Deck 8: Understanding Risk and Market Factors in Financial Securities

Question 1

In the American financial system the most readily marketable securities are issued by the U.S. Treasury Department.

Answer 1

True

Question 2

Marketability of a security is positively related to the size and reputation of the issuing institution.

Answer 2

True

Question 3

Marketability is generally greater for securities issued in large blocks.

Answer 3

True

Question 4

Investors interested in maximizing profitability usually hold a large amount of liquid securities.

Question 5

Nearly all corporate bonds and mortgages and some U.S. government bonds issued in U.S. financial markets carry a call privilege.

Question 6

The size of the call penalty paid on a security that has been called generally varies with the level of interest rates in the open market.

Question 7

For bonds the minimum call penalty required is usually one year's worth of coupon income.

Question 8

Most callable corporate bonds carry call deferments of from 15 to 20 years.

Question 9

A callable security will be called in when flotation costs of a new security issue are less than savings from issuing a new security at a lower interest rate.

Question 10

While call privileges are, in general, a disadvantage to the investor, they do have greater capital gains potential than non-callable securities.

Question 11

Generally speaking, the market price of a callable security will not rise significantly above its call price.

Question 12

Callable securities usually benefit the issuer over the buyer of the asset.

Question 13

There is a positive relationship between the length of the call deferment period on a callable security and the required rates of interest on that security.

Question 14

The key factor determining the size of the call premium on callable bonds is the promised call price offered by the security's issuer.

Question 15

Yield spreads between bonds with long call deferments versus those with short call deferments normally decrease when interest rates are expected to fall.

Question 16

Recent research evidence suggests that when interest rates are high, the call premium generally increases.

Question 17

An expectation that interest rates will fall in the market generally leads to a narrowing in the spread between corporate and U.S. government bonds of the same maturity.

Question 18

High-coupon bonds carry greater call risk than low-coupon bonds, other factors held equal.

Question 19

In general, the issuer of high-coupon callable bonds must pay a greater call premium than the issuer of low-coupon callable bonds relative to non-callable securities.

Question 20

Junk bonds are rated Baa3 or better by Moody's.

Question 21

The yields on junk bonds tend to be insufficient to cover the default risk inherent in such issues.

Question 22

Capital losses can be carried forward into subsequent years, but not backward, until all of the loss has been accounted for.

Question 23

The interest income from municipal bonds is exempt from federal income taxes.

Question 24

The foundation of the structure of interest rates in the financial markets is the risk-free interest rate.

Question 25

In recent years marginal tax rates in the 40 to 50 percent range have represented a break-even level for investors interested in municipal bonds.

Question 26

If the current yield on tax-exempt bonds is 8 percent and comparable taxable bonds carry a 12 percent yield, the break-even marginal tax rate must be 33.3 percent.

Question 27

The tax-exempt feature attached to municipal bonds actually limits, rather than expands, the market for these securities.

Question 28

The tax-exempt feature of municipal bonds has reduced the tax burden carried by the average citizen.

Question 29

Convertible bonds are examples of "hybrid securities," but convertible preferred stock is not.

Question 30

Conversion of a convertible bond into common stock can be reversed; that is, the stock received by the investor can be turned back into convertible bonds according to the indenture provision accompanying most convertible bond issues.

Question 31

Convertible bonds generally carry a higher yield than nonconvertible corporate bonds of comparable quality and maturity.

Question 32

Fees for getting a credit rating on a security are usually paid by investors interested in buying the security.

Question 33

The interest on convertible bonds is federal income tax deductible for the issuing corporation.

Question 34

When a company's common stock rises in price, its convertible bonds also tend to rise in price.

Question 35

Each interest rate prevailing at any moment in the financial markets is really a summation of various premiums paid to lenders of funds to get those investors to hold a particular security.

Question 36

Common stock is generally a more risky investment than convertible bonds issued by the same company.

Question 37

The market yield on a risky security is equal to the risk-free interest rate plus the risk premium. The higher the degree of default risk, the lower the risk premium.

Question 38

The concept of anticipated loss represents each investor's view of the appropriate risk premium on a security. If an investor faces the following situation, he or she would be inclined to buy the security: anticipated loss 6% risk-free rate 6% current yield to maturity 10%

Question 39

Among the factors influencing the risk premiums on corporate securities are: volatile earnings, length of time in operation and amount of leverage employed.

Question 40

Marketability of a security is inversely related to the size and reputation of the institution issuing that security.

Question 41

Marketability of a security is unaffected by the volume of similar securities available.

Question 42

Marketability influences the yield a security issuer must offer in the secondary market.

Question 43

Investors interested in maximizing profitability should try to expand their holdings of liquid assets as rapidly as possible.

Question 44

Suppose there are 10 possible yields on a risky security and one of those 10 possible yields doubles in size, while a second yield in the set of 10 is cut by half. These two changes taken together are exactly offsetting and the expected yield on the security in question cannot change.

Question 45

If we add the expected yield on a risky security to the security's anticipated loss due to default we derive the security's promised yield.

