Question 1

Restrictive covenants, coupled with standard debt provisions, allow the lender to monitor and control the borrower's activities in order to protect itself against increases in borrower risk.

Accepted Answer

Restrictive covenants are commonly used by lenders to monitor and control the borrower's activities, such as limiting dividend payments, incurring additional debt, or making significant investments, in order to protect themselves against potential increases in borrower risk. Coupled with standard debt provisions, such as interest rates and collateral requirements, restrictive covenants serve as an additional layer of protection for lenders.

Question 2

At any time, the slope of the yield curve is affected by

Accepted Answer

All of the options (inflationary expectations, liquidity preferences, and comparative equilibrium of supply and demand in the short-term and long-term market segments) can affect the slope of the yield curve. Factors such as changes in inflationary expectations can lead to an increase in long-term rates relative to short-term rates, while changes in liquidity preferences can lead to a flatter or steeper yield curve. Additionally, changes in the comparative equilibrium of supply and demand for short-term and long-term securities can influence the slope of the yield curve.

Question 3

Restrictive covenants are contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower.

Accepted Answer

Restrictive covenants are indeed contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower.

Question 4

The yield curve in an economic period where lower future inflation is expected would most likely be

Accepted Answer

An downward-sloping yield curve is typically observed during a period of low future inflation expectations. This is because investors are willing to accept lower yields on longer-term bonds, as they expect inflation to remain low or even decline in the future. This leads to lower long-term interest rates and a downward-sloping yield curve.

Question 5

The purpose of the restrictive debt covenant that imposes fixed assets restrictions is to limit the amount of fixed-payment obligations.

Accepted Answer

The purpose of a restrictive debt covenant that imposes fixed assets restrictions is to limit the borrower's ability to sell or pledge fixed assets, not to limit fixed-payment obligations.

Question 6

What is the nominal rate of return on an IBM bond if the real rate of interest is 3 percent, the inflation risk premium is 2 percent, the U.S. T-bill rate is 5 percent, the maturity risk premium on the IBM bond is 3 percent, the default risk premium on the IBM bond is 2 percent, and the liquidity risk premium on the bond is 1 percent?

Accepted Answer

The answer of What is the nominal rate of return...

Question 7

A trustee is a paid party representing the bond issuer in the bond indenture.

Accepted Answer

A trustee in a bond indenture represents the interests of the bondholders, not the bond issuer, to ensure the issuer complies with the terms of the bond agreement.

Question 8

Nico Nelson, a management trainee at a large New York-based bank is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent and has decided to use the consumer price index as a proxy for expected inflation. What is the estimated real rate of interest if the CPI is currently 2 percent?

Accepted Answer

The real rate of interest is the nominal rate of interest minus the inflation rate. In this case, the nominal rate of interest is the 3-month T-bill yield of 3%, and the inflation rate is the CPI of 2%. Therefore, the estimated real rate of interest is 3% - 2% = 1%.

Question 9

The theory suggesting that for any given issuer, long-term interest rates tends to be higher than short-term rates is called

Accepted Answer

The theory stating that long-term rates tend to be higher than short-term rates due to the preference of investors for liquidity is called liquidity preference theory. The expectation hypothesis suggests that long-term rates are determined by the market's expectations of future short-term rates, while market segmentation theory posits that different segments of the market have different supply and demand factors that determine interest rates. None of these theories fit the description given in the question except for liquidity preference theory.

Question 10

The yield curve in an economic period where higher future inflation is expected would most likely be

Accepted Answer

A yield curve that is upward-sloping indicates that long-term interest rates are higher than short-term interest rates. This is typically the case in periods of expected higher future inflation because investors demand higher returns to compensate for the depreciation of the future value of money. Therefore, an upward-sloping yield curve is the most likely scenario when higher future inflation is expected.

Question 11

The theory that explains only the tendency for the yield curve to be upward sloping is

Accepted Answer

The liquidity preference theory suggests that investors demand a premium for longer-term investments, which typically results in an upward-sloping yield curve.

Question 12

Consider the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based on this information, the shape of the yield curve is

Accepted Answer

The yield on the 10-year U.S. T-bond is lower than the yield on the 5-year U.S. T-note, indicating a downward sloping yield curve.

Question 13

The risk premium over and above the risk free rate consists of a number of components, including all of the following EXCEPT

Accepted Answer

The answer of The risk premium over and above the...

Question 14

In a practical sense, the longer the term of a bond, the greater the default risk associated with the bond.

Accepted Answer

The longer the term of a bond, the more time there is for economic and market conditions to change, affecting the issuer's ability to make timely interest and principal payments. This increases the risk of default, making longer-term bonds generally riskier than shorter-term bonds.

Question 15

Standard debt provisions specify certain criteria of satisfactory record keeping and reporting, tax payment, and general business maintenance on the part of the lending firm.

Accepted Answer

The answer of Standard debt provisions specify certain criteria of...

Question 16

The size of the bond offering and the cost of issuing the bond (as a percentage of the amount raised) are inversely related.

Accepted Answer

The size of the bond offering and the cost of issuing the bond are typically inversely related. This means that as the size of the bond offering increases, the cost of issuing the bond (as a percentage of the amount raised) decreases. This is because some of the fixed costs associated with issuing a bond, such as legal fees and underwriting fees, are spread out over a larger amount of capital. Conversely, if the size of the bond offering is smaller, these fixed costs are spread out over a smaller amount of capital, resulting in a higher percentage cost of issuing the bond.

Question 17

Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.

Accepted Answer

The answer of Draw a graph of a typical Treasury...

Question 18

To carry out the sinking fund requirements, corporations often make semi-annual or annual payments to trustees, who uses these funds to retire bonds by purchasing them in the marketplace.

Accepted Answer

This statement is true. Corporations set up sinking funds to retire their bonds, and often make semi-annual or annual payments to trustees who are responsible for using the funds to purchase the bonds in the marketplace.

Question 19

The three theories cited to explain the general shape of the yield curve are all of the following EXCEPT

Accepted Answer

The three theories cited to explain the general shape of the yield curve are expectations hypothesis, market segmentation theory, and liquidity preference theory. Security markets theory is not one of the theories used to explain the shape of the yield curve.

Question 20

Nico bought an investment one year ago and just calculated his return on investment. He found that his purchasing power had increased by 15 percent as a result of his investment. If inflation during the year was 4 percent, then Nico's

Accepted Answer

Nico's purchasing power increased by 15%, which is the real return. To find the nominal return, we add the inflation rate to the real return: 15% + 4% = 19%. Thus, the nominal return is more than 15%.

Quiz 6: Interest Rates and Bond Valuation