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Multiple Choice Questions 1. A zero coupon bond refers to a bond which: A) Does not pay any coupon payments because the issuer is in default. B) Promises a single future payment. C) Pays coupons only once a year. D) Pays coupons only if the bond price is above face value. Answer: B LOD: 1 Page: 120 A-Head: Bond Prices. 2. A consol is: A) Another name for a zero coupon bond. B) A bond with a maturity date exceeding 10 years. C) A bond which makes periodic interest payments forever but never matures. D) A form of a bond that is issued quite often by the U.S. Treasury. E) c and d Answer: C LOD: 1 Page: 120 A-Head: Bond Prices. 3. A pure discount bond is also known as: A) A consol. B) A fixed payment loan. C) A coupon bond. D) A zero coupon bond. E) None of the above. Answer: D LOD: 1 Page: 120 A-Head: Bond Prices. 4. The most common form of a zero-coupon bond found in the United States is: A) AAA rated corporate bonds. B) U.S. Treasury bills. C) 30 year U.S. Treasury bonds. D) Municipal bonds. Answer: B LOD: 1 Page: 120 A-Head: Bond Prices.

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5. Which of the following best expresses the formula for determining the price of a U.S. Treasury bill per $100 of face value? A) $100/(1 + i)n B) $100(1 + i) C) $100/(1 + i) D) 1 + $100/(1 + i)n Answer: A LOD: 2 Page: 120 A-Head: Bond Prices. 6. If the annual interest rate is 5% (.05), the price of a one year Treasury bill would be: A) $95.00 B) $97.50 C) $95.25 D) $96.10 Answer: C LOD: 3 Page: 120 A-Head: Bond Prices. 7. If the annual interest rate is 5% (.05), the price of a six-month Treasury bill would be: A) $97.50 B) $97.59 C) $95.25 D) $95.00 Answer: B LOD: 3 Page: 121 A-Head: Bond Prices. 8. If the annual interest rate is 5% (.05), the price of a three-month Treasury bill would be: A) $98.79 B) $95.00 C) $98.75 D) $97.59 Answer: A LOD: 3 Page: 121 A-Head: Bond Prices.

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9. The relationship between the price and the interest rate for a zero coupon bond is best described as: A) Volatile: B) Fluctuating. C) Inverse. D) Non-existent. Answer: C LOD: 1 Page: 121 A-Head: Bond Prices. 10. When a loan is said to be amortized, it means: A) The borrower is in default. B) The principal and interest are paid off by the borrower over the life of the loan. C) The interest is due entirely at the maturity date. D) The principal in never repaid, only interest. Answer: B LOD: 2 Page: 121 A-Head: Bond Prices. 11. Most home mortgages are good examples of: A) Consols. B) Zero-coupon bonds. C) Coupon bonds. D) Fixed-payment loans. Answer: D LOD: 1 Page: 121 A-Head: Bond Prices. 12. The price of a coupon bond can best be described as: A) The present value of the face value. B) The present value of the coupon payments. C) The future value of the coupon payments and the face value. D) a plus b E) None of the above. Answer: D LOD: 2 Page: 121 A-Head: Bond Prices.

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13. The difference in the price of a zero coupon bond and a coupon bond is simply: A) Nothing, since they are the same. B) The present value of the final payment. C) The present value of the coupon payments. D) The future value of the coupon payments. Answer: C LOD: 2 Page: 121 A-Head: Bond Prices. 14. The price (P) of a consol offering an annual coupon payment (C) is best expressed by: A) F/(C) B) C(1 + i) C) C/(1+ i) D) C/i Answer: D LOD: 2 Page: 122 A-Head: Bond Prices. 15. If a consol is offering an annual coupon of $50 and the annual interest rate is 6%, the price of the consol is: A) $47.17 B) $813.00 C) $833.33 D) None of the above Answer: C LOD: 3 Page: 122 A-Head: Bond Prices. 16. Which of the following statements is most true? A) Yield to maturity is equal to the coupon rate if the bond is held to maturity. B) Yield to maturity is the same as the coupon rate. C) Yield to maturity is the same as the coupon rate if the bond is purchased for face value. D) Yield to maturity is the same as the coupon rate if the bond is purchased for face value and held to maturity. Answer: D LOD: 2 Page: 123 A-Head: Bond Yields.

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17. When the price of a bond is above face value: A) The yield to maturity is below the coupon rate. B) The yield to maturity will be above the coupon rate. C) The yield to maturity will equal the current yield. D) The yield to maturity will equal the coupon rate. Answer: A LOD: 2 Page: 123 A-Head: Bond Yields. 18. When the price of a bond is below the face value: A) The yield to maturity is below the coupon rate. B) The yield to maturity will be above the coupon rate. C) The yield to maturity will equal the current yield. D) The yield to maturity will equal the coupon rate. Answer: B LOD: 2 Page: 123 A-Head: Bond Yields. 19. When the price of a bond equals the face value: A) The yield to maturity will be above the coupon rate. B) The yield to maturity will be below the coupon rate. C) The current yield is equal to the coupon rate. D) The yield to maturity is equal to the current yield. E) c and d Answer: E LOD: 2 Page: 123 A-Head: Bond Yields. 20. If the purchase price of a bond exceeds the face value: A) The yield to maturity is greater than the coupon rate because the capital gain is positive. B) The yield to maturity will equal the current yield. C) The yield to maturity will be less than the coupon rate because the capital gain will be negative. D) The yield to maturity will be greater than the current yield. Answer: C LOD: 2 Page: 123 A-Head: Bond Yields.

