Question 1

When market interest rates exceed a bond's coupon rate,the bond will:

Accepted Answer

When market interest rates exceed a bond's coupon rate, investors demand a higher yield on their investment. As a result, the bond's value decreases and it will sell for less than its par value in order to provide a yield that aligns with current market rates.

Question 2

What are the conditions imposed on a debt issuer that are designed to protect bondholders ?

Accepted Answer

Protective covenants are conditions imposed on a debt issuer that are designed to protect bondholders. These covenants may include restrictions on the issuer's ability to take on additional debt, limitations on the use of funds raised through the issuance of the bond, and requirements for maintaining certain financial ratios or other performance measures. Collateral agreements and default provisions may also provide protection for bondholders, but they are not specifically designed for this purpose. Vanilla wrappers are not relevant to this context.

Question 3

An investor buys a 10-year annual coupon bond at a yield of 8.7% and sells it 2 years later when it still yields 8.7%.What is his rate of return over this period?

Accepted Answer

Since the bond was sold at the same yield as it was bought, there was no gain or loss from the change in yield. Therefore, the investor's return is simply equal to the coupon rate (which is annual) for the two-year holding period, which results in a rate of return of 8.7%.

Question 4

The holder of which one of these securities has first claim on the assets of a firm?

Accepted Answer

Senior debt holders have the highest priority in receiving payments from a firm's assets in the event of bankruptcy or liquidation. They are considered first in line to receive their principal and interest payments.

Question 5

An investor buys a 5-year,9% coupon bond for $975,holds it for 1 year,and then sells the bond for $985.What was the investor's rate of return?

Accepted Answer

Rate of return = [$985 + (0.09 × $1,000) − $975] / $975 = 0.1026, or 10.26%

Question 6

If you purchase a 5-year,zero-coupon bond for $691.72,how much could it be sold for 3 years later if interest rates have remained stable?

Accepted Answer

$691.72 = $1,000 / (1 + i)⁵i = 0.0765Price = $1,000 / 1.0765²Price = $862.92

Question 7

An investor holds two bonds,one with 5 years until maturity and the other with 20 years until maturity.Which of the following is more likely if interest rates suddenly increase by 2%?

Accepted Answer

The longer maturity bond, which is the 20-year bond, is more sensitive to changes in interest rates than the 5-year bond. This is because the longer the maturity of the bond, the greater the risk of market fluctuations and inflation. As a result, the value of the 20-year bond will decrease more in price than the 5-year bond if interest rates suddenly increase by 2%. Therefore, choice B is the correct answer.

Question 8

Which of these bond ratings is the lowest of Moody's investment-grade ratings?

Accepted Answer

Moody's investment-grade ratings range from Aaa (highest) to Baa (lowest). Therefore, the choice with the lowest investment-grade rating is Baa.

Question 9

What causes bonds to sell for a premium?

Accepted Answer

Bonds sell for a premium when their coupon rate exceeds the current market interest rate. This means that investors are willing to pay more than the face value of the bond in order to receive the higher interest payments.

Question 10

Which one of the following is most likely for a CCC-rated bond,compared to a BBB-rated bond?

Accepted Answer

CCC-rated bonds have a higher risk of default compared to BBB-rated bonds, so issuers offer a higher promised yield to attract investors. Choice A is not necessarily true, as both CCC and BBB bonds can have fixed or variable coupons. Choice B is not necessarily true, as the term of a bond is determined by the issuer and can vary for both CCC and BBB bonds. Choice D is also not necessarily true, as the price of a bond is based on a variety of factors, including the issuer's creditworthiness, interest rates, and market demand.

Question 11

If a bond offers an investor 11% in nominal return during a year in which the rate of inflation is 4%,then the investor's real return is:

Accepted Answer

1 + real return = 1.11 / 1.04 − 1 = 0.0673, or 6.73%

Question 12

How much should you be prepared to pay for a 10-year bond with a 6% coupon,semiannual payments,and a semiannually compounded yield of 7.5%?

Accepted Answer

Semiannual interest rate = 0.075 / 2 = 0.0375Price = [(0.06 / 2) × $1,000)] {(1 / 0.0375) − [1 / 0.0375(1.0375)^{10 × 2}]} + $1,000 / 1.0375^{10 × 2}Price = $895.78

Question 13

The current yield tends to understate a bond's total return when the bond sells for a discount because:

Accepted Answer

When a bond sells for a discount, the current yield only takes into account the interest payments relative to the discounted price of the bond. However, as the bond approaches maturity, its price will gradually increase towards its face value, resulting in additional capital gains that contribute to the bond's total return. Therefore, the current yield understates the bond's total return.

Question 14

A bond has an ask quote of 99.5625 and a bid quote of 99.5475.How much will the bond dealer make on the purchase and resale of a $100,000 bond?

Accepted Answer

Dealer profit = (0.995625 − 0.995475) × $100,000 = $15

Question 15

The market price of a bond with 12 years until maturity and an annual coupon rate of 8% increased yesterday.Which one of these may have caused this price increase?

Accepted Answer

When market interest rates decrease, the value of existing bonds with higher coupon rates increase, leading to an increase in their market price. This is because investors are willing to pay more for the higher coupon rate in a low-interest-rate environment.

Question 16

How much should you be prepared to pay for a 10-year bond with an annual coupon of 6% and a yield to maturity of 7.5%?

Accepted Answer

Price = (0.06 × $1,000) {(1 / 0.075) − [1 / 0.075(1.075)¹⁰]} + $1,000 / 1.075¹⁰Price = $897.04

Question 17

An investor purchased a fixed-coupon bond at a time when the bond's yield to maturity was 6.9%.The investor sold the bond prior to maturity and realized a total return of 7.1%.Which of these most likely occurred while the investor owned the bond?

Accepted Answer

The investor realized a total return higher than the initial yield to maturity, which suggests that market interest rates declined, increasing the bond's price and resulting in a capital gain.

Question 18

The current yield tends to overstate a bond's total return when the bond sells for a premium because:

Accepted Answer

Current yield only takes into account the annual coupon payments and does not consider any capital gains or losses that may arise from buying a bond at a premium (or discount). Over time, the bond's price will decline towards par value, resulting in a capital loss that reduces the total return of the investment.

Question 19

What nominal return would an investor need to receive if he desires a real return of 4% and the rate of inflation is 5%?

Accepted Answer

Nominal return = (1.04 ×1.05) − 1 = 0.0920, or 9.20%

Question 20

An investor buys a 10-year,7% coupon bond for $1,050,holds it for 1 year,and then sells it for $1,040.What was the investor's rate of return?

Accepted Answer

Rate of return = [$1,040 + (0.07 × $1,000) − $1,050] / $1,050 = 0.0571, or 5.71%

Quiz 6: Valuing Bonds