Dividend Discount Model for a perpetually growing dividend), the price of the stock is calculated as $ P_0 = \frac{D_0 \times (1 + g)}{r - g} $, where $D_0$ is the current dividend, $g$ is the growth rate, and $r$ is the required rate of return. Plugging in the values: $ P_0 = \frac{1.20 \times (1 + 0.03)}{0.08 - 0.03} = \frac{1.20 \times 1.03}{0.05} = \frac{1.236}{0.05} = 24.72 $. Therefore, the theoretical share price is $24.72, not $15.

Question 20

An increase in interest rates results in a _________ in the price of a bond.

Accepted Answer

The answer of An increase in interest rates results in...

Quiz 4: Applying the Time Value of Money to Security Valuation