Question 46

When economic and financial conditions suggest to investors that uncertainty has increased and business prospects are less robust, the market translates these opinions into lower default-risk premiums.

Question 47

The development of an active junk-bond market gave many smaller and new firms access to another source of loanable funds.

Question 48

Convertible bonds are issued at a higher interest rate because they are riskier to the corporation issuing them.

Question 49

If the earnings of Corporation A are more viable than the earnings of Corporation B, the required yield on Corporation A's bonds will be higher than the required yield on Corporation B's bonds.

Question 50

Both capital gains and interest income on municipal bonds are exempt from federal taxation.

Question 51

Interpretation of the credit ratings assigned by different credit-rating agencies appears to vary across time and across different credit-rating agencies.

Question 52

Credit rating agencies typically release the same rating for securities.

Question 53

In an efficient market callable securities will sell at a price and yield just sufficient to compensate buyers for call risk.

Question 54

In a perfectly efficient market the management of a bond-issuing company should be indifferent between issuing callable or non-callable securities.

Question 55

Prepayment risk arises when securities backed by loans are issued.

Question 56

Securities that carry prepayment risk carry higher yields than securities without prepayment risk.

Question 57

When market interest rates fall investors in loan-backed securities will experience quicker recovery of their invested funds.

Question 58

New announcements that reflect decisions by the management of a corporation or other fund-raising unit are associated with a form of risk known as event risk.

Question 59

The announcement of a new security issue usually leads the issuer's securities to fall in price, at least temporarily.

Question 60

The announcement of a stock split tends to decrease the value of a security issuer's securities, at least temporarily.

Question 61

"On the run" Treasury bonds are so-called because of large purchases from the Cayman Islands and other bank "havens".

Question 62

Default risk premiums are often called "quality spreads."

Question 63

Because it pays no coupon, a zero-coupon bond cannot have prepayment risk.

Question 64

Rising concern over defaults and business bankruptcies in the 1980s and 1990s led to new techniques called credit derivatives that provide at least some positive rate of return to the beneficiaries of each contract.

Question 65

Among the most popular of credit derivatives contracts are credit swaps in which two or more investors in risky loans and securities agree to exchange at least a portion of their expected payments due from the borrowers.

Question 66

A rise in the junk-bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts.

Question 67

Default risk of individual security issues is rated primarily by Moody's Investors Services Inc. and Standard & Poor's Company which have 80% of the market share between them.

Question 68

Moody's Investors Services Inc. and Standard & Poor's Company publish the ratings of default risk of individual security issues as letter grades.

Question 69

Moody's Investors Services Inc. and Standard & Poor's Company rate individual security issues according to their perceived probability of default, based on the borrower's financial condition and business prospects.

Question 70

The term junk bonds refers to the likelihood of full repayment of these long-term debt securities is being significantly below that for bonds rated investment quality.

Question 71

In March of 2009, the yield to maturity on long-term U.S. Treasury bonds was close to 8.25 percent.

Question 72

When agency ratings on securities are different, the accepted practice is to take the highest rating and the lowest rating and average the results.

Question 73

Government uses its taxing power to encourage the purchase of certain financial assets and therefore redirects the flow of savings and investment towards areas of critical social need.

Question 74

A callable security will be called in when flotation costs of a new security issue are less than savings from issuing a new security at the same interest rate.

Question 75

Marketability of a security is affected by the volume of similar securities available.

Question 76

In March of 2009, Baa bonds were quoted at an average yield of only 3.00 percent.

Question 77

Which of the following statements below is incorrect? (Consider each statement by itself without reference to the other statements.)

A) Security A has the same maturity, default risk and tax status as Security B but is more marketable than B; thus, Security A should carry a lower yield
B) Securities A and B are new corporate bonds issued today and have comparable maturities and risk levels, but A has a 10-year call deferment and B a 5-year deferment; thus, Security A should carry a lower yield
C) Securities A and B are new corporate bonds issued today with comparable maturities and risk levels, but A is convertible and B is not; Security A should carry a higher yield
D) Security A is an AA-rated municipal bond, while Security B, having the same maturity and AA rating, is a corporate bond; thus, security A should have the lower yield

Question 78

There is a pronounced association between risk premiums and state of the business cycle. We would expect that the yield spread between an Aaa and Baa rated security to:

A) Vary with seasonal factors, but not with fluctuations in employment.
B) Decrease during recessions.
C) Increase during expansions and decrease during recessions.
D) Increase during recessions.
E) None of the above.

Question 79

The price at which the yield on a convertible bond matches the yield on nonconvertible bonds of the same quality and credit rating is known as the convertible bond's:

A) Investment premium
B) Conversion premium
C) Conversion value
D) Conversion price
E) Investment value

Question 80

Suppose the holder of a $1,000 par-value convertible bond is allowed by the bond's accompanying contract (indenture) to convert the bond into 25 shares of common stock. Today, the stock is selling for $60 a share. What is the bond's conversion value as expressed in terms of the market value of stock received?

A) $2,400
B) $1,500
C) $1,000
D) $600
E) None of the above