Deck 8: The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and Other Rate-Determining Factors

Question 1

Marketability is primarily an advantage to the issuer of new securities.

Answer 1

False

Question 2

There is positive relationship between a security's marketability and its yield.

Answer 2

False

Question 3

While an investor in callable bonds does not know exactly when his or her bonds will be called (if ever), he or she does know that the reinvestment rate will be at time of call because this is specified in the bond's indenture.

Answer 3

False

Question 4

Call privileges on bonds are a disadvantage to investors precisely because the price of the callable bonds may decline.

Question 5

Callable securities usually sell at lower prices and higher interest rates than non-callable securities.

Question 6

The yield differential between callable and non-callable securities is normally smallest when interest rates are expected to rise.

Question 7

The expectation in the financial marketplace of a significant decline in market interest rates should increase the differential between required rates of interest on new callable and non-callable bonds.

Question 8

Junk bonds have been used to finance mergers.

Question 9

The Tax Reform Act of 1986 eliminated the favorable tax treatment of capital gains. Such gains became taxed at ordinary income tax rates.

Question 10

The maximum possible amount of capital loss that can be deducted for tax purposes is $3,000.

Question 11

The floor which, normally, is the lowest value to which a convertible bond can fall is known as the conversion value of that bond.

Question 12

Moody's Investor Service and Standard and Poor's Corporation are two of the most widely consulted investment rating companies in the U.S.

Question 13

If we subtract the default-risk premium from the yield on a risky security we derive the promised marginal yield on a risky security.

Question 14

Recent studies cited in the textbook suggest that the default rate on junk bonds has averaged just over 15 percent of the greater of par or market value of those bonds.

Question 15

Municipal bonds are a good investment for recent college graduates because the default risk is so low.

Question 16

Investors find convertible bonds less attractive than nonconvertible bonds because the corporation can convert them to stock at any time.

Question 17

The number of credit-rating agencies worldwide is declining.

Question 18

The rise in new junk bond offerings during the 1990s can be traced to more borrowing companies bypassing rigid and expensive bank loans as a source of credit and an upward surge of corporate mergers financed by junk bond issues.

Question 19

Orange County, California in 1994 and 1995 provided an example of marketability risk in its security offerings.

Question 20

Orange County's default was most closely associated with trading in risky state and local government bonds.

Question 21

A loan-backed security derives its value from the income-earning potential of the pool of loans that backs these securities.

Question 22

Loan-backed securities pay their purchasers a stream of income that includes both repayments of loan principal and interest.

Question 23

The economic basis for the rise of credit rating agencies has to do with the economies of scale in hiring and training credit (default risk) analysts.

Question 24

To the learned observer, it is not surprising that both Moody's and Standard & Poor's often issue the same ratings for a company, since credit ratings are completely objective.

Question 25

A major part of the 1997 Taxpayer Relief Act was to reduce capital gains tax rates for short-term capital gains, in order to stimulate investment.

Question 26

According to the 2001 Economic Growth and Tax Relief Reconciliation Act, individuals with employer or business-related retirement plans (Keoghs or 401ks) can increase their annual contributions to these retirement plans from $10,500 in 2001 to, eventually, $15,000 by the year 2006.

Question 27

Between 2003 in the end of 2006 the difference between long-term interest rates on corporate bonds, Baa and the 10 year US treasury notes has decreased to around 2 ½ percent.

Question 28

Credit swaps are a form of credit derivative.

Question 29

Credits swaps cannot be used to diversify risk.

Question 30

When agency ratings on securities are different, the accepted practice is to take the highest rating or the second highest rating.

Question 31

Between 2003 in the end of 2006 the difference between long-term interest rates on corporate bonds, Baa and the 10 year US treasury notes has decreased to around 8 percent.