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21. The current yield of a bond is: A) Another term for the coupon rate. B) Another term for the yield to maturity. C) Could not be calculated for a zero-coupon bond. D) None of the above. Answer: C LOD: 1 Page: 124 A-Head: Bond Yields. 22. A $1000 face value bond purchased for $965.00, with an annual coupon of $60, and 20 years to maturity has: A) A current yield equal to 6.22%. B) A current yield equal to 6.00%. C) A coupon rate equal to 6.22%. D) A yield to maturity and current yield equal to 6.00%. E) A yield to maturity and coupon rate equal to 6.00%. Answer: A LOD: 2 Page: 124 A-Head: Bond Yields. 23. A $1000 face value bond purchased for $965.00, with an annual coupon of $60, and 20 years to maturity has: A) A current yield and coupon rate equal to 6.22%. B) A current yield equal to 6.22% and a coupon rate below this. C) A coupon rate equal to 6.00% and a current yield below this. D) A yield to maturity and current yield equal to 6.00%. E) A yield to maturity and coupon rate equal to 6.00%. Answer: B LOD: 2 Page: 124 A-Head: Bond Yields. 24. In calculating the current yield for a bond: A) The coupon payment is ignored. B) The present value of the capital gain/loss is ignored. C) The present value of the final payment is the only important consideration. D) None of the above. Answer: B LOD: 2 Page: 124 A-Head: Bond Yields.

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25. In calculating the current yield for a bond: A) The coupon payment and purchase price is all that is needed. B) The present value of the capital gain/loss is ignored. C) The present value of the final payment is the only important consideration. D) None of the above. Answer: A LOD: 2 Page: 124 A-Head: Bond Yields. 26. When the current yield and the coupon rate are equal: A) The bond is purchased at a discount. B) The bond is purchased at a price that equals the face value. C) The bond is a zero coupon bond. D) The bond is purchased at a price that exceeds face value. Answer: B LOD: 2 Page: 124 A-Head: Bond Yields. 27. If a bonds purchase price equals the face value: A) The coupon rate equals the current yield which is less than the yield to maturity. B) The current yield equals the yield to maturity, which exceeds the coupon rate. C) The coupon rate equals the yield to maturity, which equals the current yield. D) The coupon rate does not equal the current yield, which does not equal the yield to maturity. E) None of the above. Answer: C LOD: 2 Page: 124 A-Head: Bond Yields. 28. The yield to maturity can differ from the current yield: A) Because the yield to maturity considers the capital gain/loss. B) Because the current yield focuses only on the coupon payment and the purchase price. C) Because most bonds are not purchased for face value. D) All of the above. Answer: D LOD: 2 Page: 124 A-Head: Bond Yields.

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29. A $1000 face value bond, with one year to maturity that sells for $950 and has a $40 annual coupon: A) Has a current yield and yield to maturity of 4.00%. B) Has a yield to maturity that exceeds the current yield. C) Has a coupon rate of 4.00% and a current yield that is below this. D) Has a current yield of 4.21%. E) b and d Answer: E Page: 124 A-Head: Bond Yields. 30. A $1000 face value bond, with an annual coupon of $40, one year to maturity and a purchase price of $980: A) Has a current yield that equals 4.00%. B) Has a coupon rate that equals 4.08%. C) Has a current yield that equals 4.08% and a yield to maturity that equals 6.12%. D) Has a current yield that equals 4.08% and a yield to maturity that equals 4.0%. Answer: C LOD: 2 Page: 124 A-Head: Bond Yields. 31. The bid price for a bond quote is: A) The price the bond dealer will sell at. B) The price the bond dealer will purchase a bond at. C) Fixed over the life of a bond. D) Determined by the time left to maturity. Answer: B LOD: 2 Page: 127 A-Head: Bond Yields. 32. In reading bond quotes: A) The bid price is usually above the asked price. B) The asked price is fixed over the life of the bond. C) The asked price is usually above the bid price. D) Bid and asked prices must be equal as set forth by SEC regulations. Answer: C LOD: 2 Page: 127 A-Head: Bond Yields.

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33. The bond dealer's spread is: A) The asking price less the bid price. B) The difference between the current yield and the yield to maturity. C) The bid price less the asking price. D) Usually negative, the dealer makes their profit holding the bonds. Answer: A LOD: 1 Page: 127 A-Head: Bond Yields. 34. The size of the bond dealer's spread is mainly a function of: A) The purchase price of the bond. B) The current yield. C) The liquidity of the bond market. D) None of the above. Answer: C LOD: 2 Page: 127 A-Head: Bond Yields. 35. The larger the bond dealer's spread: A) The less liquid is the market for that bond. B) The greater is the coupon rate for that bond. C) The more liquid is the market for that bond. D) The less risk there is for the dealer to hold that bond. E) None of the above. Answer: A LOD: 2 Page: 127 A-Head: Bond Yields. 36. The yield on a discount basis: A) Is the same as the yield to maturity. B) Is computed as if the year is 360 days long. C) Uses the difference in face value and purchase price over purchase price to determine the return. D) b and c Answer: B LOD: 2 Page: 127 A-Head: Bond Yields.

