Fin 480 exam2

From quizlet
What is a bond?
A promise or an agreement to make payments in the
future, they are used by corporations and different
branches of the government to borrow
money. Bonds are used as a debt instrument.

What is a coupon bond?

A promise from the issuer of the bond, to make a
series of periodic interest payments called coupon
payments, plus a principal payment at maturity.

What is a consol?
A consol makes periodic interest payments forever,
never repaying the principal that was borrowed.

What is a zero-coupon bond?

A type of bond that has a 0% coupon rate, therefore
there are no coupon payments. A good example
would be U.S. treasury bills.

How is the current yield different from the yield to

maturity?
They are both measurements on the rate of return on
a bond, but the yield to maturity is the yield the
bondholders receive if they hold the bond until its
date of maturity, when the final principal payment is
made. A current yield is the yield investors expect in
the current time period, but it ignores the capital
gain or loss that arises when the price at which the
bond is purchased differs from its face value.

If a bonds price = its face value, then coupon rate

= current yield = yield to maturity. What if the
price the price is greater then the face value? What
if the price is less then face value?
When price < face value, then coupon rate < current
yield < yield to maturity.
When price > face value, then coupon rate > current
yield > yield to maturity.

How is the holding period return different from

current yield and yield to maturity?

The holding period return is the return of buying a

bond and selling it before it matures, it differs from
the yield to maturity because the yield to maturity is
the yield bondholders receive when they do hold the
bond to its maturity date. It differs from the current
yield because the current yield is simply the rate
bondholders expect in a certain time period. The
current yield is used to calculate the holding period
return, but the holding period return must also take
into account the change in price between the time of
the purchase and the time of the sale. So, unlike
current yield, the holding period return DOES
recognize capital gain and loss.

Name and briefly explain the three types of risk

associated with bonds.
1. Default risk, which is the risk of missing a
promised payment.
2. Inflation risk, which is the risk of prices fluctuating
unexpectedly. For example if inflation increases,
the real interest rate will decrease, which would
make borrowers happy and lenders sad. And vice
versa.
3. Interest rate risk, is the risk of interest rates
changing unexpectedly. If the interest rate increases,
the bond price decreases. And the more likely
interest rates are to change, the larger the risk of
holding a bond, which would cause a decrease in
demand for bonds.

What are the 5 factors that shift bond DEMAND?

1.An increase in WEALTH causes an increase in
demand for bonds.
2.An increase in RISK causes a decrease in demand
for bonds.
3.An increase in LIQUIDITY causes an increase in
demand for bonds.
4.An increase in HIGHER RETURNS ON OTHER
ASSETS causes a decrease in demand for bonds.
5.An increase in INFLATION causes a decrease in
demand for bonds.

What are the 4 factors that shift bond SUPPLY?

1.An increase in GOVERNMENT BORROWING causes
an increase in supply of bonds.
2.An increase in TAX INCENTIVES causes an increase
in supply of bonds.

3.A decrease in BUSINESS CONDITIONS causes a

decrease in supply of bonds.
4.An increase in INFLATION causes an increase in
supply of bonds.

What is the four step analysis for graphing supply

and demand?
1.Start at Equilibrium (P0, Q0)
2.Shock (given)
3.Shift: Increase or decrease in Demand or Increase
or decrease in Supply?
4.Result: How price, quantity, and the yield are
affected.

What information does a bond rating convey to

investors?
They asses creditworthiness of issuers and
assign ratings.

What is a junk bond? Give 2 examples.

Junk bonds are bonds with a higher risk, they are
anything below bond rating: BBB. One example is a
fallen angel- these bonds were once investment
grade bonds but have been downgraded because the
issuer fell on hard times. The other example is a new
company because little is known about the risk of
this issuer.

What is commercial paper? How is it different from

a bond?
Commercial paper is a very short-term version of a
bond, they have a 0% coupon rate, low risk, and are
very liquid. Both corporations and government issue
commercial paper. When issuing there is no collateral
so the form of debt is UNSECURED and only the most
creditworthy companies can issue it. They differ from
bonds because, legally, commercial paper has a
maturity date less than 270 day, and most
commercial paper is issued with a maturity of 5 to 45
days.

