Chapter 005 - Valuing Bonds

True / False Questions 1. A bond's payment at the maturity is referred to as its face value. TRUE 2. When the market interest rate exceeds the coupon rate, bonds sell for less than face value to provide enough compensation to investors. TRUE 3. Current yield overstates the return of premium bonds since investors who buy a bond at a premium face a capital loss over the life of the bond. TRUE 4. A bond's rate of return is equal to its coupon payment divided by the price paid for the bond. FALSE

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5. A Treasury bond's bid price will be lower than the ask price. TRUE 6. A long-term investor would more likely be interested in current yield than internal rate of return. FALSE

7. Bonds selling at a premium price offer a higher current yield (which overstates the true return)than bonds selling at par value. TRUE 8. Speculative-grade bonds have default risk; investment grade bonds do not. FALSE

9. TIPS are unlike most bonds in that their cash flows increase when the national unemployment rate increases. FALSE 10. "Ask Yields" can be guaranteed only to investors who buy a bond and hold it until maturity. TRUE

AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-1

11. It would be realistic to read an "Ask Price" listed as 100:16 and a "Bid Price" of 100:18. FALSE

AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1

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12. Indexed bonds were completely unknown in the United States till 1997 when the U.S. Treasury began to issue inflation-indexed bonds known as Treasury Inflation-Protected Securities, or TIPS. FALSE Indexed bonds were not completely unknown in the United States before 1997. For example, in 1780 American Revolution soldiers were compensated with indexed bonds that paid the value of "five bushels of corn, 68 pounds and four-sevenths part of a pound of beef, ten pounds of sheep's wool, and sixteen pounds of sole leather."

AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-3

13. The current yield measures the bond's total rate of return. FALSE

AACSB: Reflective Thinking Skills Bloom's: Understanding Learning Objective: 6-1

14. When a financial calculator or spreadsheet program finds a bond's yield to maturity, it uses a trial-and-error process. TRUE 15. Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds. TRUE

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16. Bonds with a rating of Ba or below by Moody's are referred to as speculative grade, highyield, or junk bond. TRUE 17. Bonds rated BBB or above by Standard & Poor's are called investment grade. TRUE

18. Bonds rated Ba by Moody's are of the same safety of the bonds rated BB by Standard & Poor's. TRUE

19. Zero-coupon bonds are issued at prices considerably below face value, and the investor's return comes from the difference between the purchase price and the payment of face value at maturity. TRUE 20. Catastrophe bonds (or Cat bonds) promise relatively high returns, and the payments on the bond are increased if a specified type of disaster occurs. FALSE 21. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. TRUE 22. Bond ratings measure the bond's credit risk. TRUE Multiple Choice Questions

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23. The coupon rate of a bond equals: A. its yield to maturity. B. a percentage of its face value. C. the maturity value. D. a percentage of its price. 24. Periodic receipts of interest by the bondholder are known as: A. the coupon rate. B. a zero-coupon. C. coupon payments. D. the default premium. 25. Which of the following presents the correct relationship? As the coupon rate of a bond increases, the bond's: A. face value increases. B. current price decreases. C. interest payments increase. D. maturity date is extended. 26. What happens when a bond's expected cash flows are discounted at a rate lower than the bond's coupon rate? A. The price of the bond increases. B. The coupon rate of the bond increases. C. The par value of the bond decreases. D. The coupon payments will be adjusted to the new discount rate.

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27. When an investor purchases a $1,000 par value bond that was quoted at 97.16, the investor: A. receives 97.5% of the stated coupon payments. B. receives $975 upon the maturity date of the bond. C. pays 97.5% of face value for the bond. D. pays $1,025 for the bond. 28. How much does the $1,000 to be received upon a bond's maturity in four years add to the bond's price if the appropriate discount rate is 6%? A. $209.91 B. $260.00 C. $760.00 D. $792.09 $1,000/(1.06)4 = $792.09 29. The numerator of the rate of return formula for bond consists of the following: A. coupon income. B. bond price change. C. both A and B. D. neither A nor B. 30. How much should you pay for a $1,000 bond with 10% coupon, annual payments, and five years to maturity if the interest rate is 12%? A. $ 927.90 B. $ 981.40 C. $1,000.00 D. $1,075.82