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37. The yield on a discount basis: A) Will overstate the return on a Treasury bill versus using yield to maturity since they are sold at discounts. B) Will understate the return on Treasury bills versus yield to maturity since they are sold at premiums. C) Will understate the return on Treasury bills versus yield to maturity since they are sold at discounts. D) Is the same as yield to maturity. Answer: C LOD: 2 Page: 127 A-Head: Bond Yields. 38. The yield on a discount basis for a $100 Treasury bill that sells for $98.50 and matures in 90 days is: A) 1.50% B) 4.80% C) 6.00% D) 4.94% Answer: B LOD: 3 Page: 127 A-Head: Bond Yields. 39. U.S. Treasury strips are: A) Bonds where the present value of the final payment and coupon payments are sold separately. B) Bonds that are stripped of their financial rating. C) Another name for Treasury Bills. D) Initially zero-coupon bonds. Answer: A LOD: 1 Page: 127 A-Head: Bond Yields. 40. The holding period return on a bond: A) Can never be more than the yield to maturity. B) Will equal the yield to maturity if the bond is purchased for face value. C) Will be less than yield to maturity if the bond is sold for more than face value. D) Will be less than the yield to maturity if the bond is sold for less than face value. Answer: D LOD: 2 Page: 125 A-Head: Bond Yields.

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41. One characteristic that distinguishes holding period return, from the coupon rate, current yield and yield to maturity is: A) All of the other returns can be calculated at the time the bond is purchased, holding period return cannot. B) Holding period return will always be the highest return. C) Holding period return will usually be less than the other returns. D) None of the above. Answer: A LOD: 2 Page: 125 A-Head: Bond Yields. 42. Which of the following best expresses the equation for holding period return? A) Current yield + coupon rate. B) Yield to maturity Current yield C) Current yield + capital gain. D) Coupon rate + Capital gain. Answer: C LOD: 2 Page: 125 A-Head: Bond Yields. 43. In considering the holding period return, the longer the term of the bond the: A) Less important is the capital gain and the more important in the current yield. B) Less important is the coupon rate and the more important is the current yield. C) Less important is the capital gain. D) The more important is the capital gain. Answer: D LOD: 2 Page: 125 A-Head: Bond Yields. 44. The holding period return has relevance because: A) Most bonds are held by the original purchaser until maturity. B) Most bonds are not held by the original purchaser until they mature. C) Bonds are frequently traded. D) Current yields are not that important to bondholders. E) b and c Answer: E LOD: 2 Page: 125 A-Head: Bond Yields.

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45. If the price a bondholder sells her bond for decreases, the holding period return will: A) Increase, since yields and prices are inverse. B) Decrease since this lowers the capital gain. C) Be negative. D) b and c Answer: B LOD: 2 Page: 125 A-Head: Bond Yields. 46. If a one year bond has a face value of $100 and is purchased for $94, and is held to maturity: A) The holding period return will equal the yield to maturity. B) The yield to maturity will exceed the holding period return. C) The yield to maturity will be 6.38% D) a and c E) b and c Answer: D LOD: 3 Page: 125 A-Head: Bond Yields. 47. Bond prices and yields: A) Move together directly. B) Bond yields do not change since the coupon is fixed. C) Move together inversely. D) Are independent of each other. Answer: C LOD: 2 Page: 130 A-Head: Bond Yields. 48. As bond prices increase: A) The quantity of bonds supplied increases. B) The quantity of bonds supplied decreases. C) The quantity of bonds demanded increases. D) Yields increase. Answer: A LOD: 2 Page: 130 A-Head: The Bond Market and the Determination of Interest Rates.

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49. The bond supply curve slopes upward because: A) As bond prices rise people holding bonds are more tempted to sell them. B) As bond prices rise yields increase. C) For companies seeking financing, the higher the price of bonds the more attractive it is to sell bonds. D) a and c. E) a and b Answer: D LOD: 2 Page: 130 A-Head: The Bond Market and the Determination of Interest Rates. 50. The bond demand curve slopes downward because: A) At lower prices the reward for holding the bond increases. B) As bond prices fall so do yields. C) As bond prices fall bonds are less attractive. D) None of the above. Answer: A LOD: 2 Page: 130 A-Head: The Bond Market and the Determination of Interest Rates. 51. If the Supply of bonds exceeded the demand for bonds: A) Bond prices would rise and yields would fall. B) Bond prices would fall and yields would rise. C) Bond prices would rise but yields will remain constant. D) Bond prices and yields would decrease. Answer: B LOD: 2 Page: 130 A-Head: The Bond Market and the Determination of Interest Rates. 52. If the demand for bonds exceeds the supply of bonds: A) Bond prices would rise and yields would fall. B) Bond prices would fall and yields would increase. C) Bond prices will rise and yields will remain constant. D) Bond prices and yields would increase. Answer: A LOD: 2 Page: 130 A-Head: The Bond Market and the Determination of Interest Rates.

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53. If the U.S. Government borrowing needs increase, all other factors constant: A) The demand for bonds will decrease. B) The price of bonds will increase. C) The supply of bonds will increase. D) The yields on bonds will decrease. E) c and d Answer: C LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 54. If the U.S. Government borrowing needs decrease, all other factors constant: A) The supply of bonds will increase. B) The demand for bonds will decrease. C) The price of bonds will decrease. D) The price of bonds will increase. Answer: D LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 55. If the U.S. Government borrowing needs increase, all other factors constant: A) The price of bonds will increase. B) The supply of bonds will increase. C) The demand for bonds will decrease. D) a and c Answer: B LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 56. If the U.S. Government borrowing needs increase, in the bond market this would be seen as: A) The bond demand curve shifting right. B) A movement up the bond supply curve. C) A movement down the bond demand curve. D) The bond supply curve shifting left. E) None of the above. Answer: E LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates.