How does an upgrade/downgrade affect a bond's

price and its yield?
Bond ratings are designed to reflect the default risk:
the lower the rating, the higher the risk of default.
The less creditworthy the borrower, the higher the

risk of default, the lower the borrowers rating, and

the higher the cost of borrowing. And the lower the
rating of the bond or commercial paper, the higher
the yield.

What is the general rule regarding taxation of

municipal bonds?
Municipal bonds, issued by government, are typically
tax-exempt. The general rule is each government
branch can tax their own bonds, but no other branch
can. An example of this is the fact that US treasuries
are taxed at a federal lever, but no other level.

A municipal bond yields typically higher or lower

than taxable bond yields?
Municipal bond yields are typically lower because
they are not taxed. A rational investor will always
choose the bond with a higher after tax yield.

Regarding interest rates and time to maturity what

3 trends are usually shown?
1. Long term yields and short term yields seem to
move together.
2. Short term yields are more volatile than
long term yields.
3. Long term yields are usually higher than short
term yields.

Use the expectations hypothesis to explain

the trend(s).
o The Expectations Hypothesis explains trends one
and two, it tells us long term yields are the average
of short term yields, so that would explain why they
move together. Also, since the long term is the
average it makes sense short term yields would be
more volatile because they are not spread out
through time like the long term yields are.

Use the Liquidity Premium Theory to explain the

trend(s).
o The Liquidity Premium Theory explains our third
trend, it tells us it is because of the fact that long
term bonds are riskier than short term bonds. This is
because bondholders face both inflation and interest
rate risk, and the longer the term of the bond, the

greater both of the risks, and the greater the risk,

the higher the yield.

What does an upward sloping yield curve mean?

An upward sloping yield curve is normal, it means
that rates are expected to rise and the long term
rates are larger than the short term rates, this is
because the risk premium increases with time to
maturity.

What does an inverted yield curve mean?

It predicts a general economic slowdown because it
is telling us the short term rates are larger than the
long term rates.

Explain how yield curves might be used as a tool

for forecasting recessions .
If the risk spread (difference between bond yields
and rick free rate) is increasing, that means a
recession is about to occur. An inverted yield curve
gives us one year of lead time when a recession is
diagnosed . They are a very good forecasting tool
because they are almost always right.

What is a stock?
Also known as common stock or equity, are shares in
a firm's ownership.

What is limited liability?

Means that even if a firm fails, the maximum that a
stockholder can lose is what they paid-in. There are
no negative stocks.

What does it mean that stockholders are residual

claimants?
The fact that stockholders are residual claimants
means that if the company runs into financial
trouble, only after all other creditors have been paid
what they are owed will the stockholders receive
what is left, if anything.

Explain why housing should not be viewed as an

investment?
Housing should not be viewed as an investment
because there is no real return, except that you have

a roof over your head. The average real increase in

the value of housing in the United States was less
than 0.20 percent.

Compare the S&P 500 Index and the Dow Jones

Industrial Average. What does each index tell us?
The Dow Jones Industrial Average is the first and
still the best known stock market index. The index is
based on the stock prices of 30 of the largest
companies in the United States, mimics our
economy. The Dow Jones Industrial Average is a price
weighted average which means it gives greater
weight to shares with higher prices. This index tells
us the return to holding ONE share of each company
in the United States.
The S&P 500 index differs from The Dow Jones
Industrial Average, because it is based on the value
of 500 of the largest firms and it is a value-weighted
index. A value-weighted index assigns weights equal
to each firm's market capitalization, or its total
market value, which is calculated by the share price
times the number of shares outstanding. The S&P
500 mirrors changes to the economy's overall
wealth.

Explain the Theory of Market Efficiency

The Theory of Market Efficiency is the notion that
the prices of all financial instruments, including
stocks, reflect all available information. As a result,
markets adjust immediately and continuously to
changes in fundamental values.

