Finance Chapter 06: Interest Rates and Bonds
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Questions and Answers

What is the term for the amount that is repaid at maturity for bonds?

  • Coupon rate
  • Yield to maturity
  • Maturity date
  • Par value (correct)

    • If interest rates increase, the prices of bonds will also increase.

    False

    What does YTM stand for in relation to bonds?

    Yield to maturity

    The ______ rate reflects the stated interest rate of a bond.

    <p>Coupon</p> Signup and view all the answers

    Match the following bond terms with their definitions:

    <p>Coupon rate = The stated interest rate of a bond Maturity = Years until bond must be repaid Par value = Face amount to be repaid at maturity Yield to maturity = Market required rate of return for bonds</p> Signup and view all the answers

    Which of the following factors causes bond values to fluctuate?

    <p>Changes in inflation</p> Signup and view all the answers

    Coupon payments are calculated by multiplying the coupon rate by the par value.

    <p>True</p> Signup and view all the answers

    What is the relationship between interest rates and the present value of bonds?

    <p>As interest rates increase, present values decrease.</p> Signup and view all the answers

    What type of government debt is known as Treasury Bills?

    <p>Pure discount bonds with maturity of one year or less</p> Signup and view all the answers

    Interest from municipal bonds is usually taxable at both federal and state levels.

    <p>False</p> Signup and view all the answers

    At what tax rate would an investor be indifferent between a taxable bond yielding 8% and a municipal bond yielding 6%?

    <p>25%</p> Signup and view all the answers

    Treasury bonds are classified as ________ debt with original maturity greater than ten years.

    <p>coupon</p> Signup and view all the answers

    Match the following bond types with their characteristics:

    <p>Zero Coupon Bonds = Make no periodic interest payments Floating Rate Bonds = Coupon rate floats based on an index value Municipal Bonds = Interest received is tax-exempt at the federal level Convertible Bonds = Can be converted into equity shares</p> Signup and view all the answers

    Which of the following bonds offers less price risk due to their adjustable rates?

    <p>Floating Rate Bonds</p> Signup and view all the answers

    Structured notes and puts are types of bonds that can have added provisions.

    <p>True</p> Signup and view all the answers

    What is the primary market structure for bond transactions?

    <p>Over-the-counter transactions</p> Signup and view all the answers

    What is a characteristic of common stockholders in terms of legal recourse?

    <p>They have no legal recourse if dividends are not declared.</p> Signup and view all the answers

    Creditors have no legal recourse if interest or principal payments are missed.

    <p>False</p> Signup and view all the answers

    What is the term that describes the contract between issuing companies and bondholders?

    <p>Bond Indenture or Deed of Trust</p> Signup and view all the answers

    Moody’s Aaa and S&P AAA ratings indicate a capacity to pay that is _____ strong.

    <p>extremely</p> Signup and view all the answers

    Which of the following bond types is considered speculative?

    <p>Moody’s B, Caa</p> Signup and view all the answers

    Match the government bonds with their types:

    <p>Municipal Securities = Issued by local governments Treasury Securities = Federal government debt Treasury Notes = Long-term securities with fixed interest Treasury Bills = Short-term securities maturing in a year or less</p> Signup and view all the answers

    What is the effect of excess debt on a company?

    <p>Financial distress and potential bankruptcy</p> Signup and view all the answers

    Dividends are not a liability of the firm until they are _____ .

    <p>declared</p> Signup and view all the answers

    What happens to the price of a bond when the YTM is greater than the coupon rate?

    <p>Price is less than par value</p> Signup and view all the answers

    A bond is considered a premium bond if its coupon rate is greater than the YTM.

    <p>True</p> Signup and view all the answers

    What is the formula to value a bond?

    <p>B = PV(annuity) + PV(lump sum)</p> Signup and view all the answers

    When the YTM is less than the coupon rate, the bond is referred to as a ______.

    <p>Premium Bond</p> Signup and view all the answers

    What does the real rate of interest take into account?

    <p>Inflation</p> Signup and view all the answers

    The nominal rate of interest reflects the purchasing power of money after accounting for inflation.

    <p>False</p> Signup and view all the answers

    Match the following bond characteristics with their descriptions:

    <p>Discount Bond = Price is less than par value Premium Bond = Price is greater than par value Par Value Bond = Price equals par value Coupon Rate = Annual interest payment as a percentage of the face value</p> Signup and view all the answers

    What is the Fisher effect?

