Series 7 STC Corporate Debt (Ch. 6) Flashcards
Which of the following statements is TRUE concerning reverse convertible securities?
An investor will receive a coupon rate that’s below prevailing market rates.
An investor is anticipating a decrease in the value of the underlying asset.
They’re suitable for an investor who wants to own shares of the underlying asset.
The investor is anticipating that the price of the underlying asset will be above the knock-in value.
The investor is anticipating that the price of the underlying asset will be above the knock-in value.
Reverse convertible securities are short-term notes that are issued by banks and broker-dealers and typically pay a coupon rate that’s above prevailing market rates. They’re considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security that’s unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value that’s referred to as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of her principal (the most beneficial option). If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal. The investor is anticipating a stable price for the underlying asset and is not able to participate in any increase in the value of the underlying asset. Ultimately the investor doesn’t want to own the underlying asset at a depreciated value.
When a corporation goes bankrupt, which of the following is the last to be paid?
The Internal Revenue Service
Debenture holders
Preferred stockholders
Holders of warrants
Holders of warrants
A holder of common stock is typically the last to be paid in a corporate bankruptcy. The holder of a warrant has the right to purchase common stock and is paid after a holder of common stock. In practical terms, the common stock is worthless if a corporation declares bankruptcy.
Which of the following statements is NOT TRUE regarding negotiable CDs?
The minimum denomination is $100,000, but they commonly have face values of $1,000,000 or more.
They’re unsecured and normally have a fixed rate of interest.
Owners can resell negotiable CDs in the secondary market.
Maturities of more than one year are prohibited.
Maturities of more than one year are prohibited.
Negotiable CDs are traded in the secondary market in minimum denominations of $100,000, but typically trade in $1,000,000 denominations. They’re issued by commercial banks and are secured only by the bank’s credit. Maturities of less than one year are common, but there’s no time limit.
Which of the following securities is MOST appropriate for an investor seeking to buy a new home in one year?
A long-term CD that’s purchased in the secondary market with two years to maturity, but callable in 6 months
A newly issued 20-year bond that’s callable in six months
A newly issued non-callable five-year Treasury note
A long-term CD that’s purchased in the secondary market and matures in 12 months
A long-term CD that’s purchased in the secondary market and matures in 12 months
In general, the most liquid securities are money-market securities (those that mature in a year or less). Securities with longer maturities tend to be more volatile. Even if a security is callable, there’s no guarantee that will be called. If interest rates are rising, bond prices will fall, and call features are unlikely to be exercised by issuers.
A reverse convertible security is MOST suitable for an investor who:
Is anticipating a dramatic decrease in the value of the underlying asset
Is willing to accept a lower yield in return for potential appreciation in the value of the underlying asset
Desires higher yield and is anticipating that the value of the underlying asset will remain stable
Is anticipating an increase in the value of the issuer’s common stock
Desires higher yield and is anticipating that the value of the underlying asset will remain stable
Reverse convertible securities are short-term notes that are issued by banks and broker-dealers and typically pay a coupon rate that’s above prevailing market rates. They’re considered structured products because, in addition to the coupon rate, the investor may be required to purchase shares of an underlying asset at a fixed price. The underlying asset may be an equity security that’s unrelated to the issuer, or a basket of stock, or an index. The issuer agrees to pay this higher coupon rate since it has an option to sell a security to the investor if the price of the security falls below a specified value that’s referred to as the knock-in level. If the price of the underlying asset stays above the knock-in level, the investor will receive the high coupon and the full return of her principal (the most beneficial option). If the underlying asset falls below the knock-in level, the investor will be obligated to purchase shares of the underlying asset at a fixed price. The price of this asset may have depreciated below the knock-in level and the investor may receive substantially less than the original principal. The investor is anticipating a stable price for the underlying asset and is not able to participate in any increase in the value of the underlying asset.
If the investor was anticipating an increase in the value of the underlying asset, buying this asset would be more suitable. Any change in the value of the issuer’s common stock will have little impact on the value of a reverse convertible security.
Long-term certificates of deposit (CDs) have which of the following characteristics?