31. How much would an investor expect to pay for a $1,000 par value bond with a 9% annual coupon that matures in 5 years if the interest rate is 7%? A. $696.74 B. $1,075.82 C. $1,082.00 D. $1,123.01

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32. Which of the following statements is correct for a 10% coupon bond that has a current yield of 7%? A. The face value of the bond has decreased. B. The bond's maturity value exceeds the bond's price. C. The bond's internal rate of return is 7%. D. The bond's maturity value is lower than the bond's price. 33. If an investor purchases a bond when its current yield is higher than the coupon rate, then the bond's price will be expected to: A. decline over time, reaching par value at maturity. B. increase over time, reaching par value at maturity. C. be less than the face value at maturity. D. exceed the face value at maturity. 34. The current yield of a bond can be calculated by: A. multiplying the price by the coupon rate. B. dividing the price by the annual coupon payments. C. dividing the price by the par value. D. dividing the annual coupon payments by the price. 35. What is the current yield of a bond with a 6% coupon, four years until maturity, and a price of $750? A. 6.0% B. 8.0% C. 12.0% D. 14.7% $60/750 = 8%

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36. A bond's par value can also be called its: A. coupon payment. B. present value. C. default value. D. face value 37. A bond's yield to maturity takes into consideration: A. current yield but not price changes of a bond. B. price changes but not current yield of a bond. C. both current yield and price changes of a bond. D. neither current yield nor price changes of a bond. 38. The discount rate that makes the present value of a bond's payments equal to its price is termed the: A. rate of return. B. yield to maturity. C. current yield. D. coupon rate. 39. What is the coupon rate for a bond with three years until maturity, a price of $1,053.46, and a yield to maturity of 6%? A. 6% B. 8% C. 10% D. 11%

40. What is the yield to maturity for a bond paying $100 annually that has six years until maturity and sells for $1,000? A. 6.0% B. 8.5% C. 10.0% D. 12.5%

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41. What happens to the price of a three-year bond with an 8% coupon when interest rates change from 8% to 6%? A. A price increase of $51.54 B. A price decrease of $51.54 C. A price increase of $53.47 D. No change in price

This represents a price change of $53.47, since the bond had sold for par. 42. Which of the following factors will change when interest rates change? A. The expected cash flows from a bond B. The present value of a bond's payments C. The coupon payment of a bond D. The maturity value of a bond 43. What happens to the coupon rate of a bond that pays $80 annually in interest if interest rates change from 9% to 10%? A. The coupon rate increases to 10%. B. The coupon rate remains at 9%. C. The coupon rate remains at 8%. D. The coupon rate decreases to 8%. 44. Which of the following is fixed (e.g., cannot change) for the life of a given bond? A. Current price. B. Current yield. C. Yield to maturity. D. Coupon rate.

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45. What is the rate of return for an investor who pays $1,054.47 for a three-year bond with a 7% coupon and sells the bond one year later for $1,037.19? A. 5.00% B. 5.33% C. 6.46% D. 7.00% Rate of Return = ($70.00 - $17.28)/$1,054.47 = $52.72/$1,054.47 = 5% 46. Which of the following is correct when a bond investor's rate of return for a particular period equals the bond's coupon rate? A. The bond increased in price during the period. B. The bond decreased in price during the period. C. The coupon payment increased during the period. D. The bond price remained unchanged during the period. 47. What is the relationship between an investment's rate of return and its yield to maturity for an investor that does not hold a bond until maturity? A. Rate of return is lower than yield to maturity. B. Rate of return is higher than yield to maturity. C. Rate of return equals yield to maturity. D. There is no predetermined relationship. 48. If the coupon rate is lower than current interest rates, then the yield to maturity will be: A. lower than current interest rates. B. equal to the coupon rate. C. higher than the coupon rate. D. lower than the coupon rate. 49. If a four year bond with a 7% coupon and a 10% yield to maturity is currently worth $904.90, how much will it be worth one year from now if interest rates are constant? A. $ 904.90 B. $ 925.39 C. $ 947.93 D. $1,000.00

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50. What price will be paid for a U.S. Treasury bond with an ask price of 135:20? A. $1,350.20 B. $1,350.31 C. $1,350.63 D. $1,356.25

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