    <p>The Fisher effect defines the relationship between real rates, nominal rates, and inflation.</p> Signup and view all the answers

    For a bond with a face value of $1,000, a coupon rate of 10%, and a YTM of 11% over 5 years, what is the price of the bond?

    <p>$963.04</p> Signup and view all the answers

    If a bond pays a nominal rate of 5% and inflation is 3%, the real rate is ___%.

    <p>2</p> Signup and view all the answers

    A bond priced at $1,196.36 would have a coupon rate lower than its YTM.

    <p>False</p> Signup and view all the answers

    If a bond has semiannual coupons, how do you adjust the coupon payment for the pricing equation?

    <p>Divide the annual coupon payment by 2.</p> Signup and view all the answers

    Which of the following formulas is used to approximate the nominal rate of interest?

    <p>R = r + h</p> Signup and view all the answers

    Match the following terms related to bond returns:

    <p>Nominal Rate = Stated interest rate on bond Real Rate = Rate after accounting for inflation Default Risk Premium = Risk of borrower defaulting Taxability Premium = Difference between municipal and taxable bonds</p> Signup and view all the answers

    In the example provided, the required real return was ___ percent.

    <p>10</p> Signup and view all the answers

    Treasury securities generally have a high daily volume of bond issues.

    <p>False</p> Signup and view all the answers

    Study Notes

    Key Concepts and Skills

    • Recognize bond characteristics and categories.
    • Understand bond value fluctuations and their influences.
    • Know the significance of bond ratings.
    • Assess inflation's effect on interest rates.
    • Grasp the term structure of interest rates and factors affecting bond yields.

    Bond Definitions

    • A bond is a debt contract, typically structured as an interest-only loan.
    • Par value (face value) is generally around $1,000.
    • Key terms include coupon rate, coupon payment, maturity date, and yield to maturity (YTM).

    Key Features of a Bond

    • Par Value: Amount repaid at maturity; often $1,000 for corporate bonds.
    • Coupon Interest Rate: Stated interest rate, generally equal to YTM at issuance.
    • Maturity: Duration until repayment is due.
    • Yield to Maturity (YTM): Required market return for bonds of similar risk; used to discount cash flows.

    Bond Valuation

    • Bond value = Present Value (PV) of coupons + PV of par value.
    • As interest rates rise, present values decline, leading to decreased bond prices (and vice versa).

    Pricing Bonds

    • Discount Bonds: Occur when YTM > Coupon rate; priced below par.
    • Premium Bonds: Happen when YTM < Coupon rate; priced above par.
    • If coupon rate = YTM, bond price equals par value.

    Bond-Pricing Equation (Semiannual Coupons)

    • Adjustments required for semiannual payments include halving the coupon payment and yield, and doubling the number of periods.

    Bond Indenture

    • The bond indenture is a contract outlining the terms between issuers and bondholders, detailing aspects such as total debt issued, security status, and sinking fund provisions.

    Bond Ratings

    • Investment Grade: Includes Moody's Aaa (extremely strong capacity) to Baa (adequate capacity).
    • Speculative Grade: Ranges from Ba (speculative) to D (default).
    • Ratings indicate creditworthiness and influence interest rates.

    Types of Bonds

    • Government Bonds:
      • Municipal Securities: Tax-exempt at federal level, varying default risk.
      • Treasury Securities (T-bills, notes, bonds): Federal debt with specific maturities.
    • Zero Coupon Bonds: No periodic interest payments; yields come from capital gains upon maturity.
    • Floating Rate Bonds: Coupon rates adjust with market conditions, reducing price risk.

    Bond Markets

    • Predominantly over-the-counter transactions; characterized by a large number of issues but typically low trading volume.
    • Treasury securities are exceptions with more transparent pricing.

    Inflation and Interest Rates

    • Real Rate of Interest: Actual purchasing power after adjusting for inflation.
    • Nominal Rate of Interest: Stated interest rate not adjusted for inflation.
    • Fisher Effect relates real rates, nominal rates, and inflation.

    Factors Affecting Required Return

    • Default risk premium influenced by bond ratings.
    • Taxability premium differentiating municipal and taxable bonds.

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    Related Documents

    Chapter 06 Interest Rates and Bond Valuation PDF

    Description

    Explore the key concepts of bond valuation and interest rates in this comprehensive quiz based on Chapter 06. Gain insights into bond features, types, values, ratings, and the impact of inflation on interest rates as you assess your understanding of these critical financial principles.

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