A municipal bond carries a coupon rate of 6.75 and is trading at par

Chapter 2 Asset Classes and Financial Instruments - Solutions

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She has the following information: Girard also wants to determine how the bond's value will change if yield volatility increases. Which of the following choices is closest to what Girard calculates as the value for the callable bond and correctly describes the bond's price behavior as yield volatility increases? Which of the following statements about balancing reinvestment risk and price risk is TRUE? When interest rates: All other things being equal, which one of the following bonds has the greatest duration?

If expected yield volatility increases, the price of a n A. Kirsten Thompson, CFA candidate, is studying the relationships between a bond's coupon rate and the required market yield. Which of the following choices correctly describes the bond and accurately represents the relationship of the bond's market yield to the coupon? Premium bond, required market yield is less than 6. Premium bond, required market yield is greater than 6. Discount bond, required market yield is less than 6.

Jori England, CFA candidate, is studying the value of callable bonds. Which of the following choices is closest to what England calculates as the value for the callable bond? Which of the following statements is TRUE? When a rating agency downgrades a security, the bond's price usually falls. Technical default usually refers to the issuer's failure to make interest or principal payments as scheduled in the indenture. Default risk is important because if a bond issuer defaults, the bondholder likely loses his entire investment.

Which of the following statements about how the features of a bond impact interest rate risk is FALSE? Bond price movements depend upon the direction and magnitude of changes in interest rates. All else equal, a longer-term bond is more sensitive to interest rates than a shorter-term bond. An inverse relationship between interest rates and bond prices means that the greater the change in interest rates, the less the change in fixed-coupon bond prices.

Price compression: Inclusion of a call feature will decrease the duration of a fixed income security. The credit risk spread is measured in relation to a default-free security. Of the choices above, the security with the least chance of default is the Treasury bond. The lowyield corporate bond is a possibility, but it is not likely that this bond is as default-free as the Treasury security. Default risk is the possibility that the issuer will fail to meet its obligations under the indenture, for which investors demand a premium above the return on a default-risk-free security.

Downgrade risk is the risk that a bond is reclassified as a riskier security by a credit rating agency. Reinvestment risk is the risk that the investor will have to reinvest the proceeds available for reinvestment at a lower interest rate than anticipated.

Only amortizing securities with a prepayment option are subject to prepayment risk. Volatility risk only applies to bonds that have embedded options. Liquidity risk can be important even for a bond held to maturity if the portfolio manager needs to mark its holdings to market for performance reporting purposes. Low liquidity for the bond can mean the prevailing price is not an accurate measure of the bond's value. Reinvestment risk becomes more problematic when the current coupons being reinvested are relatively large.

When the foreign currency appreciates, each foreign currencydenominated cash flow buys more domestic currency units-increasing the domestic currency return from the investment. The appreciation of the foreign asset benefits the investor as well. Resetting interest rates makes the bond less, not more, susceptible to interest rate changes. The price of a bond changes in the opposite direction to the change in interest rates.

Long-term, low-coupon bonds are more sensitive than short-term and high-coupon bonds. As yields rise, the value of the embedded put option in a putable bond increases and beyond a critical point reduces the decline in the value of the bond compared to a similar option-free bond. As yields fall, the value of the embedded put option decreases, and beyond a critical point the put-able bond behaves much the same as a similar option-free bond since the embedded put option has little or no value.

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The key term here is coupon bond. While an investor in a fixedcoupon bond can usually eliminate price risk by holding a bond until maturity, the same is not true for reinvestment risk. The receipt of periodic coupon payments exposes the investor to reinvestment risk. An option-free bond's price sensitivity interest rate risk is greater when both the coupon rate and level of market interest are low; price sensitivity is negatively correlated with both factors.

Volatility risk is the risk of that the price of a bond with an embedded option will decline when expected yield volatility changes. Option-free bond is net affected by Volatility risk. To calculate the option value, rearrange the formula for a callable bond to look like: The call option is of value to the issuer, not the holder. A local government regulatory agency introducing more stringent clean-water requirements that will significantly reduce the cash flow of an area paper mill is an example of regulatory risk, which is a type of event risk.

The impact of regulatory risk can be long-term, in that the company may be unable to pass on the increased cost to customers. The 3-year coupon bond fulfills the treasurer's requirement concerning funds for repayment, it does not minimize reinvestment risk. Among the zero-coupon bonds, the one that best matches the loan's maturity will minimize reinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. A bondholder will most likely lose if a bond is called because a bond is most likely to be called in a declining interest rate environment.

