Fixed-Income Securities - ReviewQuestions

Question 1

Which of the following is True

1) The value of a fixed-income security is derived from the future value of all of its present cash flows, including the return of principal or par value at maturity.

2) The value of a fixed-income security is derived from the present value of all of its future cash flows, including the return of principal or par value at maturity.

Answer 1

2) The value of a fixed-income security is derived from the present value of all of its future cash flows, including the return of principal or par value at maturity.

Question 2

Which of the following is True

1) Callable debt provides a benefit to the issuer
2) Callable debt provides a benefit to the holder
3) Put provision benefits the issuer
4) Put provision benefits the holder

Answer 2

1) Callable debt provides a benefit to the issuer
4) Put provision benefits the holder

Question 3

If there was a money market instrument with a $1,000,000 denomination quoted with a discount rate of 1.5%, how much would the investor pay for the security and what would be the investor’s real interest rate?

Answer 3

The investor will purchase the security for $985,000 or $1,000,000 X .985. The bank discount basis which is the investor’s real interest rate = 1.52% or $15,000/$985,000.

Question 4

The current price of the T-Bill can be determined by applying equation:

Answer 4

Current Price=Face Value×[1−(Days to Maturity/360)×Discount Yield]

Question 5

6-month T-Bill maturing in 30 days with a discount yield of 2.4% would have a current price of ?

Answer 5

$1000×[1−(30/360)×.024]=$998

Question 6

Review Question
You own a 9-month T-Bill ($1,000 face value) with a discount rate of 3% that matures in 180 days. If you were to sell this T-Bill now, how much would you get for it?

Answer 6

$1000×[1−(180/360)×.03]=$985

Question 7

Review Question
An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year. What will be the coupon payment made to the investor?

Answer 7

An investor buys $100,000 of TIPS bearing a 3.5% coupon. For the next 6 months, the inflation rate averages 3% per year. What will be the coupon payment made to the investor?

The coupon rate (3.5% in this case) is fixed. The principal is adjusted every six months to reflect the inflation rate. In this case the principal would be increased to $101,500 ($100,000×.03/2)
, and therefore the payment of the first coupon would be $1,776.25 ($101,500×.035/2)

It is important to note that the principal amount can be increased or decreased every payment period. However, on the maturity date, the treasury guarantees that the principal will not decline below par value ($100,000 in this case).

Question 8

Review Question
Bonnie, a resident of Ohio, has an effective tax rate of 36%. If risk was not an issue for Bonnie, which of the following choices would provide her the highest yield?
Choose the best answer.

30-year T-Bond paying 6%
Disney 30-year-bond paying 7%
Ohio 30-year GO municipal bond paying 5%
Ohio 30-year revenue municipal bond paying 5.5%

Answer 8

Ohio 30-year revenue municipal bond paying 5.5%

The TEY for the revenue municipal bond = 5.5%/(1-.36) = 8.593% which is a higher yield than the other choices. The TEY for the GO municipal bond = 7.8125% which is still a higher equivalent yield than the taxable T-Bond and Disney bond.

Question 9

Which bonds needs to be registered with the SEC

1) Corporate bonds
2) Municipal bonds

Answer 9

1) Corporate bonds

Question 10

Review Question
If a bond’s conversion ratio is 50 shares of stock per bond and the price of the stock is at $30, would it be beneficial for the bondholders to convert?

Answer 10

If stock is a suitable investment for the investor, then it would make sense to convert. Since the conversion price is $1,000/50 or $20 per share, the investor can convert and sell the shares for $30 and earn a $10 profit each or $500.

Question 11

Joseph would like to invest in a government bond that will mature in three years. Which of the following should he purchase?

1) Treasury bond
2) Treasury bill
3) Treasury note
4) Either a Treasury bill or a Treasury bond

Answer 11

3) Treasury note

Treasury bills mature in less than one year. Treasury notes mature in one to ten years. Treasury bonds mature in ten years or longer.

Question 12

You are formulating a plan to save for the college education of a seven-year-old son of a client. The client expects to need the funds for college in about eleven years. The client’s adjusted gross income will be approximately $46,000 at that time. She would like to invest part of these funds in tax-exempt securities. Which investment(s) below would yield tax-exempt interest on the client’s federal return if the proceeds were used to finance her son’s education?

1) GNMA funds
2) EE bonds
3) Zero-coupon Treasury bonds
4) Treasury bills

2) only
(3) only
(1), (3), and (4) only
(2) and (4) only

Answer 12

2) only

The interest on Treasury bills, GNMA funds, and zero-coupon Treasury bonds is taxable as income. The interest on EE bonds, however, is tax-deferred until the bonds are redeemed or reach final maturity date. Also, for EE bonds purchased after 1989, the interest earnings are free of federal income taxation if an amount equal to the proceeds is used to pay college tuition and fees.

Question 13

Which of the following will increase the likelihood that a corporation will exercise the right to call a callable bond?
1) An increase in the general level of interest rates
2) Rumors of a corporate buyout
3) A favorable change in the rating assigned to the issuing corporation by a credit rating organization
4) A decrease in the general level of interest rates

(1) only
(2) and (3) only
(1) and (2) only
(3) and (4) only

Answer 13

(3) and (4) only

Both lower interest rates and an increase in the rating of a bond will increase the likelihood that the bond will be called. Each of these circumstances will let a company reissue bonds at a lower rate.

Question 14

A bond that has a discount rate greater than its coupon interest rate will sell for a price that is:

1) At par
2) Above par
3) Below par
4) Equal to the face value of the bond plus the present value of all interest payments

Answer 14

3) Below par

If a bond has a discount rate, or required return, that exceeds its coupon rate the bond must sell at a discount to attract investors.

Question 15

A taxpayer who is in the marginal 28% tax bracket and is considering a 4% municipal bond should also consider a corporate bond earning:

1) 3.7%
2) 6.8%
3) 5.6%
4) 11.2%

Answer 15

3) 5.6%

The formula used to find tax-equivalent yield is:
Taxable yield= Tax-free rate/(1- Tax rate). By substitution,
Taxable yield= 0.04/(1-0.28)= 0.0555, or 5.6%.