Asset classes and Financial Instruments

Question 1

Which of the following municipal bonds typically has the greater risk and is issued with higher yields?

• revenue bonds
• appropriation-backed obligations
• limited tax general obligation bonds
• treasury bonds

Answer 1

Revenue bond issues are only obligated to pay principal and interest if revenue from the project that they helped fund is sufficient enough to service the issue. When issued, revenue bonds typically are riskier than general obligation bonds and, consequently, have higher yields.

Question 2

A Eurodollar time deposit:

• is priced on a discount basis
• is only available in London
• is held at a bank within the United States
• may be issued by a Japanese bank.

Answer 2

Eurodollar time deposits are U.S.-dollar-denominated accounts with banks outside the United States and are quoted as an add-on yield rather than on a discount basis.

Question 3

Given two bonds that are equivalent in all respects except tax status, the marginal tax rate that will make an investor indifferent between an 8.2% taxable bond and a 6.25 tax-exempt bond is closest to:

• 24.39%
• 32.26%
• 37.04%
• 43.47%

Answer 3

taxable yield x (1 - marginal tax rate) = after-tax yield

The tax rate that makes investors indifferent between two otherwise equivalent bonds is determined by solving for the tax rate in the equation.

rearranging this relationship, we have:

marginal tax rate = 1 - tax-exempt rate / taxable rate

1 - 6.2 / 8.2 = 24.39%

Question 4

Which of the following is NOT a criticism of the Dow Jones Industrial Average?

• the index does not track the NYSE
• there are a limited number of stocks in the index.
• the stocks only represent the biggest NYSE stocks
• the divisor acts more like a multiplier

Answer 4

The DJIA does a good job tracking the NYSE but is criticised because it only contains 30 stocks. The index represents the 30 largest stocks, and the price-weighting causes a downward bias in the index.

Question 5

Which of the following most accurately describes a derivative security? A derivative:

• has no risk
• always increases risk
• has no expiration date
• has a payoff based on another asset

Answer 5

A derivative’s value is “derived” from another asset.

Question 6

Assume an investor is in the 31st marginal tax bracket. She is considering the purchase of either a 7.5% corporate bond that is selling at par or a 5.25% tax-exempt municipal bond that is also selling at par. Given that the two bonds are comparable in all respects except their tax treatments, the investor should buy the:

• corporate bond since it has the higher yield of 7.50%
• municipal bond since the taxable-equivalent yield on it is 10.87%
• municipal bond since its taxable-equivalent yield is 7.61%
• corporate bond since it has the higher yield of 10.87%

Answer 6

The taxable-equivalent yield on this municipal bond:

taxable-equivalent yield = tax-free yield / (1 - marginal tax rate)

0.0525 / 1 - 0.31 = 0.0761

Since this is higher than the yield on the (taxable) corporate bond, the municipal bond is preferred. Alternatively, the after-tax yield on the corporate is

7.5% (1 - 0.31) = 5.175%

which is less than the tax-exempt yield, leading to the same decision.

Question 7

Common stock investors have:

• limited liability, a residual claim on the firm’s assets, and ownership of the firm.
• limited liability, exposure to default risk, and a residual claim on the firm’s assets.
• unlimited liability, exposure to default risk, and ownership of the firm
• unlimited liability, a residual claim on the firm’s assets, and ownership of the firm.

Answer 7

Common stockholders have limited liability, a residual claim on the firm’s assets, and ownership of the firm. Default risk is a risk faced by bondholders, not shareholders.