The issuer will likely call the bond and replace it with lower cost lower coupon debt. The holder faces prepayment and reinvestment risk, because he must reinvest the bond cash flows into lower-yielding current investments. As interest rates decline, the price of the option-free bond rises. However, the price Of the embedded call option also rises. Consequently, the price of a callable bond rises by less than the price of an otherwise identical option-free bond.

When the issue price is less than par, the bond is selling at a discount. We also know that the current market required rate is greater than the coupon rate because the bond is selling at a discount. Of the three choices, zero-coupon bonds have the least reinvestment risk. An investor can nearly eliminate reinvestment risk by holding a noncallable zero-coupon bond until maturity because zero-coupon bonds deliver all cash flows in one lump sum at maturity. Straight coupon bonds no prepayment or other embedded options have the next most reinvestment risk because of the periodic coupon payments.

If interest rates decline, the bondholder will have to reinvest the coupons at a rate lower than that required to earn the original expected yield-to-maturity. Callable bonds have more reinvestment risk because the right to prepay principal compounds reinvestment risk. A call option is one form of prepayment right that benefits the issuer, or borrower. Mortgage backed and other asset backed securities have the most prepayment risk because in addition to cash flows from periodic interest payments bond coupons , these securities have periodic repayment of principal.

The lower the interest rate, the higher chance that the loans underlying these assets will repay in full.

A year bond with a coupon formula equal to the U. The holder of an adjustable rate asset is impacted less by inflation than the holder of a fixed-rate asset because the increased cash flow from the higher coupon payments when the base rate increases at least partially offsets the decreased purchasing power caused by inflation. The formula for credit spread risk or the yield on a risky asset is: Rearranging this formula results in: The size of the issuing firm, represented by the amount of sales, will play a role in the financial stability of the firm.

However, liquidity and leverage are more directly related to the bond's rating. Smaller firms are not likely to issue bonds and issuers are typically larger firms overall. As yield volatility increases, the value of the call option increases, and the value of the callable bond decreases and thus the bondholder loses. As shown by the equation: Duration of 5. A 25 basis point change would be 5. The yield differential above the return on a benchmark security measures the credit spread risk.

Credit spread risk is also known as the risk premium or spread. The shorter the bond's maturity and the higher the yield to maturity, the shorter the duration and the lower the interest rate risk. Even if an investor intends to hold securities to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time. For example, liquidity is important to institutional investors that must determine market values for net asset values NAVs and to dealers in the repurchase market for collateral valuation.

In a liquid market with large trading volumes, large block trades should not affect prices. All other choices are characteristics of illiquid markets or assets. Treasury securities are the most liquid of the investments mentioned.

The repurchase market is short term in nature and the collateral is marked-to-market daily. Thus, the need to quickly convert securities to cash and at approximately market value is very important. Emerging markets are usually less liquid than established markets, one reason being the small trading volumes. Even if an investor intends to hold the security to maturity, liquidity risk impacts portfolios when marking to market and through changes in investor tastes and preferences over time.

For example, liquidity is important to institutional investors that must determine market values for net asset values NAVs. If the home currency appreciates against the foreign i. If the foreign currency appreciates, a given foreign cash flow will be worth more units of the home currency, thereby benefiting the domestic investor holding foreign securities.

The return on a foreign bond is a combination of the return on the bond and the movement in the foreign currency. In the base case, the movement in the foreign security was 0 and thus the return was just the holding period return on the bond. If the foreign currency depreciates, the return will be lowered because the investor will lose upon conversion to the dollar. Golson most likely forgot to take into account the impact of the percentage change in the dollar value of the foreign currency. Here, since the correct return calculated by Meyer is lower than that calculated by Golson who omitted the impact of foreign exchange , the foreign currency depreciated in relation to the dollar.

The appreciation in the bond value was not enough to offset the currency depreciation, and the total return in dollar terms was negative. Inflation risk refers to the possibility that prices of general goods and services will increase in the economy. Empirical evidence shows that equity securities, or stocks, have the least inflation risk of the investments listed here.

Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. Investors want to be compensated for the inflation they expect plus for the risk that inflation will increase during the term of the investment. Here, the bank's estimated inflation rate is just that-an estimate. Thus, we cannot say for certain that the investor will not lose purchasing power.

Chapter 2 Asset Classes and Financial Instruments - Solutions

Inflation risk introduces uncertainty to the investment process. To calculate the callable bond value, use the following formula: The call option is subtracted from the bond value because the call option is of value to the issuer, not the holder. As yield volatility increases, the value of the embedded option increases. The formula above shows that for a callable bond, an increase in the option value results in a decreased bond value. All else equal, reinvestment risk and price risk move in opposite directions.

