Deck 14: The Valuation of Fixed Income Securities

Question 1

If bond prices rise, the yield to maturity declines.

Answer 1

True

Question 2

If interest rates increase, a bond may be called.

Answer 2

False

Question 3

As interest rates increase, the prices of existing bonds increase.

Answer 3

False

Question 4

A few bonds called "perpetuals" never mature.

Question 5

An investor may expect a bond to be called if its
current yield exceeds the yield to maturity.

Question 6

If interest rates have fallen, a firm may prefer to
repurchase the bonds on the market instead of calling and redeeming them.

Question 7

If a $1,000 bond with a 7 percent coupon were to sell for $978, the current interest rate exceeds 7 percent.

Question 8

Most bonds pay interest semi-annually.

Question 9

If a bond sells for a premium, the current yield exceeds the yield to maturity.

Question 10

A call penalty is a payment made to the firm to encourage early retirement of the bond.

Question 11

A call feature will have no impact on the value of a bond if interest rates rise.

Question 12

If investors expect interest rates to decline, they are also expecting bond prices to rise.

Question 13

The current yield exceeds the yield to maturity if
interest rates fall.

Question 14

The prices of low coupon bonds tend to fluctuate more than the prices of high coupon bonds.

Question 15

A bond is more likely to be called after interest
rates have fallen.

Question 16

If bond prices were to decline, the current yield would increase.

Question 17

The value of a bond depends on the amount of principal, when it matures, and the interest it pays.

Question 18

If a bond sells for a discount, the yield to maturity exceeds the current yield.

Question 19

If a $1,000 bond has a coupon of 8 percent and matures after eight years, the price of the bond will exceed $1,000 if the current interest rate is 9 percent.

Question 20

Bonds that are callable often have a call penalty.

Question 21

If a 7 percent, $1,000 bond matures after ten years and current interest rates are 9 percent, the current price of the bond should not be
1) $1,000
2) $872
3) $1,140

A) 1 and 2
B) 1 and 3
C) 2 and 3
D) only 2

Question 22

If interest rates decline after a bond is issued and the investor reinvests the interest payment, the realized yield exceeds the yield to maturity.

Question 23

Since preferred stock pays a fixed dividend, it is
often valued as if it were a bond.

Question 24

From the viewpoint of the investor, preferred stock is riskier than bonds issued by the same firm.

Question 25

The spread (the basis points) between the yields on AAA-rated bonds and B-rated bonds tends to rise when yields increase.

Question 26

The prices of zero coupon bonds fluctuate less than
bonds with large coupons.

Question 27

A conservative investor will prefer a bond with a smaller duration even though it may have a longer term to maturity.

Question 28

The value of a bond depends on
1) the coupon rate
2) the terms of the indenture
3) the maturity date

A) 1 and 2
B) 1 and 3
C) 2 and 3
D) all of the above

Question 29

Preferred stock pays a fixed amount of interest.

Question 30

Fluctuations in yields is one means by which the economy allocates scarce credit.

Question 31

If preferred stock is subject to mandatory retirement, its price is more volatile than preferred stock without the retirement feature.

Question 32

The prices of twenty?year bonds tend to fluctuate less than bonds with five years to maturity.

Question 33

The term and duration of a bond are equal for zero
coupon bonds.

Question 34

The smaller a bond's coupon implies a longer duration.

Question 35

If a bond pays $90 interest annually, matures after ten years, and costs $1,100, the current yield is

A) 8.2 percent
B) 10.1 percent
C) 9.0 percent
D) 9.6 percent

Question 36

Matching a bond's duration with the time the funds are needed reduces reinvestment risk.

Question 37

The smaller the duration, the more volatile the bond's price.

Question 38

If investors expect interest rates to rise, they should sell preferred stock and buy bonds.

Question 39

The market price of preferred stock moves directly with changes in interest rates.

Question 40

The concept of duration stresses when a bond will make its payments to bondholders.

Question 41

If an investor were to anticipate that interest rates were going to fall, that individual should

A) take no action
B) buy bonds
C) sell bonds
D) acquire money market securities

Question 42

Preferred stock generally pays

A) a variable dividend
B) a fixed dividend
C) a stock dividend
D) no dividend

Question 43

A bond with a 5 percent coupon ($50 a year) that matures after eight years is selling for $779. What is the yield to maturity?

