Multiple Choice Answers

Question 1
Assume interest rates on long-term government and corporate bonds were as follows: T-bond = 7.72% A = 9.64% AAA = 8.72% BBB = 10.18% The differences in rates among these issues were caused primarily by

A. a. Tax effects.
B. b. Default risk differences.
C. c. Maturity risk differences.
D. d. Inflation differences.
E. e. Answers b and d are correct.
Question 2
You read in The Wall Street Journal that 30-day T-bills are currently yielding 8 percent. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums: Inflation premium 5% Liquidity premium 1% Maturity risk premium 2% Default risk premium 2% Based on these data, the real risk-free rate of return is

A. a. 0%
B. b. 1%
C. c. 2%
D. d. 3%
E. e. 4%

Question 3
A Treasury bond which matures in 20 years has a yield of 9 percent. A 20-year corporate bond has a yield of 11 percent. Assume that the liquidity premium on the corporate bond is 1.0 percent. What is the default risk premium on the corporate bond?

A. a. 0.50%
B. b. 2.00%
C. c. 1.00%
D. d. 1.25%
E. e. 1.60%

Question 4
Which of the following statements is correct?

A. a. Ignoring interest accrued between payment dates, if the required rate of return on a bond is less than its coupon interest rate, and rd remains below the coupon rate until maturity, then the market value of that bond will be below its par value until the bond matures, at which time its market value will equal its par value.
B. b. Assuming equal coupon rates, a 20-year original maturity bond with one year left to maturity has more interest rate risk than a 10-year original maturity bond with one year left to maturity.
C. c. Regardless of the size of the coupon payment, the price of a bond moves in the same direction as interest rates; for example, if interest rates rise, bond prices also rise.
D. d. For bonds, price sensitivity to a given change in interest rates generally increases as years remaining to maturity increases.
E. e. Because short-term interest rates are much more volatile than long-term rates, you would, in the real world, be subject to more interest rate risk if you purchased a 30-day bond than if you bought a 30-year bond.

Question 5
Which of the following statements is correct?
A. a. Bonds C and Z both have a $ 1,000 par value and 10 years to maturity. They have the same default risk, and they both have an effective annual rate (EAR) = 8%. If Bond C has a 15 percent annual coupon and Bond Z a zero coupon (paying just $1,000 at maturity), then Bond Z will be exposed to more interest rate risk, which is defined as the percentage loss of value in response to a given increase in the going interest rate.
B. b. If the words “interest rate risk” were replaced by the words “reinvestment rate risk” in Statement a, then the statement would be true.
C. c. The interest rate paid by the state of Florida on its debt would be lower, other things held constant, if interest on the debt were not exempt from federal income taxes.
D. d. Given the conditions in Statement a, we can be sure that Bond Z would have the higher price.
E. e. Statements a, b, c, and d are all false.

Question 6
If a company’s bonds are selling at a discount, then:

A. a. The YTM is the return investors probably expect to earn.
B. b. The YTC is probably the expected return.
C. c. Either a or b could be correct, depending on the yield curve.
D. d. The current yield will exceed the expected rate of return.
E. e. The after-tax cost of debt to the company will have to be less than the coupon rate on the bonds

Question 7
You just purchased a 15-year bond with an 11 percent annual coupon. The bond has a face value of $1,000 and a current yield of 10 percent. Assuming that the yield to maturity of 9.7072 percent remains constant, what will be the price of the bond 1 year from now?

A. a. $1,000
B. b. $1,064
C. c. $1,097
D. d. $1,100
E. e. $1,150

Question 8
A bond matures in 12 years, and pays an 8 percent annual coupon. The bond has a face value of $1,000, and currently sells for $985. What is the bond’s current yield and yield to maturity?

A. a. Current yield = 8.00%; yield to maturity = 7.92%.
B. b. Current yield = 8.12%; yield to maturity = 8.20%.
C. c. Current yield = 8.20%; yield to maturity = 8.37%.
D. d. Current yield = 8.12%; yield to maturity = 8.37%.
E. e. Current yield = 8.12%; yield to maturity = 7.92%.

Question 9
Hood Corporation recently issued 20-year bonds. The bonds have a coupon rate of 8 percent and pay interest semiannually. Also, the bonds are callable in 6 years at a call price equal to 115 percent of par value. The par value of the bonds is $1,000. If the yield to maturity is 7 percent, what is the yield to call?

A. a. 8.33%
B. b. 7.75%
C. c. 9.89%
D. d. 10.00%
E. e. 7.00%

Question 10
Meade Corporation bonds mature in 6 years and have a yield to maturity of 8.5 percent. The par value of the bonds is $1,000. The bonds have a 10 percent coupon rate and pay interest on a semiannual basis. What are the current yield and capital gains yield on the bonds for this year? (Assume that interest rates do not change over the course of the year).

A. a. Current yield = 8.50%, capital gains yield = 1.50%
B. b. Current yield = 9.35%, capital gains yield = 0.65%
C. c. Current yield = 9.35%, capital gains yield = -0.85%
D. d. Current yield = 10.00%, capital gains yield = 0.00%
E. e. None of the answers above is correct.

Question 11
Which of the following statements is correct?

A. a. A firm with a sinking fund payment coming due would generally choose to buy back bonds in the open market, if the price of the bond exceeds the sinking fund call price.
B. b. Income bonds pay interest only when the amount of the interest is actually earned by the company. Thus, these securities cannot bankrupt a company and this makes them safer to shareholders than regular bonds.
C. c. One disadvantage of zero coupon bonds is that issuing firms cannot realize the tax savings from issuing debt until the bonds mature.
D. d. Other things held constant, callable bonds should have a lower yield to maturity than noncallable bonds.
E. e. All of the above statements are false.

Question 12
Which of the following statements is correct?

A. a. All else equal, a 1-year bond will have a higher (i.e., better) bond rating than a 20-year bond.
B. b. A 20-year bond with semiannual interest payments has higher price risk (i.e., interest rate risk) than a 5-year bond with semiannual interest payments.
C. c. 10-year zero coupon bonds have higher reinvestment rate risk than 10-year, 10 percent coupon bonds.
D. d. If a callable bond is trading at a premium, then you would expect to earn the yield-to-maturity.
E. e. Statements a and b are correct.

Question 13
Which of the following Treasury bonds will have the largest amount of interest rate risk (price risk)?

A. a. A 7 percent coupon bond which matures in 12 years.
B. b. A 9 percent coupon bond which matures in 10 years.
C. c. A 12 percent coupon bond which matures in 7 years.
D. d. A 7 percent coupon bond which matures in 9 years.
E. e. A 10 percent coupon bond which matures in 10 years.
Question 14
Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle’s criteria?
A. a. AAA bond with 10 years to maturity.
B. b. BBB perpetual bond.
C. c. BBB bond with 10 years to maturity.
D. d. AAA bond with 5 years to maturity.
E. e. BBB bond with 5 years to maturity.