They may only be sold by broker-dealers that are subsidiaries of banks
They’re considered risk-free investments
They may be sold prior to maturity at a price that’s different from the client’s original cost
They’re not subject to interest-rate risk since the principal is insured by the FDIC
They may be sold prior to maturity at a price that’s different from the client’s original cost
Long-term CDs have a maturity of more than one year. Since the securities are traded in the secondary market, changes in interest rates will cause price fluctuations. If sold prior to maturity, a CD investor may experience a gain or loss. Long-term CDs are issued by banks, but may be sold by any type of broker-dealer. The FDIC provides protection of up to $250,000.
Which of the following factors is LEAST important when recommending a long-term brokered CD to a client?
The CD was issued by a bank that’s located in a different state from where the client lives.
The CD has a feature in which the interest rate is based on a percentage increase in an equity index.
The client will be purchasing the CD in a retirement account.
The firm may make a market in this CD, but is not obligated to do so.
The CD was issued by a bank that’s located in a different state from where the client lives.
The state in which the client or issuing bank is located is not an important factor when recommending a long-term brokered CD. The features that establish the interest rate of the security, such as an index of fixed-income or equity securities, is relevant to the client. The amount of FDIC insurance and tax considerations are different depending on whether the CD is purchased in a retirement account. In addition, a broker-dealer is not required to maintain a secondary market or act as a market maker in a CD that was sold to the client. This will limit the liquidity of the security if the client needs the funds prior to maturity.
A 4% 10-year bond is convertible at $40. If the common stock is currently trading at $46 per share, what’s the parity price of the bond?
$25
$1,840
$1,000
$1,150
$1,150
The first step is to find the conversion ratio. The formula for calculating the conversion ratio is Par ÷ Conversion Price. In this case, the conversion ratio is 25 shares ($1,000 par ÷ $40 conversion price). To find the parity price of the bond, the next step is to multiply the stock’s current price by the conversion ratio, which is $1,150 per share ($46 share price x 25 share conversion ratio).
A convertible bond has a conversion price of $50 and is currently selling in the market at $975. The conversion ratio is:
20
19.5
40
38
20
The formula for calculating the conversion ratio of a convertible bond, the bond’s par value is divided by the conversion price. In this question, the conversion ratio is 20 shares, or 20:1 ($1,000 par ÷ $50 conversion price). To calculate the conversion ratio, the market price of the bond is irrelevant.
A 7% convertible bond has a conversion ratio of 50. The bond has a non-dilutive feature and the common stock is selling at $53 per share. If the company distributes a 25% stock dividend, which of the following statements is TRUE regarding the convertible bond?
The conversion ratio remains at 50, but the conversion price is reduced.
The conversion ratio increases to 62.50 and the conversion price remains constant.
The conversion price decreases to $16 and the conversion ratio remains the same.
The conversion price decreases to $16 and the conversion ratio increases to 62.50.
The conversion price decreases to $16 and the conversion ratio increases to 62.50.
A non-dilutive feature requires that the conversion features be adjusted if there’s a stock split or stock dividend. The conversion ratio will be increased and the conversion price will be reduced. The new conversion ratio will be 25% more than the old ratio, which means that it’s now 62.5 (50 old ratio x 25% stock dividend = 12.5 additional shares; 50 old ratio + 12.5 additional shares = 62.5 new ratio). The new conversion price is the par value of the bond divided by the new conversion ratio, which is $16 ($1,000 par ÷ 62.50 conversion ratio).
A corporate bond that has no specific collateral backing it and is guaranteed by the full faith and credit of the issuing corporation is referred to as a(n):
Debenture
Guaranteed bond
Income bond
Equipment trust certificate
Debenture
A corporate bond that has no specific collateral backing it and is guaranteed by the full faith and credit of the issuing corporation is referred to as a debenture. A strong, financially sound, well regarded company is able to borrow money backed by its full faith and credit and its reputation and doesn’t need to provide collateral as a guarantee.
The minimum denomination for negotiable certificates of deposit is:
$1,000
$5,000
$10,000
$100,000
$100,000
The minimum denomination for negotiable CDs is $100,000. Typical denominations are often $1,000,000 or more.
Which of the following securities are BEST described as collateralized loans?
Open-end investment company shares
Eurodollar bonds
Yankee bonds
Repurchase agreements
Repurchase agreements
In a repurchase agreement (repo), a dealer sells securities to another dealer or investor and agrees to buy them back at a specific time and price. In effect, the selling dealer borrows money from another party and collateralizes the transaction with the securities. The other side is lending money and is receiving interest from the dealer that created the repo.
