READING 2 THE TIME VALUE OF MONEY IN FINANCE Flashcards by Abdulmjeed Almutairi

What is a pure discount instrument?

A) Pays periodic coupons
B) Purchased at a discount, pays full face value at maturity
C) Pays premium at issuance
D) Does not mature

B) Purchased at a discount, pays full face value at maturity

Pure discount instruments like zero-coupon bonds are bought for less than their face value and pay full face value at maturity.

How well did you know this?

Not at all

Perfectly

The yield to maturity (YTM) on a zero-coupon bond refers to:

A) The bond’s coupon rate
B) Inflation rate
C) Discount rate applied to the face value
D) Premium over par

C) Discount rate applied to the face value

YTM is the discount rate that equates the bond’s price with the present value of its future payments.

How well did you know this?

Not at all

Perfectly

How is interest earned on a pure discount bond calculated?

A) Purchase price minus face value
B) Face value minus purchase price
C) Coupon rate times face value
D) Purchase price times YTM

B) Face value minus purchase price

Interest is simply the difference between the face value and the purchase price.

How well did you know this?

Not at all

Perfectly

A zero-coupon bond with a negative yield would be priced:

A) At par
B) At a discount
C) At a premium
D) Same as face value

C) At a premium

Negative yields imply the bond sells above its face value.

How well did you know this?

Not at all

Perfectly

The coupon rate determines:

A) Final maturity value
B) Size of periodic interest payments
C) Initial bond price
D) Yield to maturity

B) Size of periodic interest payments

The coupon rate, applied to the face value, determines each interest payment.

How well did you know this?

Not at all

Perfectly

What is a bond with no maturity date called?

A) Fixed-coupon bond
B) Amortizing bond
C) Perpetuity
D) Convertible bond

C) Perpetuity

Perpetual bonds (perpetuities) have no maturity.

How well did you know this?

Not at all

Perfectly

For a perpetuity, which value can be calculated meaningfully?

A) Future Value
B) Yield to maturity
C) Present Value
D) Duration

C) Present Value

Only the present value is relevant for a perpetuity.

How well did you know this?

Not at all

Perfectly

Amortizing bonds differ from fixed-coupon bonds because:

A) They pay only interest
B) They pay principal and interest each period
C) They offer no periodic payment
D) They pay floating coupons

B) They pay principal and interest each period

Amortizing bonds include part of the principal in each payment.

How well did you know this?

Not at all

Perfectly

When is principal repaid in a fixed-coupon bond?

A) Each period
B) At maturity
C) Halfway through the term
D) Upon issuance

B) At maturity

Fixed-coupon bonds repay the full principal at maturity.

How well did you know this?

Not at all

Perfectly

An example of an annuity instrument is:

A) Zero-coupon bond
B) Perpetual bond
C) Amortizing bond
D) Convertible bond

C) Amortizing bond

Amortizing bonds have fixed periodic payments, similar to annuities.

How well did you know this?

Not at all

Perfectly

Zero-coupon bonds provide:

A) Regular coupon payments
B) No periodic payments, only lump sum at maturity
C) Floating coupon payments
D) Decreasing face value

B) No periodic payments, only lump sum at maturity

Zero-coupon bonds make no interim payments.

How well did you know this?

Not at all

Perfectly

Investor’s return on a zero-coupon bond is from:

A) Periodic coupons
B) Capital gain at maturity
C) Floating interest
D) Issuer’s dividends

B) Capital gain at maturity

The return is the difference between purchase price and face value.

How well did you know this?

Not at all

Perfectly

A zero-coupon bond can have which type of yield?

A) Positive only
B) Negative only
C) Positive or negative
D) None of the above

C) Positive or negative

Depending on market conditions, a zero-coupon bond may have either yield.

How well did you know this?

Not at all

Perfectly

Negative interest rates cause a bond to trade:

A) At par
B) At a premium
C) At a discount
D) At face value

B) At a premium

A negative yield drives bond prices above face value.

How well did you know this?

Not at all

Perfectly

What best defines an annuity?

A) Fixed cash flows forever
B) Fixed cash flows for a set period
C) Variable cash flows forever
D) Single future cash flow

A) Fixed cash flows forever

An annuity provides fixed payments for a specified time.