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57. If the U.S. Government borrowing needs increase, in the bond market this would be seen as: A) The bond demand curve shifting right. B) A movement up the bond supply curve. C) A movement down the bond demand curve. D) The bond supply curve shifting right. E) None of the above. Answer: D LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 58. As general business conditions improve, we would witness the following in the bond market: A) The bond demand curve shifting left. B) The bond supply curve shifting right. C) Bond prices decreasing. D) a and c E) b and c Answer: E LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 59. As general business conditions deteriorate, all other factors constant: A) The demand for bonds will increase. B) The supply of bonds will increase. C) Bond prices will decrease. D) Bond yields will increase. E) None of the above. Answer: E LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 60. As general business conditions improve, all other factors constant: A) The price of bonds will increase. B) The yield on bonds will increase. C) The bond demand curve shifts right. D) The bond supply curve shifts left. E) b and c Answer: B LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates.
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61. As general business conditions deteriorate, all other factors constant: A) The bond supply curve will shift left. B) The re will be a movement down the existing bond supply curve. C) The bond demand curve shifts left. D) The price of bonds will decrease. Answer: A LOD: 2 Page: 131 A-Head: The Bond Market and the Determination of Interest Rates. 62. When expected inflation increases for any given nominal interest rate: A) The cost of borrowing increases and the desire to borrow decreases. B) The real interest rate increases. C) Te bond supply curve shifts to the left. D) None of the above. Answer: D LOD: 2 Page: 132 A-Head: The Bond Market and the Determination of Interest Rates. 63. When expected inflation decreases for any given nominal interest rate: A) The real interest rate increases. B) The bond supply curve shifts to the left. C) The cost of borrowing increases and the desire to borrow decreases. D) The price of bonds increases. E) All of the above. Answer: E LOD: 2 Page: 132 A-Head: The Bond Market and the Determination of Interest Rates. 64. When expected inflation increases for any given nominal interest rate: A) The bond demand curve shifts left. B) The bond supply curve shifts right. C) The price of bonds increases. D) The yield on bonds will increase. Answer: B LOD: 2 Page: 132 A-Head: The Bond Market and the Determination of Interest Rates.

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65. When expected inflation increases for any given nominal interest rate: A) The real cost of repayment for bond issuers increases. B) The real return for bondholders increases. C) The real cost of repayment for bond issuers decreases. D) The bond demand curve shifts right. E) b and d Answer: C LOD: 2 Page: 132 A-Head: The Bond Market and the Determination of Interest Rates. 66. 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: A) The bond demand curve shift right. B) The bond supply curve shift left. C) The bond supply curve shift right. D) The bond demand curve shift left. Answer: C LOD: 2 Page: 132 A-Head: The Bond Market and the Determination of Interest Rates. 67. An increase in the nation's wealth, all other factors constant, would cause the following in the bond market: A) The bond supply curve would shift left. B) The bond demand curve would shift left. C) The bond supply curve would shift right. D) The bond demand curve would shift right. Answer: D LOD: 2 Page: 134 A-Head: The Bond Market and the Determination of Interest Rates. 68. An increase in the nation's wealth, all other factors constant: A) Would cause bond prices to fall and yields to increase. B) Would cause bond prices and yields to increase. C) Would cause bond prices to rise and yields to decrease. D) Would cause the bond supply curve to shift right. Answer: C LOD: 2 Page: 134 A-Head: The Bond Market and the Determination of Interest Rates.

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69. A decrease in the nation's wealth, all other factors constant: A) Would cause the bond demand curve to shift left. B) Would cause bond prices to rise. C) Would cause interest rates to increase. D) a and c. Answer: D LOD: 2 Page: 134 A-Head: The Bond Market and the Determination of Interest Rates. 70. An increase in expected inflation for any given nominal interest rate will cause: A) The bond demand curve to shift to the left. B) The bond demand curve to shift to the right. C) The price of bonds to decrease. D) a and c E) b and c Answer: D LOD: 2 Page: 134 A-Head: The Bond Market and the Determination of Interest Rates. 71. A decrease in expected inflation for any given nominal interest rate will cause: A) Bond prices to increase and interest rates to decrease. B) Bond prices to decrease and interest rates to increase. C) The bond demand curve to shift to the left. D) None of the above. Answer: A LOD: 2 Page: 134 A-Head: The Bond Market and the Determination of Interest Rates. 72. An increase in expected inflation for any given nominal interest rate will cause: A) The real return to bondholders to decrease. B) A movement down the bond demand curve. C) The bond demand curve to shift right. D) The price of bonds to increase. E) a and d Answer: A LOD: 2 Page: 134 A-Head: The Bond Market and the Determination of Interest Rates.

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73. The return on bonds falls relative to other assets, in the bond market this will result in: A) The bond supply curve shifting left. B) A movement down the bond demand curve. C) A shift to the left of the bond demand curve. D) An increase in the price of bonds. Answer: C LOD: 2 Page: 135 A-Head: The Bond Market and the Determination of Interest Rates. 74. The return on assets other than bonds falls, in the bond market this will result in: A) A movement down the bond demand curve. B) A shift to the left of the bond demand curve. C) An increase in the price of bonds. D) A shift to the left of the bond supply curve. E) c and d Answer: C LOD: 2 Page: 135 A-Head: The Bond Market and the Determination of Interest Rates. 75. The return on bonds rises relative to other assets, in the bond market this will result in: A) The price of bonds falling and the yields increasing. B) A movement up the bond supply curve. C) A shift to the right of the bond demand curve. D) An increase in bond prices. E) c and d Answer: E LOD: 2 Page: 135 A-Head: The Bond Market and the Determination of Interest Rates. 76. If interest rates are expected to rise, the impact on bond prices will be: A) Nothing until interest rates actually change. B) They will fall, due to the demand for bonds decreasing. C) They will rise, as people seek capital gains. D) None of the above. Answer: B LOD: 2 Page: 136 A-Head: The Bond Market and the Determination of Interest Rates.