If a corporate bond is referred to as guaranteed, it’s secured by:
Mortgages
The U.S. government
Another corporation
Loans that are held by other financial institutions
Another corporation
Guaranteed bonds are secured by the corporation’s own collateral as well as a guarantee by another corporation (which is often a parent company). Bonds that are backed by loans of other financial institutions are considered asset-backed securities (ABS).
Which of the following investments is NOT considered a money-market instrument?
U.S. Treasury bills
Money-market mutual funds
Banker’s acceptances
Commercial paper
Money-market mutual funds
Money-market securities are defined as debt instruments with less than one year until maturity. Money-market mutual funds are a type of investment company that represent an ownership in a portfolio of money-market securities. In other words, what’s in the fund are money-market instruments; however, the fund itself is not a money-market instrument. Banker’s acceptances are money-market securities that are used to facilitate foreign trade. U.S. Treasury bills and commercial paper are both short-term debt instruments and are also considered money-market instruments.
If a corporation is in liquidation, the holder of a subordinated debenture is paid:
Before bank loans and before accounts payable
Before bank loans and after accounts payable
After bank loans and before accounts payable
After bank loans and after accounts payable
After bank loans and after accounts payable
In the liquidation of a corporation, the subordinated debenture holders are paid after bank loans and after accounts payable or other creditors. The subordinated debenture holders are paid after all other creditors, but still before preferred and common stockholders.
A corporation will be considered in default if it fails to pay interest on all of the following bonds, EXCEPT a(n):
Second mortgage bond
Debenture
Subordinated debenture
Income bond
Income bond
Interest on an adjustment (income) bond is only required to be paid if the corporation has sufficient income. Interest on all other debt securities must be paid regardless of the corporation’s income.
Repurchase agreements (repos) and reverse repos are MOST LIKELY used by:
A municipality that’s borrowing to build a new highway
Institutions that have a need to borrow on a short-term basis, or have money to lend on a short-term basis
Corporations that are issuing stock to raise money
Importers and exporters in connection with foreign trade that represents money to be paid in the future and is guaranteed by a bank
Institutions that have a need to borrow on a short-term basis, or have money to lend on a short-term basis
In a repurchase agreement, a firm sells securities to another firm and agrees to repurchase them at a specific time and a specific price, which produces an agreed-upon rate of return. In effect, one firm is borrowing money from the other with securities as collateral.
Which of the following money-market securities assists in the financing of importing and exporting operations?
Bankers’ acceptances
Treasury bills
Eurodollar CDs
Revenue anticipation notes
Bankers’ acceptances
Of the choices given, a banker’s acceptance (BA) is the only instrument that’s used as a means of financing foreign trade. Don’t confuse a BA with an ADR (American depositary receipt) which facilitates the trading of foreign securities in U.S. markets. A Eurodollar certificate of deposit pays interest and principal in Eurodollars (U.S. dollars deposited in non-domestic banks) and is not used to finance importing and exporting operations. A revenue anticipation note is a short-term municipal security that’s issued in anticipation of receiving revenues from the federal or state government.
A type of money-market security that’s typically collateralized by U.S. Treasury securities, in which an investor agrees to lend funds to a broker-dealer for a specified time and rate, is referred to as:
Federal funds
A reverse repurchase agreement
LIBOR
A repurchase agreement
A repurchase agreement
In a repurchase agreement (repo), a dealer sells securities (usually T-bills) to an investor and agrees to repurchase them at a specific time and at a specified price. In effect, the dealer is borrowing funds from an investor and securing the loan with securities (a collateralized loan). The investor (the lender) receives the difference between the purchase price and the resale price of the securities in return for making the loan.
If a dealer purchases securities and agrees to sell them back to an investor at a specific date and price, this is referred to as a reverse repo or matched sale. In this situation, the dealer lends funds (with securities as collateral) to the investor and earns the difference in sales prices. Many corporations and financial institutions, as well as dealers, engage in repos and reverse repos. Repos and reverse repos are typically short-term, with most being overnight transactions.
In most cases, the transaction is determined from the dealer’s point of view. In other words, if the dealer is borrowing funds and the customer is lending, it’s a repo. However, if the customer is borrowing funds and the dealer is lending, it’s a reverse repo. If the transaction is between two dealers, determination of whether the transaction is a repo or reverse repo depends on which dealer initiates the transaction.
