FINA 320 Exam 2

Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT?

1. If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds.

2. If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds.

3. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal.

4. If the Treasury yield curve is upward sloping, and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds.

5. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.

4. If the Treasury yield curve is upward sloping, and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds.

What is the Corporate Bond Yield formula?

r = r* + IP + DRP + LP + MRP

What is the Treasury Bond Yield Formula?

r = r* + IP + MRP (Excludes LP and DRP)

What is Pure Expectations Theory?

The Pure Expectations Theory posits that the yield on long-term bonds reflects the expected future short-term interest rates, implying that the term structure of interest rates is determined solely by investors' expectations of future rate movements, all while ignoring MRP.

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT?

1. In equilibrium, long-term rates must be equal to short-term rates.

2. An upward-sloping yield curve implies that future short-term rates are expected to decline.

3. The maturity risk premium is assumed to be zero.

4. Inflation is expected to be zero.

5. Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

3. The maturity risk is assume to be zero

Which of the following statements is CORRECT?

1. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.

2. The real risk-free rate is higher for corporate than for Treasury bonds.

3. Most evidence suggests that the maturity risk premium is zero.

4. Liquidity premiums are higher for Treasury than for corporate bonds.

5. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

5. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

Which of the following statements is CORRECT?

1. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.

2. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

3. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

4. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond.

5. The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

2. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond

Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?

1. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.

2. The yield on any corporate bond must exceed the yields on all Treasury bonds.

3. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.

4. The stated conditions cannot all be true–they are internally inconsistent.

5. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

1. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.

Which of the following statements is CORRECT?

1. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.

2. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.

3. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.

4. If the maturity risk premium (MRP) equals zero, the yield curve must be flat.

5. The yield curve can never be downward sloping.

1. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.

A bond trader observes the following information:

• The Treasury yield curve is downward sloping.

• Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.

• Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields.

On the basis of this information, which of the following statements is most CORRECT?

1. A 10-year corporate bond must have a higher yield than a 5-year Treasury bond.

2. A 10-year Treasury bond must have a higher yield than a 10-year corporate bond.

3. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

4. The corporate yield curve must be flat.

5. Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping.

3. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

Question 23

Which of the following statements is CORRECT?

1. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.

2. The most likely explanation for an inverted yield curve is that investors expect inflation to increase.

3. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.

4. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.

5. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

3. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.

If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT?

1. An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future.

2. A 5-year T-bond would always yield less than a 10-year T-bond.

3. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.

4. The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope.

5. If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.

3. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.

Which of the following statements is CORRECT?

1. If a coupon bond is selling at par, its current yield equals its yield to maturity.

2. If rates fall after its issue, a zero coupon bond could trade at a price above its maturity (or par) value.

3. If rates fall rapidly, a zero coupon bond’s expected appreciation could become negative.

4. If a firm moves from a position of strength toward financial distress, its bonds’ yield to maturity would probably decline.

5. If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon rate.

1. If a coupon bond is selling at par, its current yield equals its yield to maturity.

A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT?

1. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.

2. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.

3. If two classes of debt are used (with one senior and the other subordinated to all other debt), the subordinated debt will carry a lower interest rate.

4. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond.

5. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan.

2. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.

Which of the following statements is CORRECT?

1. If two bonds have the same maturity, the same yield to maturity, and the same level of risk, the bonds should sell for the same price regardless of their coupon rates.

2. All else equal, an increase in interest rates will have a greater effect on the prices of short-term than long-term bonds.

3. All else equal, an increase in interest rates will have a greater effect on higher-coupon bonds than it will have on lower-coupon bonds.

4. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value.

5. If a bond’s yield to maturity exceeds its coupon rate, the bond’s current yield must be less than its coupon rate.

4. If a bond’s yield to maturity exceeds its coupon rate, the bond’s price must be less than its maturity value.

A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following statements is CORRECT?

1. If the yield to maturity remains constant, the bond’s price one year from now will be higher than its current price.

2. The bond is selling below its par value.

3. The bond is selling at a discount.

4. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price.

5. The bond’s current yield is greater than 9%.

4. If the yield to maturity remains constant, the bond’s price one year from now will be lower than its current price.

Assume that a noncallable 10-year T-bond has a 12% annual coupon, while a 15-year noncallable T-bond has an 8% annual coupon. Assume also that the yield curve is flat, and all Treasury securities have a 10% yield to maturity. Which of the following statements is CORRECT?

1. If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price.

2. If interest rates decline, the prices of both bonds would increase, but the 10-year bond would have a larger percentage increase in price.

3. The 10-year bond would sell at a discount, while the 15-year bond would sell at a premium.

4. The 10-year bond would sell at a premium, while the 15-year bond would sell at par.

5. If the yield to maturity on both bonds remains at 10% over the next year, the price of the 10-year bond would increase, but the price of the 15-year bond would fall.

1. If interest rates decline, the prices of both bonds would increase, but the 15-year bond would have a larger percentage increase in price.