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77. If interest rates are expected to fall, the impact on bond prices will be: A) They will fall as the demand for bonds decreases. B) They will remain constant until interest rates actually change. C) They will fall as people fear capital losses in the future. D) They will increase due to the demand for bonds increasing. Answer: D LOD: 2 Page: 136 A-Head: The Bond Market and the Determination of Interest Rates. 78. If the risk on foreign government bonds increases relative to U.S. government bonds, we should expect what impact on the price of U.S. government bonds: A) No impact since U.S. government bonds are free of default risk. B) The price of U.S. government bonds should decrease since people will bail out of all government bonds. C) The price of U.S. government bonds will increase as the demand for these bonds increases. D) None of the above. Answer: C LOD: 2 Page: 136 A-Head: The Bond Market and the Determination of Interest Rates. 79. One reason the demand for U.S. government bonds is high relative to other bond issues is: A) The liquidity of other bond issues is high relative to U.S. government bonds. B) The U.S. bond market has low transaction spreads due to high illiquidity. C) The market for U.S. government bonds is more liquid than most if not all other bond markets. D) Has nothing to do with liquidity and everything to do with default risk. E) c and d Answer: C LOD: 2 Page: 136 A-Head: The Bond Market and the Determination of Interest Rates. 80. The impact of a decrease in expected inflation in the bond market will have reinforcing effects on the prices of bonds prices because: A) The bond demand curve will shift right as will the bond supply curve. B) The bond demand curve will shift right but the bond supply curve shifts left. C) The bond demand and supply curves will shift left. D) The bond demand curve will shift left as the bond supply curve shifts right. Answer: B LOD: 2 Page: 138 A-Head: The Bond Market and the Determination of Interest Rates.
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81. A deterioration in business conditions that also causes a decrease in a nation's wealth will: A) Leave the impact on bond prices ambiguous since both the bond demand and supply curves shift left. B) Cause the price of bonds to increase if bond supply decreases more than bond demand. C) Cause the interest rates to increase if bond demand decreases more than bond supply. D) All of the above. Answer: D LOD: 2 Page: 138 A-Head: The Bond Market and the Determination of Interest Rates. 82. Fly-By-Night Inc. issues $100 face value, zero-coupon, one year bonds. The current return on one year, zero-coupon U.S. government bonds is 3.5%. If the Fly-By-Night bonds are selling for $92.00, what is the risk premium for these bonds? A) 8.7% B) 1.5% C) 5.2% D) 8.0% Answer: C LOD: 3 Page: 141 A-Head: Why Bonds are Risky. 83. Default risk is the risk associated with: A) The bond issuer not being able to make the promised payments. B) The illiquidity associated with small issues. C) The affect on bond prices caused by changes in market rates of interest. D) Changes in the expected inflation rate. Answer: A LOD: 1 Page: 138 A-Head: Why Bonds are Risky. 84. U.S. Government bonds that have been introduced where bondholders receive a fixed rate of interest plus the change in the consumer price index were designed to remove: A) Default risk. B) Liquidity risk. C) Inflation risk. D) Interest rate risk. Answer: C LOD: 2 Page: 142 A-Head: Why Bonds are Risky.
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85. The U.S. Treasury has introduced bonds where the return is indexed to the consumer price index. We should expect the price and fixed return of these bonds relative to other U.S. Treasury bonds to be: A) Price and return lower due to the decreased risk. B) Higher price but a lower fixed return since the demand for them should be higher. C) Higher price and higher fixed return since we always seem to have some inflation. D) Higher price and lower return due to the decreased risk from inflation in holding these bonds. E) b and d Answer: E LOD: 2 Page: 142 A-Head: Why Bonds are Risky. 86. Interest rate risk results from: A) Bond prices being fixed over the life of the bond. B) A mismatch between an individual's investment horizon and a bond's maturity. C) The fact that most people hold bonds until they mature. D) a and c Answer: B LOD: 2 Page: 143 A-Head: Why Bonds are Risky. 87. Interest rate risk would not matter to which of the following bondholders: A) A holder of a U.S. Government bond. B) A holder of a U.S. Government bond indexed for inflation. C) A holder of a U.S. Government bond who plans on selling it in one year. D) A holder of a U.S. Government bond that plans on holding it until it matures. E) None of the above. Answer: D LOD: 2 Page: 143 A-Head: Why Bonds are Risky.

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88. When looking at bond quotes in the Wall Street Journal, you notice a bond is listed as having two maturity dates, this is due to: A) The bond making half of the coupon payment on the first date and the other half on the second. B) The bond will pay half of the bondholders on the first date and the other half on the second. C) The bond is callable. D) The bondholder can insist on being paid on the first day or hold the bond until the second date. E) c and d Answer: C LOD: 2 Page: 127 A-Head: Bond Yields. Short Answer Questions 89. Consider a $1000.00 face value bond with a $55 annual coupon and 10 years until maturity. Calculate the current yield; the coupon rate and the yield to maturity under each of the following: a) The bond is purchased for $940.00 b) The bond is purchased for $1130.00 c) The bond is purchased for $1000.00 LOD: 3 Page: 123 Answer: We can use a financial calculator to solve for each of these. The easiest is to realize the coupon rate will not change it is $55/$1000 or 5.50% (.055). The current yield, which is the coupon divided by the purchase price will vary for each: for a), the current yield is 5.85%; for b) it is 4.87% and for c it is 5.50%. The yield to maturity will also vary, for a) it is 6.33% for b) it is 3.90% and for c) it is 5.50%. A-Head: Bond Yields.

