Answer Options:
a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.
b. The real risk-free rate is higher for corporate than for Treasury bonds.
c. Most evidence suggests that the maturity risk premium is zero.
d. Liquidity premiums are higher for Treasury than for corporate bonds.
e. The pure expectations theory states that the maturity risk premium for bonds is zero.
Answer: e
Question: 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%.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following events would make it more likely that a company would call its outstanding callable bonds? a. The company’s bonds are downgraded. b. Market interest rates rise sharply.
Answer Options:
a. True
b. False
Answer: b. False
Question: A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT?
Answer Options:
a. If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price.
b. The bond is selling below its par value.
c. The bond is selling at a discount.
d. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price.
e. The bond’s current yield is greater than 9%.
Answer: d
Question: Which of the following statements is CORRECT?
Answer Options:
a. If a bond is selling at a discount to par, its current yield will be greater than its yield to maturity.
b. All else equal, bonds with longer maturities have less price risk than bonds with shorter maturities.
c. If a bond is selling at its par value, its current yield equals its capital gains yield.
d. If a bond is selling at a premium, its current yield will be less than its capital gains yield.
e. All else equal, bonds with larger coupons have less price risk than bonds with smaller coupons.
Answer: e
Question: Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the largest percentage increase in price? a. An 8-year bond with a 9% coupon. b. A 1-year bond with a 15% coupon. c. A 3-year bond with a 10% coupon. d. A 10-year zero coupon bond. e. A 10-year bond with a 10% coupon.
Answer: d. A 10-year zero coupon bond.
Question: 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.
Answer Options:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT? a. All else equal, secured debt is more risky than unsecured debt. b. The expected return on a corporate bond must be greater than its promised return if the probability of default is greater than zero. c. All else equal, senior debt has more default risk than subordinated debt. d. A company’s bond rating is affected by its financial ratios but not by provisions in its indenture. e. Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Act.
Answer: e. Under Chapter 7 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Act.
Question: Which of the following statements is CORRECT? a. One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold. b. Long-term bonds have less price risk but more reinvestment risk than short-term bonds. c. If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less price risk.
Answer: b. Long-term bonds have less price risk but more reinvestment risk than short-term bonds.
Question: 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.
Answer Options:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT? a. Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued. b. Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. c. A sinking fund provision makes a bond more risky to investors at the time of issuance. d. Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time. e. If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price.
Answer Options:
a. True
b. False
c. True
d. False
e. False
Answer: a. True
Question: Which of the following statements is CORRECT? a. You hold two bonds, a 10-year, zero coupon issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline. b. The time to maturity does not affect the change in the value of a bond in response to a given change in rates. c. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline. d. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates, other things held constant. e. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates.
Answer Options:
a. True
b. False
c. True
d. False
e. False
Answer: a. True
Question: If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?
Answer Options:
a. An upward-sloping yield curve would imply that interest rates are expected to be lower in the future.
b. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now.
c. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond.
d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.
e. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.
Answer: d
Question: 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.
Answer Options:
a. True
b. False
Answer: a. True
Question: 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.
Answer Options:
a. True
b. False
Answer: b. False
Question: 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.
Answer Options:
a. True
b. False
Answer: a
Question: Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT?
Answer Options:
a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%.
b. The interest rate today on a 2-year bond should be approximately 6%.
c. The interest rate today on a 2-year bond should be approximately 7%.
d. The interest rate today on a 3-year bond should be approximately 7%.
e. The interest rate today on a 3-year bond should be approximately 8%.
Answer: c
Question: The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of the following statements is CORRECT?
Answer Options:
a. Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond.
b. Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.
c. Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds.
d. The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
e. The 10-year corporate bond must have a higher yield than the 5-year corporate bond.
Answer: e
Question: Which of the following statements is CORRECT?
Answer Options:
a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
b. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
c. The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping.
d. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
e. Liquidity premiums are generally higher on Treasury than on corporate bonds.
Answer: c
Question: 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.
Answer Options:
a. True
b. False
Answer: b. False
Question: If the pure expectations theory holds, which of the following statements is CORRECT?
Answer Options:
a. The yield curve for both Treasury and corporate bonds should be flat.
b. The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping.
c. The yield curve for Treasury securities cannot be downward sloping.
d. The maturity risk premium would be zero.
e. If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end up with more money if he or she bought 2-year bonds.
Answer: d
Question: 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.
Answer Options:
a. True
b. False
Answer: b
Question: Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, then we could be sure that
Answer Options:
a. Long-term interest rates are more volatile than short-term rates.
b. Inflation is expected to decline in the future.
c. The economy is not in a recession.
d. Long-term bonds are a better buy than short-term bonds.
e. Maturity risk premiums could help to explain the yield curve’s upward slope.
Answer: e
Question: A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT? a. The bond’s expected capital gains yield is zero. b. The bond’s yield to maturity is above 9%. c. The bond’s current yield is above 9%. d. If the bond’s yield to maturity declines, the bond will sell at a discount. e. The bond’s current yield is less than its expected capital gains yield.
Answer: a. The bond’s expected capital gains yield is zero.
Question: You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT? a. The price of Bond B will decrease over time, but the price of Bond A will increase over time. b. The prices of both bonds will remain unchanged. c. The price of Bond A will decrease over time, but the price of Bond B will increase over time. d. The prices of both bonds will increase by 7% per year. e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.
Answer: c. The price of Bond A will decrease over time, but the price of Bond B will increase over time.