Question 32

One of the following statements below is incorrect. Which one? (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
E) All of the above statements are correct.
F) None of the above statements are correct

Question 33

So-called "investment grade securities" carry Moody's bond ratings of Aaa down to:

A) C
B) B
C) Ba
D) Baa
E) None of the above

Question 34

If the risk-free rate is 6.25%, the inflation premium is 2% and the liquidity premium is 0.5%, the long-term Treasury bond rate should be:

A) 6.75%
B) 7.75%
C) 8.25%
D) 8.75%
E) None of the above

Question 35

According to the 2001 Economic Growth and Tax Relief Reconciliation Act,

A) A new 10 percent personal income tax rate is created applying to the first $6,000 in taxable income for an individual taxpayer or the first $12,000 earned by a married couple filing jointly
B) The highest income tax bracket for U.S. personal taxpayers will decrease from 39.6 percent in the year 2000 to 35 percent by 2006
C) Estate taxes will be phased out over the next 10 years and will have a tax rate of zero in 2010
D) All of the above
E) None of the above

Question 36

For financial losses that individual taxpayers incur, the current federal law

A) Allows the taxpayer to deduct a maximum of $3000 per year
B) Does not allow losses to be carried backward
C) Allows losses to be carried forward
D) All of the above
E) None of the above

Question 37

The Jobs And Growth Tax Relief Reconciliation Act of 2004 set the capital gains tax to

A) 10%
B) 15%
C) 20%
D) 25%
E) None of the above

Question 38

What is the relationship between marketability and the yield on a financial instrument?

Question 39

Please explain the meaning of the phrase default risk. What factors appear to have the most influence upon the degree of default risk displayed by a security, loan or other financial asset?

Question 40

In what ways are security ratings (sometimes called credit quality ratings) designed to reflect default risk?

Question 41

Exactly what are junk bonds? Why are they issued? How does their actual yield compare to their degree of default risk? Why do you think this is so?

Question 42

What are credit derivatives? What are their principal advantages and disadvantages?

Question 43

What is a call privilege? Why is this privilege an advantage to a security issuer and a disadvantage to a buyer of financial instruments?

Question 44

What exactly is prepayment risk? What factors lead to an increase in prepayment risk?

Question 45

What is meant by the term event risk? What factors appear to contribute to an increase in a corporation's stock price? A decrease in its stock price?

Question 46

What portion of the income generated by municipal bonds is considered tax-exempt and what portion is taxable income? Why do you think United States' laws are structured in this way?

Question 47

Explain the relationship between an investor and a taxpayer's marginal tax rate and the after-tax rates of return on corporate and municipal bonds. Would municipals be a worthwhile investment for you today? Please explain why or why not.

Question 48

What does convertibility refer to in Finance? Why are convertibles sometimes called hybrid securities?

Question 49

Convertibles typically carry lower yields than nonconvertibles of the same maturity and risk class. Can you explain why?

Question 50

What do we mean by the term interest rate structure? What does the structure of interest rates tell us about the difficulties involved in trying to forecast movements in interest rates?

Question 51

A risky bond has a market yield of 14.50 percent and the risk-free rate is 9.25 percent. What is the default-risk premium?

Question 52

A 10-year corporate bond issued January 1, 1992 and sold to investors at par ($1,000) with a 10 percent coupon rate is called on January 1, 1995 at par plus one year's coupon income. At time of call prevailing rates on comparable securities were 8 percent. If the bond's holder reinvested the call price at 8 percent for 7 years, what is his 10-year holding-period yield?

Question 53

A Aaa-rated municipal bond carries a market yield of 5.25 percent today while Aaa-rated corporate bonds have 11.50 percent market yields. What is the break-even tax rate that would make a taxable investor indifferent between these two types of bonds?

Question 54

An investor purchases a 10-year U.S. Government bond for $800. The bond's coupon rate is 10 percent and it has 5 years remaining until maturity. If the investor holds the bond to maturity and collects the bond's $1,000 par value and has a marginal income-tax rate of 28 percent, what will his after-tax yield to maturity be?

Question 55

If the yield to maturity on comparable quality instruments is 14 percent, what should be the market value (price) of each security issued against this particular pool of credit-card loans?

Question 56

If the following events happened to Alvernon Way Corporation what is likely to happen to the company's stock price, all other factors held constant?

Question 57

If the following events happened to Alvernon Way Corporation what is likely to happen to the company's stock price, all other factors held constant?