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90. Calculate the holding period return for a $1000 face value bond with a $60 annual coupon purchased for $970.00 and sold three years later for $1060.00. LOD: 3 Page: 125 Answer: 9.02%. Here we have to consider the present value of the three coupon payments as well as the present value of the capital gain that results from purchasing the bond for $970 and selling it for $1060. A-Head: Bond Yields. 91. Could the holding period return ever be less than the yield to maturity? Explain LOD: 2 Page: 125 Answer: This is possible under the condition that the bond is sold before it matures for an amount less than the face value. If this happened then the holding period return would be less than the yield to maturity. A-Head: Bond Yields. 92. Use the example of a consol to show how bond prices and yields are inverse. LOD: 2 Page: 130 Answer: A consol is a bond that pays a fixed payment forever but does not mature. In calculating the price of a consol we use the formula Price = Coupon/interest rate. This simple formula shows the inverse relationship between price and interest rate since price is in the numerator on the left and interest rate is in the denominator on the right. A-Head: Bond Yields

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93. If a Treasury bill has a purchase price of $9865.50; a face value of $10,000 and 90 days to maturity; calculate the yield to maturity and the yield on a discount basis. LOD: 3 Page: 127 Answer: The yield to maturity is 6.27%. This is obtained by using 90/365 as the time period until maturity. For the yield on a discount basis we would take [($10,000 - $9865.50)/ $10,000] x 360/90 and obtain 5.38%. The difference stems from the fact that the yield on a discount basis uses 360 instead of 365 days in a year, and the yield to maturity looks at the capital gain as a percentage of the purchase price and not the face value. A-Head: Bond Yields. 94. Notice the following model of a bond market. In each situation given, explain what happens to the bond price and yield and why.
$ P r i c e o f b o n d s S
B o n d s

D Q u

o n

a n

t i t y

a) Expected Inflation increases. b) The return on bonds rises relative to other assets. c) The federal government deficit increases? LOD: 2 Page: 131 Answer: If expected inflation increases the demand for bonds will decrease and the supply will increase. Both of these will reinforce each other, causing the bond prices to fall and interest rates to increase. If the return on bonds rises relative to other assets, the bond demand curve will shift to the right, causing bond prices to increase and interest rates to decrease. Finally, if the federal budget deficit increases, the bond supply curve will shift to the right, causing the bond prices to fall and interest rates to increase. A-Head: The Bond Market and the Determination of Interest Rates.

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95. Calculate the price of a zero coupon bond that has an interest rate of 6.65% (.0665), a face value of $100.00 and six-months to maturity. LOD: 3 Page: 122 Answer: We can use the formula from the text where Price (P) = Face value/(1 + i)n. In this case, P = $100/(1 + .0665)0.5, which equals $96.83. A-Head: Bond Prices. 96. Calculate the monthly payment for a 30 year mortgage, where the amount borrowed is $100,000 and the annual interest rate is 6.0%. LOD: 3 Page: 121 Answer: If we use 360 months for the 30 years and convert the 6.0% annual rate to a monthly rate of 0.48676%, [this is found by solving (1 + im) = (1.06)1/12 where im = 0.0048676]. Using a financial calculator, we find the monthly payment equals $589.37. A-Head: Bond Prices. 97. Calculate the price of a $1000 face value bond, that offers a $45 annual coupon, has six years to maturity, when the interest rate is 6.0% (0.060). LOD: 3 Page: 121 Answer: Using a financial calculator the price of the bond is $926.24. We insert $1000 for the face (future) value; $45 for the annual payment, 6.0 for the annual interest rate, 6 for the N (or years) and solve for P (or PV on most calculators). A-Head: Bond Prices.

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98. Which bond will have a higher yield to maturity, a $1,000 face value bond, with a 5.0% coupon rate that sells for $900; or a $1000 face value bond, with a $50 annual coupon that sells for $1,050. Explain your choice. LOD: 2 Page: 123 Answer: The bond that is selling for $900 will. Both bonds have the same coupon rate, of 5%, and they have the same maturity, so the bondholders return from the coupons are equal. What differentiates the two is that the bondholder who purchases the bond for $900 will also receive a capital gain which increases her yield to maturity. A-Head: Bond Yields. 99. Explain the relationship between coupon rate or coupon yield and current yield. LOD: 2 Page: 124 Answer: The coupon rate is simply the annual coupon divided by the face value. The current yield is the annual coupon divided by the price of the bond. The only time these should equal each other is when the price of the bond equals the face value. If the price is greater than the face value the current yield should be less than the coupon rate. If the price of the bond is less than the face value, the current yield should be greater than the coupon rate. A-Head: Bond Yields. 100. Explain why the spreads on most municipal bonds would be greater than the spread on U.S. Treasury bonds. LOD: 2 Page: 127 Answer: Spreads are the difference between the dealer's bid and asked prices. Since dealers are ready to buy or sell the bond, they must carry an inventory, which means they accept risk just like any other bondholder would. One of these risks is liquidity risk, which is the risk of not being able to sell the bond when you would like. Since the market for U.S. Treasury bonds is far more liquid than would be the market for any single municipal bond, the dealer of the municipal bond would face greater liquidity risk and require a larger spread. A-Head: Bond Yields.

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101. Explain why holding period return, as an economic measure, does not have the same significance as say current yield or yield to maturity. LOD: 2 Page: 125 Answer: One of the things economists do is try to explain behavior, or decisions people make. Current yield and yield to maturity are a priori measures, meaning we can calculate these prior to actually making the purchase of the bond. The holding period return cannot be calculated a priori, it is only calculated after the bond is purchased; to a certain degree it represents a sunk cost. A-Head: Bond Yields. 102. If a bond is purchased at a discount, meaning for less than face value? Could the yield to maturity ever be less than the coupon rate? Could the holding period return be less than the coupon rate? Explain. LOD: 3 Page: 125 Answer: If a bond is purchased for less than face value, the yield to maturity will always exceed the coupon rate. For the yield to maturity to be less than the coupon rate would require the price of the bond to exceed the face value. On the other hand the holding period return could be less than the coupon rate. Even if a bond is purchased for less than face value, there is no guarantee it will sell before the maturity date for an amount that is at or above the face value, in fact it could sell for an amount well below the actual purchase price. A-Head: Bond Yields. 103. At the time the government of Bulgrovia issued new bonds, they issued them at a price that reflected the risk free rate because investors had no concerns regarding default risk, so did not require a risk premium. That risk free rate was 4%. These bonds currently have one year to maturity and you notice the yield is 20%. What is the probability that the Bulgrovian government will default? LOD: 3 Page: 141 Answer: We can calculate the probability fairly easily by realizing the probability the bond will not default can be expressed by 1.04/1.20, which equals 0.867. If we subtract this from 1.0 we obtain the probability of default which is 0.133. A-Head: Why Bonds are Risky.
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104. Consider two investors: one is risk neutral the other is risk averse. How do they approach the risk premium? LOD: 2 Page: 141 Answer: The risk neutral investor seeks a risk premium that has the price of the bond (and its subsequent yield) such that the price equals the expected value (the sum of the payoffs times the probabilities). The risk averse investor would offer a price less than this (and therefore seek a higher yield) since they require additional compensation for risk, so their risk premium would be greater. A-Head: Why Bonds are Risky. 105. Explain why two countries with the same average rate of inflation may not present the same inflation risk for holders of those countries' bonds? LOD: 2 Page: 142 Answer: As the text points out, expected, or average inflation can be the same, however, the standard deviation around this expected rate presents different amounts of risk, the higher the standard deviation, the greater the risk. For countries where inflation is volatile, the standard deviation around their average expected rate will be greater, and therefore their bonds will present greater inflation risk. A-Head: Why Bonds are Risky. 106. Which bond should sell for the higher price and why? A basic U.S. Treasury bond, with a $10,000 face value and 20 years to maturity or a U.S. Treasury TIPS bond with the same maturity and face value? LOD: 2 Page: 142 Answer: The TIPS bond should sell for the higher price and (lower return) since it presents less risk to the bondholder. These bonds have returns that adjust to the CPI (rate of inflation), as a result the inflation risk is removed, and with lower risk these bonds would be in greater demand, driving their prices higher and returns lower. A-Head: Why Bonds are Risky.

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107. The text identified the various sources of risk for bonds. Are U.S. Treasury TIPS bonds free from risk? Explain. LOD: 2 Page: 143 Answer: These bonds are free from two main sources of risk that makes holding bonds risky. U.S. Treasury bonds are free from default risk, and the TIPS bonds also remove the inflation risk. However, the risk still present with these bonds is the interest rate risk. If the bondholder does not plan on holding these bonds until maturity, changes in the interest rate (specifically increases) can result in capital losses or returns less than expected. A-Head: Why Bonds are Risky. 108. Compute the change in the price of a five year (until maturity) $1000 face value zero coupon bond that currently yields 7%; when expected inflation increases from 3% to 4%. LOD: 3 Page: 120 Answer: The bond currently will see for $897.50. Once the expected inflation increases by 1%, the bondholders would want to keep the same real return which would drive the bond yield up to 8%. This increase in bond yield will drive the price down to $860.26, or a decrease of more than 4.0% of the bond's price. A-Head: Bond Prices. 109. In early 2001 the stock market in the U.S. suffered significant losses. What impact should this have had on the bond market and why? LOD: 2 Page: 134 Answer: One of the factors that determine the demand for bonds is the relative risk of bonds versus other assets. When the overall value of the stock market decreases or when people assign greater risk to stocks, the relative risk of bonds decreases and this will increase the demand for bonds. All other factors constant, the increase in the demand for bonds will drive up bond prices and decrease yields. A-Head: The Bond Market and the Determination of Interest Rates.