Which of the following statements is CORRECT?

1. The yield to maturity for a coupon bond that sells at a premium consists entirely of a positive capital gains yield; it has a zero current interest yield.

2. The market value of a bond will always approach its par value as its maturity date approaches. This holds true even if the firm has filed for bankruptcy.

3. Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to maturity that is based on market prices.

4. The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield.

5. The expected capital gains yield on a bond will always be zero or positive because no investor would purchase a bond with an expected capital loss.

4. The yield to maturity on a coupon bond that sells at its par value consists entirely of a current interest yield; it has a zero expected capital gains yield.

Bonds A, B, and C all have a maturity of 10 years and a yield to maturity of 7%. Bond A’s price exceeds its par value, Bond B’s price equals its par value, and Bond C’s price is less than its par value. None of the bonds can be called. Which of the following statements is CORRECT?

1. If the yield to maturity on each bond decreases to 6%, Bond A will have the largest percentage increase in its price.

2. Bond A has the most price risk.

3. If the yield to maturity on the three bonds remains constant, the prices of the three bonds will remain the same over the next year.

4. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.

5. Bond C sells at a premium over its par value.

4. If the yield to maturity on each bond increases to 8%, the prices of all three bonds will decline.

Which of the following statements is CORRECT?

1. Two bonds have the same maturity and the same coupon rate. However, one is callable, and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.

2. A callable 10-year, 10% bond should sell at a higher price than an otherwise similar noncallable bond.

3. Corporate treasurers dislike issuing callable bonds because these bonds may require the company to raise additional funds earlier than would be true if noncallable bonds with the same maturity were used.

4. Two bonds have the same maturity and the same coupon rate. However, one is callable, and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is above the coupon rate than if it is below the coupon rate.

5. The actual life of a callable bond will always be equal to or less than the actual life of a noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping, the required rate of return will be lower on the callable bond.

1. Two bonds have the same maturity and the same coupon rate. However, one is callable, and the other is not. The difference in prices between the bonds will be greater if the current market interest rate is below the coupon rate than if it is above the coupon rate.

Listed below are some provisions that are often contained in bond indentures. Which of these provisions, viewed alone, would tend to reduce the yield to maturity that investors would otherwise require on a newly issued bond?

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1. Fixed assets are used as security for a bond.

2. A given bond is subordinated to other classes of debt.

3. The bond can be converted into the firm's common stock.

4. The bond has a sinking fund.

5. The bond has a call provision.

6. The indenture contains covenants that restrict the use of additional debt.

1. 1, 3, 4, 6

2. 1, 4, 6

3. 1, 2, 3, 4, 6

4. 1, 2, 3, 4, 5, 6

5. 1, 3, 4, 5, 6

1. 1, 3, 4, 6

An investor is considering buying one of two 10-year, $1,000 face value, noncallable bonds: Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, and the YTM is expected to remain constant for the next 10 years. Which of the following statements is CORRECT?

1. Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

2. One year from now, Bond A’s price will be higher than it is today.

3. Bond A’s current yield is greater than 8%.

4. Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.

5. Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.

2. One year from now, Bond A’s price will be higher than it is today.

Which of the following statements is CORRECT?

1. If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where r_d = YTM = 5%, the bond would sell at a premium over its $1,000 par value.

2. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where r_d = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.

3. Other things held constant, including the coupon rate, a corporation would rather issue noncallable bonds than callable bonds.

4. Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond because it would have a shorter expected life.

5. Bonds are exposed to both reinvestment risk and price risk. Longer-term low-coupon bonds, relative to shorter-term high-coupon bonds, are generally more exposed to reinvestment risk than price risk.

2. If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where r_d = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.

Which of the following statements is CORRECT?

1. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

2. An indenture is a bond that is less risky than a mortgage bond.

3. The expected return on a corporate bond will generally exceed the bond's yield to maturity.

4. If a bond’s coupon rate exceeds its yield to maturity, then its expected return to investors will also exceed its yield to maturity.

5. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

1. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

Which of the following statements is CORRECT?

1. A bond is likely to be called if its coupon rate is below its YTM.

2. A bond is likely to be called if its market price is below its par value.

3. Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called.

4. A bond is likely to be called if its market price is equal to its par value.

5. A bond is likely to be called if it sells at a discount below par.

3. Even if a bond's YTC exceeds its YTM, an investor with an investment horizon longer than the bond's maturity would be worse off if the bond were called.

Which of the following bond ratings would indicate investment-grade bonds?

1. Double B rated bonds

2. Triple A and double A rated bonds only

3. A and triple B rated bonds and above

4. C rated bonds

5. Junk rated bonds

3. A and triple B rated bonds and above

Which of the following statements is CORRECT?

1. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the use of debt until the bonds mature.

2. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond.

3. Once a firm declares bankruptcy, it must be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and legal fees.

4. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds.

5. A firm with a sinking fund that gives it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate.

4. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds.