Question 1

Which of the following would NOT be listed on the face of a bond?

Accepted Answer

The market price of the bond is not typically listed on the face of a bond. However, it may be included in the bond's prospectus or other documentation. The other options (A, B, D, and E) are typically listed on the face of a bond.

Question 2

A premium bond is deﬁned as a bond which has a market price:

Accepted Answer

A premium bond is a bond that has a market price that exceeds its face value. This is because the bond's coupon rate is higher than the market interest rate, making it more attractive to investors and driving up its price.

Question 3

The difference between the clean price and the dirty price of a bond is:

Accepted Answer

The clean price of a bond is the actual market value of the bond, while the dirty price includes any accrued interest that the seller is entitled to receive up to the settlement date. The accrued interest is the interest that has accumulated on the bond since the last coupon payment date. Therefore, the difference between the clean price and the dirty price of a bond is the amount of accrued interest.

Question 4

When pricing bonds, if a bond's coupon rate is less than the required rate of return, then:

Accepted Answer

The answer of When pricing bonds, if a bond's coupon...

Question 5

The written, legally binding agreement between the corporate borrower and the lender detailing the terms of a bond issue is called the:

Accepted Answer

An indenture is a written agreement between the borrower and the lender that details the terms of a bond issue. It typically includes provisions such as the interest rate, maturity date, and repayment terms.

Question 6

Which of the following is NOT a typical negative bond covenant?

Accepted Answer

Negative bond covenants typically restrict actions that could harm bondholders, such as limiting dividends, mergers, additional debt, or pledging assets. However, maintaining a specific bond rating is not a typical covenant, as ratings are influenced by external factors beyond the firm's direct control.

Question 7

The total interest paid on a zero coupon bond is equal to:

Accepted Answer

The total interest paid on a zero-coupon bond is indeed the face value minus the issue price. This is because a zero-coupon bond is sold at a discount to its face value and does not pay periodic interest. The difference between the purchase price (issue price) and the face value (which is paid at maturity) represents the interest earned by the holder.

Question 8

The relationship between nominal interest rates on default-free, pure discount securities and the time to maturity is called the:

Accepted Answer

The term structure of interest rates refers to the relationship between nominal interest rates on default-free, pure discount securities and the time to maturity. Choice A refers to the impact of changes in market liquidity on interest rates, choice B refers to the relationship between nominal interest rates and expected inflation, choice D refers to extra compensation demanded by investors to compensate for inflation expectations, and choice E refers to the compensation demanded by investors for the risk of interest rates changing during the holding period of a security.

Question 9

Which of the following is an example of a positive covenant.

Accepted Answer

A positive covenant is a requirement for a company to take certain actions, such as maintaining certain financial ratios or levels of working capital. Choice E mandates that the company must maintain its working capital at or above a specified minimum level, making it an example of a positive covenant.

Question 10

Sensitivity to interest rate risk is directly dependent on:

Accepted Answer

Sensitivity to interest rate risk is directly dependent on the time to maturity and the coupon rate because these two factors determine the cash flows received over the life of the bond. A longer time to maturity and a lower coupon rate increase the sensitivity to interest rate changes because the bondholder is locked into receiving lower coupon payments for a longer period of time, resulting in greater potential loss of value when interest rates rise. Conversely, a shorter time to maturity and a higher coupon rate decrease sensitivity to interest rate changes because the bondholder is not exposed to low coupon payments for as long a period of time. The future value, yield, present value, and future value are all important factors when considering a bond investment, but they are not direct determinants of interest rate risk sensitivity.

Question 11

Lady Products, Inc. just issued 10-year, 8% coupon bonds at par. Outstanding Limbaugh Corp. bonds, which have a maturity of 10 years, sell at a premium to par and are viewed by investors as
Having the same risk as the Lady bonds. Therefore, it must be true that:

Accepted Answer

The Limbaugh bonds sell at a premium, indicating their coupon rate is higher than the market interest rate, which is the same as the Lady bonds' coupon rate of 8%.

Question 12

A corporation undertaking an expansion project issues 20 year bonds to ﬁnance the project. Which of the following is most likely true?