T/F. In a repurchase agreement (repo), a dealer sells securities (usually T-bills) to an investor and agrees to repurchase them at a specific time and at a specified price.
True
T/F. If a dealer purchases securities and agrees to sell them back to an investor at a specific date and price, this is referred to as a reverse repo or matched sale
True
Which of the following statements BEST describes a banker’s acceptance (BA)?
It facilitates the trading of foreign stocks in the United States.
It helps to finance foreign trade between importers and exporters.
It’s used by a municipal issuer to raise funds in order to meet a seasonal need for cash.
It’s issued by non-domestic banks and is secured by Eurodollar deposits.
It helps to finance foreign trade between importers and exporters.
Bankers’ acceptances (BAs) help facilitate foreign trade. On the other hand, ADRs permit the trading of foreign stocks in the United States.
A 10-year bond is currently priced at 105 and has a conversion price of $25. The company’s common stock is currently trading at $27 per share. What’s the parity price of the stock?
$25
$27
$26.25
$40
$26.25
The first step is to find the conversion ratio. The formula for calculating the conversion ratio is Par ÷ Conversion Price. In this case, the conversion ratio is 40 shares ($1,000 par ÷ $25 conversion price). To find the parity price of the stock, the next step is to divide the bond’s current price by the conversion ratio, which is $26.25 per share ($1,050 bond price ÷ 40 share conversion ratio). In other words, since the bond is currently trading at $1,050 and the investor would receive 40 shares upon conversion, the stock must be trading at $26.25 for the overall value to equal $1,050 (40 shares x $26.25).
When a corporation declares bankruptcy, what’s the priority of payment?
Preferred shareholders, secured bondholders, debenture holders, common shareholders
Debenture holders, secured bondholders, common shareholders, preferred shareholders
Common shareholders, preferred shareholders, secured bondholders, debenture holders
Secured bondholders, debenture holders, preferred shareholders, common shareholders
Secured bondholders, debenture holders, preferred shareholders, common shareholders
When a corporation declares bankruptcy, secured bondholders are paid first, then payments are made to unsecured bondholders (e.g., debentures). After the creditors (i.e., bondholders), preferred shareholders are paid, with the common shareholders being paid last.
An investor holds a debenture that was issued by XYZ Corporation. If XYZ is in the process of being liquidated, the investor’s claim to payments would be:
Before secured bondholders, preferred stockholders, and common stockholders
Before preferred and common stockholders, but after secured bondholders
Before common stockholders, but after secured bondholders and preferred stockholders
After secured bondholders, preferred stockholders, and common stockholders
Before preferred and common stockholders, but after secured bondholders
When a corporation is liquidated, investors are generally paid from the proceeds in the following order:
1. Secured bondholders
2. Unsecured bondholders (e.g., investors who own debentures)
3. Preferred stockholders
4. Common stockholders
A convertible bond is selling in the market at $987.30 and is convertible at $80. XYZ common stock’s market price is 87.50. The bond is callable at 100. Which of the following is the MOST attractive alternative for a holder of the bond?
Sell the bond
Convert to common and sell the common
Allow the bond to be called
Convert common stock to a bond
Convert to common and sell the common
The bondholder could sell the bond and receive $987.30. If converted, the bondholder would receive 12.5 shares ($1,000 par ÷ $80 conversion price) with a total value of $1,093.75 (12.5 shares x $87.50 stock price). Ultimately, the most attractive alternative is to convert the bonds and sell the stock for $1,093.75.
A corporation has raised money to use for the expansion of its plant within the next six months. In which of the following securities should the corporation invest the funds until they’re needed?
High-quality commercial paper
Long-term municipal zero-coupon bonds
U.S. Treasury bonds
High-quality preferred stocks
High-quality commercial paper
Because the corporation intends to use the money in a short period, it doesn’t want to assume undue investment risks. Of the choices given, the most suitable investment is high-quality commercial paper since it’s extremely safe and can be purchased with a short maturity to match the corporation’s needs.
A corporate bond that’s not secured by any specific assets and only the full faith and credit of the corporation is referred to as a(n):
Collateral trust bond
Debenture
Equipment trust certificate
Mortgage bond
Debenture
An unsecured corporate bond is referred to as a debenture. Collateral trust bonds, equipment trust certificates, and mortgage bonds are all types of secured debt.