What does the Theory of Market Efficiency imply

about stock price movements? What does this
imply about investment advice?
The Theory of Efficient Markets implies that stock
price movements are unpredictable.
This would imply that the fact that money
managers say the can "beat the market" is false
because no one can predict the prices of stocks. And
the ones who actually have beat the market, it
means they were either getting inside information
(which is illegal), taking on risk (which is
compensated ), or they just got lucky and that
cannot be easily repeated.

Stocks appear to be risky investments in the short

run; what about the long run?
Even though stocks seem risky, people hold a
substantial amount of wealth into stocks because
actually, in the long run, there is much less risk when
investing over longer time periods.

How do stocks compare to bonds in the long run?

Stocks outperformed bonds for every 30 year
periods on record. So we can conclude, stocks are
less risky than bonds over the long run.

What factors make mutual funds attractive

investments?
They are affordable, allowing small initial
investments.
They are very liquid and can be withdrawn from
quickly.
They have diversification .
They offer the advantage of professional
management rather than indexes.
The offer good cost, but be sure to look for low
management fees. (Index fund fees are typically
much lower.)

What are bubbles?

Persistent or expanding gaps between actual
stock prices and those warranted by fundamentals.

How do bubbles cause problems in the economy?

This is when stock prices rise and financing is
easier to obtain. So firms over invest, causing them
to under invest elsewhere.
They also distort consumer spending. Increasing
wealth causes us to spend more and save less. When
the bubble bursts (creating crashes), firms are
harmed as households re-asses their wealth.
A zero coupon bond
Promises a single future payment

Which of the following best expresses the formula

for determining the price of a US Treasury bill per
$100 of face value
$100/(1+i)^n

If the annual interest rate if 6%, the price of a one

year Treasury bill would be...
$94.33
100/1.06

If the annual interest rate is 6%, the price of a

three-month Treasury bill would be:
$98.55
100/1.06^1/4

The relationship between the price and the interest

rate for a zero coupon bond is best described as
inverse

The price of a coupon bond can best be described

as
A and C

When the price of a bond is above face value

The YTM is below the coupon rate

The coupon rate of a bond is

not calculated for a zero-coupon bond

A $1000 face value bond purchased for $950, with

an annual coupon of $60, and 20 year maturity
has..
A current yield equal to 6.45%
1000 x coupon rate (60/950) over selling price (950)

When the current yield and the coupon rate are

equal
The bond is purchased at a price that equals the face
value

The bond dealer's spread is

The asking price less the bid price

Which of the following best expresses the equation

for holding period return

Current yield + capital gain

Bond prices and yields

move together inversely

If the supply of bonds exceeded the demand for

bonds
bond prices would fall and yields would rise

When expected inflation increases for any given

nominal interest rate
the real cost of repayment for bond issuers
decreases

The bond rating of a security refers to

The likelihood the lender/borrower will be repaid by
the borrower/issuer

The lowest rating for an investment grade bond

assigned by Moody's is
Baa

Which of the following would probably not earn an

A rating from Standard & Poors:
-A 30 year bond issues by the US treasury
-90 day T-bills from the US treasury

Risk spread is
Usually positive for non US treasury Bonds
The difference between the bond's yield and the
yield on US Treasury bond of the same maturity.

The default premium

Is also known as the risk spread

The risk structure of interest rates says

The interest rates on a variety of bonds will move
together
Lower rated bonds will have higher yields

The market for junk bonds increased after Michael

Milkin's involvement because..