Accepted Answer

When a corporation issues bonds, it is borrowing money and must pay interest on the amount borrowed. The option of not making payments unless there are positive earnings is associated with equity financing, not debt financing. The presence or absence of outstanding bonds prior to issuing new bonds is not relevant. Whether the bonds sold at a premium or discount depends on market conditions and the creditworthiness of the corporation. Without more information about the company's specific circumstances, it is impossible to determine whether they would have preferred stock as an alternative to bonds.

Question 13

Blackwater Industries just issued 12-year, 7% coupon bonds. Freshwater Enterprises just issued 12- year, 6% coupon bonds. Both bonds sold at par. Which one of the following statements is correct
Concerning these two bonds?

Accepted Answer

The Freshwater bonds have a lower coupon rate than the Blackwater bonds, making them more sensitive to changes in the market interest rate. This means that the price of the Freshwater bonds will be more affected by changes in market interest rates compared to the Blackwater bonds. Therefore, the Freshwater bonds are more interest rate sensitive than the Blackwater bonds. The other statements are incorrect.

Question 14

Margaret wants to compute the present value of a six year semi-annual 8% coupon bond that has a 9% yield to maturity. Which one of the following is correct?

Accepted Answer

The bond pays interest semi-annually for six years, resulting in 6*2 = 12 interest payments.

Question 15

Which of the following statement is incorrect if interest rates fall?

Accepted Answer

When interest rates fall, coupon payments on floating rate bonds will decrease, not increase, as they are typically tied to a benchmark rate that moves with market interest rates.

Question 16

Milner's Tools has a 9-year, 7% annual coupon bond outstanding with a $1,000 par value. Carter's Tools has a 10-year, 6% annual coupon bond with a $1,000 par value. Both bonds currently have a
Yield to maturity of 6.5%. Which of the following statements is correct if the market yield increases
To 6.75%?

Accepted Answer

When the market yield increases to 6.75%, the price of a bond with a lower coupon rate, like Milner's, will increase more than the price of a bond with a higher coupon rate, like Carter's. Therefore, Carter's bond will decrease in value by 1.80% (the difference between its coupon rate and the market yield increase), while Milner's bond will only decrease in value by 1.63% (the difference between its coupon rate and the market yield increase).

Question 17

"Disaster" bonds are primarily designed to help:

Accepted Answer

"Disaster" bonds are a type of catastrophe bond designed to provide insurance companies with additional funds to cover the costs of natural disasters. In the event of a disaster, the bondholders may lose part or all of their investment, but the insurance company receives the necessary capital to cover claims.

Question 18

A put provision in a bond indenture allows:

Accepted Answer

A put provision in a bond indenture allows the bondholder to force the issuer to buy back the bond at a specified price prior to maturity.

Question 19

Which of the following would be classiﬁed as a positive protective covenant?

Accepted Answer

A positive protective covenant requires the firm to take certain actions, such as furnishing audited annual financial statements.

Question 20

Jackson Central has a 6-year, 8% annual coupon bond with a $1,000 par value. Earls Enterprises has a 12-year, 8% annual coupon bond with a $1,000 par value. Both bonds currently have a yield to
Maturity of 6%. Which of the following statements are correct if the market yield increases to 7%?

Accepted Answer

To find the new price of the Jackson Central bond, we can use the formula:
P = (Coupon Payment / (1 + Market Yield)^Time) + (Coupon Payment / (1 + Market Yield)^(Time - 1)) + ... + (Coupon Payment + Face Value / (1 + Market Yield)^Time)
P = (80 / 1.07) + (80 / 1.07^2) + (80 / 1.07^3) + (80 / 1.07^4) + (80 / 1.07^5) + (80 / 1.07^6) + (1080 / 1.07^6)
P = $1,027.06

To find the new price of the Earls Enterprises bond, we can use the same formula:
P = (80 / 1.07) + (80 / 1.07^2) + ... + (80 / 1.07^11) + (1080 / 1.07^11)
P = $1,052.44

The percentage change in price for the Earls bond is:
(1052.44 - 1000) / 1000 = 5.24%
Therefore, the correct choice is D, as the Earls bond will decrease in value by 7.56% (not increase) if the market yield increases to 7%.

Quiz 7: Interest Rates and Bond Valuation