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110. In mid-2004 there was speculation that the Federal Reserve would be raising interest rates before the end of the year. What impact should this news have on the bond market and why? LOD: 2 Page: 134 Answer: The speculated increase in interest rates by the Federal Reserve would cause the value of bonds to decrease. As we saw in the text, an increase in the expected future interest rate makes bonds less attractive. This will lower the demand for bonds, causing bond prices to decrease and yields to increase. As we also saw, however, the change in bond prices and yields will occur before the actual interest rate changes since existing and prospective bondholders will act on their expectations. A-Head: The Bond Market and the Determination of Interest Rates. 111. Use our model of the bond market (supply and demand) to explain what happens if the U.S. economy continues to grow at robust rates. LOD: 2 Page: 134 Answer: Growth in the economy should result in greater supply of bonds, the bond supply curve shifting right, as more firms seek resources to finance expansion and inventories. The increase in supply by itself would result in lower bond prices and higher interest rates. From the demand side, the robust economy should also cause increase in wealth. The increases in wealth would cause bond demand to increase (the curve shifts right), which would drive up bond prices and decrease interest rates. The net effect will be determined by which shift is larger. If Supply shifts by an amount greater than demand, the bond prices will fall and yields will rise. On the other hand, if demand increases by more than supply, the bond prices will rise and yields will fall. A-Head: The Bond Market and the Determination of Interest Rates.

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112. Everything else equal (mainly risk characteristics), which bond would you expect to have a higher price, a bond that is callable or one that isn't? Why? LOD: 2 Page: 143 Answer: The bond that is callable should have a lower price, and therefore a higher yield. The main reason for this is callable bonds present the investor with an additional risk, and that is the expected yield to maturity may not materialize for the bondholder if the issuer calls the bond. This additional risk makes the bond less attractive versus noncallable bonds, so the demand for these bonds is less, leading to lower prices and higher yields. A-Head: Why Bonds are Risky. 113. In the chapter you read about David Bowie, a rock and roll artist from Great Britain, who has issued bonds. Would this be a likely avenue of financing for a new rock and roll group needing to raise funds to get their career going? Explain. LOD: 2 Page: 144 Answer: Not likely. The reason an artist like David Bowie could successfully issue bonds is that he has created a large body of work that continues to generate a cash flow from which interest payments and future principal payments can be made. And while there is still considerable risk with these bonds, the large existing body of work allows prospective investors to measure the risk. A new musical group or artist lacks the large cash flow generating body of work so there would be considerable, almost un-measurable, risk in these bonds making the risk premium required very large, which by itself would likely doom the issue. A-Head: Why Bonds are Risky.

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114. If you were going to issue bonds, would you prefer to be in a country with an average expected 3% inflation rate n however the rate fluctuates wildly, or a country with a higher, 4% expected inflation rate, but it is always 4%. Explain. LOD: 3 Page: 142 Answer: Even though the 4% expected rate is higher, it is stable. As we saw, the inflation risk isn't really the risk from inflation; it is the risk that results from unexpected changes in inflation which then can significantly alter the real interest rate, and therefore the real returns bondholders receive. Because bondholders tend to be risk averse, they would want to be compensated for the inflation risk, and since the inflation risk results from the fluctuations in the rate of inflation, the returns required by bondholders in the country where the average expected rate is 3% but volatile are likely to be higher than the required returns on the bonds in the higher but stable inflation country. This explains, at least partially, why the central banks in many developed countries strive for inflation stability. Stable prices will lead to lower inflation risk and a more efficient bond market. A-Head: Why Bonds are Risky. Essay Questions 115. Many people are worried that with the growing number of people that will be retiring in the U.S over the next 40 years that the Social Security System will need to borrow large amounts of money. If we assume that Social Security taxes and the current eligibility age remain constant, explain the likely impact this will have on bond markets. LOD: 2 Page: 131 Answer: If the Social Security Administration finds that they will need to borrow to finance their obligations this will cause the bond supply to increase, a shift to the right of the bond supply curve. All other factors constant, this will cause bond prices to fall and yields to increase. The yields on all bonds will rise, however, since the U.S. government, and the SSA is a government agency, is usually viewed as the risk free rate from a default standpoint. Since the yields on these bonds will likely increase, this will cause the yields on all bonds to rise since all other bonds have their respective risk premiums which are then added to the risk free return associated with U.S. government bonds. A-Head: The Bond Market and the Determination of Interest Rates.
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116. You win your state lottery. The lottery officials offer you the option of taking your winnings in one lump-sum payment, or fixed annual payments for the next 20 years. The sum of the 20 annual payments is larger than the lump-sum payment. Before deciding what are the key factors you will want to consider that could influence your decision? LOD: 2 Page: 121 Answer: Although this is certainly a pleasant decision to think about, the options presented do require serious thought. For example, you should certainly take the flow of payments for the next 20 years and equate this to the lump-sum being offered. This will allow you to determine the discount rate the state is applying. You can compare this rate to the interest rate you think you could safely earn on the lump-sum if you invested it. You also would want to consider the tax treatment of the winnings. All other factors equal, if you believe that the tax rates are going to rise faster than inflation you may prefer to take more of your winnings early. On the other hand, if you believe that taxes are likely to fall or to rise at a lower rate than inflation, this may have you delaying taking your winnings. You also need to consider the expected rate of inflation. The state is offering fixed-payments for the next 20 years. Any positive rate of inflation reduces the real value of those fixed payments. Receiving the funds in a lump-sum will provide the opportunity to put those funds in an investment that may protect the principal from inflation risk. Although morbid, you should also consider your own life expectancy. If you do not think you are going to live another 20 years, you would certainly want to take your winnings early. Lifestyle is also important as is the degree of risk aversion you exhibit. One advantage to taking the payments over 20 years is that it is a form of expenditure discipline that may prevent you from going through the funds quickly (though it is highly likely that you will find plenty of sources that will loan you funds for the assignment of the winnings to them). If you are a person that needs external discipline, the 20 year payout may be more attractive. While this certainly is not an exhaustive list, it does show that many of the factors discussed in the chapter come into play in a decision such as this one A-Head: Bond Yields.

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