How well did you know this?

Not at all

Perfectly

Present value of a perpetuity is calculated by:

A) Cash flow divided by discount rate
B) Face value divided by interest rate
C) Face value minus coupon payments
D) Discount rate divided by face value

A) Cash flow divided by discount rate

PV = Cash Flow ÷ Discount Rate.

How well did you know this?

Not at all

Perfectly

What does the coupon rate express?

A) Yield to maturity
B) Principal repayment
C) Interest payment as a percentage of face value
D) Market price appreciation

C) Interest payment as a percentage of face value

The coupon rate represents interest as a percentage of face value.

How well did you know this?

Not at all

Perfectly

A bond trading above its face value is:

A) At par
B) At a discount
C) At a premium
D) Defaulted

C) At a premium

Premium means the price is higher than the bond’s face value.

How well did you know this?

Not at all

Perfectly

How are equity securities valued?

A) Future market prices
B) Present value of future cash flows
C) Book value
D) Par value

B) Present value of future cash flows

Like fixed-income securities, equity securities are valued as the present value of expected future cash flows.

How well did you know this?

Not at all

Perfectly

A key difference between bonds and equity securities is:

A) Bonds mature, equity does not
B) Bonds are riskier than equities
C) Equities pay fixed cash flows
D) Bonds have variable interest rates

A) Bonds mature, equity does not

Bonds have a maturity date, while equity securities (common and preferred stock) typically do not.

How well did you know this?

Not at all

Perfectly

Preferred stock dividends are:

A) Variable based on earnings
B) Fixed percentage of par value
C) Paid irregularly
D) Decided annually by shareholders

B) Fixed percentage of par value

Preferred dividends are usually a fixed percentage of the stock’s par value.

In equity valuation, the required return represents:

A) Risk-free rate
B) Inflation rate
C) Discount rate for cash flows
D) Dividend growth rate

C) Discount rate for cash flows

The required return is the discount rate applied to future cash flows to value equity securities.

What kind of claim do common stockholders have?

A) Priority claims on assets
B) Secured claim
C) Residual claim
D) Senior debt claim

C) Residual claim

Common stockholders have a residual claim on assets after all other claims are satisfied.

Common stock dividends are:

A) Guaranteed at a fixed rate
B) Promised under corporate law
C) Paid at management’s discretion
D) Paid before bond interest

C) Paid at management’s discretion

Management decides whether and when to pay common stock dividends.

Which model assumes a constant future dividend for common stock? A) Gordon Growth Model B) Constant Dividend DDM C) Multistage DDM D) Residual Income Model

B) Constant Dividend DDM Constant Dividend DDM values common stock assuming dividends stay the same forever.

Which formula is used to value a stock with constant dividends? A) PV = FV / (1 + r)^n B) P = D / r C) P = D1 / (r - g) D) P = (D / g)

D) P = (D / g) The perpetuity formula (P = D / r) is used for stocks with constant dividends.

The Gordon Growth Model assumes: A) Zero growth B) Constant dividend growth C) Declining dividends D) Fixed maturity date

B) Constant dividend growth The Gordon Growth Model assumes dividends grow at a constant rate indefinitely.

The formula for the Gordon Growth Model is: A) P = D / r B) P = D1 / (r - g) C) P = (1 + r)^t D) P = D0 / (r + g)

B) P = D1 / (r - g) P = D1 / (r - g), where D1 is the dividend next year, r is the required return, and g is the growth rate.

Which valuation method is used when dividend growth changes over time? A) Constant Dividend Model B) Gordon Growth Model C) Multistage DDM D) Bond Pricing Model

C) Multistage DDM

In a multistage DDM, dividends during high-growth periods are: A) Ignored B) Discounted individually C) Treated as constant D) Multiplied by par value

B) Discounted individually Short-term dividends are discounted individually in a multistage DDM.

After the initial high-growth period, dividends in a multistage DDM are: A) Assumed to decline to zero B) Assumed to grow at a constant rate C) Randomly forecasted D) Multiplied by the risk-free rate

B) Assumed to grow at a constant rate

What is the primary challenge in valuing common stock? A) Predictable cash flows B) Fixed cash flows C) Uncertainty of future cash flows D) Known maturity

C) Uncertainty of future cash flows Common stock valuation is difficult because dividends and future cash flows are uncertain.