Milken convinced his employer to allow him to make

a market in these securities

Municipal bonds re...

issued by states and cities and their interest is
exempt from US government taxation

In the fall of 1998, we saw an increase in risk

spread
the russian gov't defaulted on some of its bonds

The expectations hypothesis does not suggest

the yield curve is downward sloping

When the yield curve is downward sloping

people are expecting an economic slowdown

Inflation risk increases over time because

it is more difficult to forecast inflation over longer
periods of time

considering the liquidity premium theory, if

investors expect short term interest rates to
decrease...
The yield curve should be flat

The slope of the yield curve seems to predict the

performance of the economy with
usually a one year lag

A share of common stock represents

A share of ownership of the company

The fact that common stockholders are residual

claimants means...
the stockholders receive the remains after everyone
else is paid

The concept of limited liability sys a stockholder of

a corporation
cannot lose more than their investmtnet

an index number is a valuable took because

the index provides a meaningful measurement scale

to calculate percentage changes

The Dow Jones Industrial Average is an example of..

A price-weighted index

If the Dow Jones Industrial Average increases from

9800 to 10250, the percentage change in the index
is..
4.59%

The most broadly based stock index in use is..

The Wilshire 5000

You start with a $1000 portfolio; it loses %40 over

the next year, the following year it gains 50% in
value; at the end of two years your portfolio is
worth...
$900

The Dividend-Discount Model of Stock valuation

is an application of the net present value formula

If we ignore risk, the dividend discount model says

that the fundamental price of a stock is simply
The current dividend divided by the interest rate less
the dividend growth rate.

The theory of efficient markets

allows for higher than average returns if the investor
takes higher than average risk

Professor Jeremy Siegel, of UPENN, did research

that points out
Over the long run, stocks are less risky than bonds.

Stock market bubbles can lead to

Inefficient allocation of resources
Stock market crashes
Patterns of volatile returns from the stock market

When stock prices reflect fundamental values,

the allocation of resources will be more efficient.

The "coupon rate" is:
the annual amount of interest payments made on a
bond as a percentage of the amount borrowed

A mortgage, where the monthly payments are the

same for the duration of the loan, is an example of:
a fixed payment loan

Standardization of financial instruments has

occurred as a result of:
economies of scale

A zero-coupon bond refers to a bond which:

promises a single future payment

Which of the following makes fixed payments

indefinitely--amortized loan, consol, coupon bond,
zero-coupon bond?
consol

Most home mortgages are good examples of:

fixed-payment loans

When the price of a bond is above face value:

the yield to maturity is below the coupon rate

Bond prices and yield:

move together inversely

As bond prices increase:

the quantity of bonds supplied increases

If the quantity of bonds supplied exceeds the

quantity of bonds demanded, bond prices:
would fall and yields would rise

If the US government's borrowing needs increase,

in the bond market this would be seen as:
the bond supply curve shifting right
a zero coupon bond refers to a bond which

promises a single future payment

a consol is
a bond that makes periodic interest payments
forever

the most common form of zero coupon bonds

founds found in the united states is
us treasury bills

which of the following best expresses the formula

for determining the price of a us treasury bill that
matures n periods from now per $100 of face value
when the interest rate is i
$100/(1+i)n

once you buy a coupon bond, which of the

following can change
yield to maturity

the relationship between the price and the interest

rate for a zero coupon bond is
inverse

which of the following statements is most accurate

yield to maturity is the same as the coupon rate id
the bond is purchased for face value and held to
maturity

the bid price for a bond quote is

the price at which a bond dealer is willing to
purchase the bond

in reading bond quotes

the ask price is usually above the bid price

bond prices and yields

move together inversely

as bond prices increase, ceteris paribus

the quantity of bonds supplied increases

the bond demand curve slopes downward because

at lower prices the reward for holding the bond

increases

if the quantity of bonds supplied exceeds the

quantity of bonds demanded bonds prices would
at lower prices the reward for holding the bond
increases

if the us governments borrowing needs increase

ceteris paribus the
supply bonds will increase

if the federal government were to offer larger tax

breaks on the purchase of new equipment for
businesses all other factors constant we would
expect to see the
bond supply curve shift right

an increase in the nations wealth all other factors

constant would cause the
bond demand curve to shift right

suppose that the return on assets other than bonds

falls. in the bond market this will result in an
increase in the price of the bonds

if the risk on foreign government bonds increases

relative to us government bonds, the equilibrium
price of us government bonds should
increase as the demand for these bonds increases