finance exam 2 study

What is the true cost of lending?

Effective annual rate.

Which investors primarily dominate the corporate bond market?

Large institutional investors.

What happens to bond prices as interest rates change?

As interest rates decline, the prices of bonds rise and as interest rates rise, the prices of bonds decline.

What is true regarding preferred stockholders?

Preferred stockholders usually do not have voting rights.

Why are direct search markets considered inefficient in price discovery?

Because buyers and sellers must conduct their own search, leading to inefficient pricing.

What does failure to pay a preferred dividend signal to the market?

It signals that the firm is experiencing significant financial difficulties.

How is the liability of common shareholders characterized?

Their liability is limited to the amount they invested in the company's common stock.

Why is preferred stock sometimes treated like a debt security?

Preferred dividend payments are similar to bond interest payments and are fixed in nature regardless of the firm's earnings.

Which statement about common stock is NOT true?

Owners of common stock are guaranteed dividend payments by the firm.

Do owners of preferred stock typically have voting rights?

No, they have no voting rights.

What is true regarding common stock claims in bankruptcy?

Owners of common stock have the last claim on the firm's assets in the event of bankruptcy.

What type of market is the New York Stock Exchange?

Auction market.

What characterizes a vanilla bond?

Fixed coupon payments with the principal repaid at maturity.

How do brokers incentivize investors to use their services over direct search?

By charging a commission fee that is lower than the cost of direct search for investors.

What can be inferred if the yield curve is upward sloping?

Long-term bonds are yielding more than short-term bonds.

What is the main venue for secondary market transactions in the United States?

Organized stock exchanges.

What does default risk refer to in the context of bonds?

The possibility that the bond issuer might not make the scheduled payments.

What are the three economic factors that affect the shape of the yield curve?

The real rate of interest, the expected rate of inflation, and interest rate risk.

How is the value of an asset typically determined?

By calculating the present value of its future cash flows.

Why do risk-averse investors require a premium for certain securities?

They require a premium to purchase a security that exposes them to default risk.

When do downward-sloping (inverted) yield curves usually occur?

Before the beginning of a recession.

Which securities are typically used as a proxy for the risk-free rate in financial calculations?

U.S. Treasury securities such as T-bills and notes.

How is the annual percentage rate (APR) different from the effective annual interest rate (EAR)?

APR is a rate without compounding, while EAR reflects a rate with compounding.

What is true regarding the marketability of U.S. Treasury bills?

U.S. Treasury bills have the largest and most active secondary market and are considered to be the most marketable of all debt securities.

Why do long-term bonds generally exhibit greater interest rate risk than short-term bonds?

Their prices are more sensitive to interest rate changes due to longer cash flow durations.

What is true of zero-coupon bonds?

Zero coupon bonds have no coupon payments over their life and only offer a single payment at maturity.

Which statement regarding bond prices and interest rates is NOT true?

As interest rates increase, bond prices increase.

How do falling interest rates usually affect bond prices?

Bond prices are expected to go up as rates drop.

What is the typical face value of a corporate bond?

$1,000.

What information does an amortization schedule provide?

It provides principal, interest, and unpaid principal balance for each period.

What is a key characteristic of zero-coupon bonds regarding their price?

They sell below their par value due to the absence of coupons.

Which type of investor is most active in the corporate bond market?

Life insurance companies and pension funds.

How are zero-coupon bonds typically priced when first issued?

They typically sell at a deep discount below par.

What does the effective annual interest rate (EAR) represent?

The true annual interest rate that accounts for compounding effects.

What is the correct way to annualize an interest rate for comparison purposes?

Compute the effective annual interest rate (EAR).

Which statement about vanilla bonds is NOT true?

Coupon payments are usually made quarterly.

What is a growing perpetuity?

A firm receives a cash flow from an investment that will increase by 10% annually for an infinite number of years.

When do cash flows occur in an annuity due?

At the beginning of each period.

What is the appropriate interest rate to use for future or present value calculations?

The effective annual interest rate (EAR).

Why is EAR preferred over APR for annualizing interest rates?

Because EAR accounts for the number of periods and compounding throughout the year.