Question 44

The yield to call

A) is important if interest rates have fallen
B) is important if interest rates have risen
C) equals the yield to maturity
D) equals the current yield

Question 45

If interest rates in general were to fall, 1. the prices of existing bonds would rise
2) the prices of existing bonds would fall
3) yields to maturity would rise
4) yields to maturity would fall

A) 1 and 3
B) 1 and 4
C) 2 and 3
D) 2 and 4

Question 46

If a preferred stock pays an annual $4.50 dividend, what should be the price of the stock if comparable yields are 10 percent? What would be the loss if yields rose to 12 percent?

Question 47

If a $100 par value preferred stock pays an annual
Dividend of $5 and comparable yields are 10 percent,
The price of this preferred stock will be

A) $100
B) $75
C) $50
D) $25

Question 48

If a bond is selling for a premium,

A) the yield to maturity exceeds the current yield
B) the current yield exceeds the yield to maturity
C) the current yield has risen
D) the bond cannot be called

Question 49

While bond prices fluctuate,

A) yields are constant
B) coupons are constant
C) the spread between yields is constant
D) short?term bond prices fluctuate more

Question 50

Buying a bond with a duration equal to when the funds are needed

A) reduces reinvestment rate risk
B) increases impact of higher interest rates
C) reduces the impact of default
D) increases the bond's yield

Question 51

If a $1,000 bond costs $1,000 and pays $50 interest, 1. the current yield is 5 percent
2) the yield to maturity is 5 percent
3) the bond is selling for par

A) 1 and 2
B) 1 and 3
C) 2 and 3
D) all of the above

Question 52

A bond's call feature may be exercised if
1) the yield to maturity exceeds the current yield
2) the yield to maturity is less than the current
Yield
3) interest rates have risen
4) interest rates have fallen

A) 1 and 3
B) 1 and 4
C) 2 and 3
D) 2 and 4

Question 53

An individual may purchase preferred stock
1) in anticipation of lower interest rates
2) in anticipation of higher interest rates
3) to receive a flow of tax?free income
4) to receive a flow of income

A) 1 and 3
B) 1 and 4
C) 2 and 3
D) 2 and 4

Question 54

A bond has the following terms:

a. What is the current price of the bond if comparable yields are 7 percent?
b. What are the current yield and yield to maturity given the price of the bond in the previous question?
c. If you expect the bond to be called at the end of the year, what would be the maximum price you should pay for the bond?
d. Is there a reason to expect that the bond will be called?

Question 55

Deep Check
A high-yield bond has the following terms:

a. What is the bond's price if comparable debt yields 12 percent?
b. What would be the price if comparable debt yields 12 percent and the bond matures after five years?
c. What are the current yields and yields to maturity in a and b?
d. What would be the bond's price in a and b if interest rates declined to 9 percent?
e. What are the current yield and yield to maturity in d?

Question 56

The current yield on a long?term bond is the

A) coupon interest divided by the price of the bond
B) coupon
C) interest paid, adjusted for price changes
D) going rate of interest

Question 57

Preferred stock and long?term bonds are similar because

A) they both have voting power
B) interest and dividend payments are fixed
C) interest and dividend payments are legal obligations
D) interest and dividend payments are tax?deductible expenses

Question 58

If interest rates rise, the price of preferred stock

A) rises
B) falls
C) is not affected
D) rises or falls

Question 59

Compute the durations of the following bonds and rank them on the basis of their price volatility. Assume that the current rate of interest is 8 percent.

Confirm your ranking by calculating the percentage change in the price of each bond when interest rates rise from 8 to 12 percent.

Question 60

The concept of duration considers

A) the timing of interest payments
B) the timing of principal repayment
C) the current rate of interest
D) the timing of both interest and principal repayment

Question 61

Junk Corp.'s high?yield bond has the following features:
Special features: Company may extend the life

of the bond to 10 years
a. If interest rates are currently 12 percent on comparable high-yield securities and are not expected to change, what is the price of this bond?
b. If interest rates are currently 9 percent on comparable high?yield securities and are not expected to change, what is the price of this bond?
c. If interest rates are currently 9 percent on comparable high?yield securities but the investor has no forecast as to future rates, what is the possible range of prices for this bond?

Question 62

An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years have passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?
SOLUTIONS TO PROBLEMS

Question 63

You purchase a high-yield, junk bond for $1,000 that pays $140 annually. After buying the bond, yields decline and you are able to reinvest the interest at only 9 percent. You reinvest all the interest payments. How much will you have when the bond is retired after twelve years? What was the annual return you earned on this investment?

Question 64

If you purchase a $5 preferred stock for $40 a share, what is the current yield? If you anticipate that yields will decline to 10 percent, what will be the anticipated capital gain on this investment?