Which type of stock has characteristics most similar to a perpetuity? A) Preferred stock B) Common stock with no dividends C) Zero-coupon bonds D) Treasury Bills

A) Preferred stock Preferred stock, with its fixed dividend, resembles a perpetuity.

In the constant dividend model, if required return (r) increases, the stock price: A) Increases B) Decreases C) Remains unchanged D) Grows at the same rate

B) Decreases An increase in the required return lowers the present value of dividends, thus lowering the stock price.

The constant growth DDM requires which relationship between r and g? A) r = g B) r > g C) r < g D) r = 0

B) r > g For the model to be valid, the required return (r) must be greater than the growth rate (g).

What happens to bond prices when yields rise? A) Prices rise B) Prices stay the same C) Prices fall D) Yields also fall

C) Prices fall Prices and yields move inversely. When yields increase, bond prices decrease.

What is the required return for an equity investor used for? A) To calculate dividends B) As the discount rate in valuation C) To determine market price D) To estimate future profits

B) As the discount rate in valuation The required return is used to discount future cash flows when valuing equity.

What principle states that PV of combined cash flows equals sum of individual PVs? A) No-arbitrage principle B) Law of large numbers C) Cash flow additivity principle D) Discounted cash flow principle

C) Cash flow additivity principle PV of a set of cash flows is the sum of the PVs of individual cash flows.

Which principle supports the idea that identical cash flows must have identical prices? A) Time value of money B) Arbitrage principle C) No-arbitrage principle (Law of One Price) D) Opportunity cost principle

C) No-arbitrage principle (Law of One Price) If cash flows are identical, they must have the same present value to prevent arbitrage.

A forward interest rate is: A) A rate on a loan made today B) A fixed-rate bond coupon C) An interest rate agreed today for a loan in the future D) The yield to maturity of a bond

C) An interest rate agreed today for a loan in the future Forward rates are set today for loans that start later.

What does "2y1y" mean in forward rate notation? A) 2-year loan made 1 year from today B) 1-year loan made 2 years from today C) 3-year loan made today D) 2-year spot rate

B) 1-year loan made 2 years from today 2y1y = 1-year loan starting in 2 years.

Which of the following is a spot rate? A) 1y1y B) 2y1y C) 3y2y D) S2

D) S2 "S" indicates a spot rate; S2 is today's 2-year rate.

Which equation reflects the relation between spot and forward rates? A) (1 + S3)³ = (1 + S1)(1 + 1y1y)(1 + 2y1y) B) (1 + S1)² = (1 + S2) C) (1 + S2)³ = (1 + S1)(1 + S3) D) (1 + 2y1y) = (1 + 3y2y)

(1 + S3)³ = (1 + S1)(1 + 1y1y)(1 + 2y1y) The cost of borrowing for 3 years must match the compounded spot and forward rates.

In an exchange rate quote of 1.416 USD/EUR, which is the base currency? A) USD B) EUR C) Both D) Neither

B) EUR The denominator (EUR) is the base currency.

If interest rate parity holds, then the forward premium or discount approximates: A) Exchange rate movements B) Interest rate differential C) Stock market returns D) Inflation differences

B) Interest rate differential Forward-spot difference reflects the interest rate difference between countries.

An arbitrage opportunity exists when: A) Two assets have the same return B) Two identical cash flows are priced differently C) Risk-free rate is constant D) Spot rate equals forward rate

B) Two identical cash flows are priced differently Arbitrage profits arise when identical cash flows have different prices.

What type of option gives the right to buy an asset? A) Call option B) Put option C) Forward contract D) Swap

A) Call option A call option gives the holder the right to buy an asset.

A put option gives the holder: A) Right to buy B) Obligation to buy C) Right to sell D) Obligation to sell

C) Right to sell A put option gives the right to sell the underlying asset at a fixed price.

An option is "out of the money" when: A) Exercise is profitable B) Exercise is unprofitable C) Strike equals market price D) Option is expiring soon

B) Exercise is unprofitable The holder would not benefit from exercising.