For example, when interest rates rise, bond prices decrease, but the loss is at least partially offset by decreased reinvestment risk it is less likely that a bond will be called and bondholders can invest coupon payments at higher yields. If bonds are identical except for maturity and coupon, the one with the longest maturity and lowest coupon wilt have the greatest duration.

The rationale for this is similar to that for price volatility. The later the cash flows are received, the greater the duration. The longer the time to maturity, the greater the duration. A longer-term bond pays its cash flows later than a shorter-term bond, increasing the duration. Here, one of the year bonds will have the greatest duration. The lower the coupon rate, the greater the duration. A lower coupon bond pays lower annual cash flows than a higher-coupon bond and thus has less influence on duration.

Here, the year bond with the lowest coupon 8. Increasing yield volatility increases the value of both put options and call options, which decreases the value of a put-able bond but decreases the value of a callable bond. When the issue price is greater than par, the bond is selling at a premium. We also know that the current market required rate is less than the coupon rate of 6.

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For the examination, remember the following relationships: The market will likely demand a higher yield from the downgraded bond the risk premium has increased and thus the price wilt likely fall. Technical default usually refers to an issuer's violation of bond covenants, such as debt ratios, rather than the failure to pay interest or principal. In the event of default, the holder lender may recover some or all of the investment through legal action or negotiation. The inverse relationship between interest rates and bond prices means that when interest rates increase, fixed-coupon bond prices decrease.

In other words, the inverse relationship means that interest rates and bond prices move in opposite directions, it does not infer anything about the magnitude of the change. When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price, even if interest rates fall considerably.

It is unlikely that investors would pay a price that exceeds the call price. Price compression benefits the issuer, because it allows the issuer to call the bond if interest rates decrease allowing the issuer to replace the existing debt with lower cost debt. For collateralized mortgage obligations CMOs , are prepayment risk and interest rate risk, respectively, different for the various classes tranches of bonds? If an investor wants only investment grade bonds in her portfolio, she would be least likely to purchase a n: A-rated municipal bond. Which of the following statements about debt securities is least accurate?

Commercial paper is a short-term less than nine months vehicle for corporate borrowing. A MTN is a shelf-registered debt instrument that is continually offered to investors by an agent of the issuer and varies in maturity from nine months to over 30 years. A medium-term note MTN differs from a corporate bond in that a MTN is sold to investors on a "firm commitment" basis wherein the investment banker guarantees a price to the issuer.

Which of the following statements regarding mortgage-backed securities MBS and collateralized mortgage obligations CMOs is most likely correct? Creating CMOs does not reduce the overall prepayment risk of a mortgage pass through security. The prepayment option of an MBS benefits the security holder.

Which of the following statements about debt securities is most likely correct? A collateralized mortgage obligation is a derivative of a passthrough security with a payment structure that redistributes risk among investors in various tranches. Insured bonds are bonds collateralized by an escrow of securities guaranteed by the U. Tax-backed municipal bonds are supported through revenues generated from projects that are funded in whole or in part with the proceeds of the original bond issue. An investor is considering floating-rate debt and other investments to protect against unexpected increases in inflation.

The friend also states on-the-run Treasury issues have narrower bid-ask spreads than other Treasury issues. Should the investor agree or disagree with the friend's statements about TIPS and on-the-run issues? Disagree Agree A. For an asset-backed security ABS , a special purpose vehicle: Which of the following statements about different types of bonds is least likely correct? Municipal bonds are traded primarily on the New York Stock Exchange.

Solved: 1. A Municipal Bond Carries A Coupon Rate Of % | stuntmomfilm.com

Tax-backed bonds are backed by the full faith and credit of the issuer's entire taxing power. Government-sponsored enterprises issue securities directly in the marketplace, but federally related institutions generally do not. Government National Mortgage Association. Student Loan Marketing Association. Federal National Mortgage Association. Which of the following institutions are federally-related institutions? The annual Fixed Income Analysts' Forum had just ended and two attendees, James Purcell and Frederick Hanes, were discussing some of the comments made by the panelists.

Purcell and Hanes were specifically concerned with the following two statements that were made: Panelist 1: Mortgage-backed securities and asset-backed securities are both fixed income securities that are backed by pools of loans and are said to be amortizing securities. For many of the loans, no principal payments are required to be made prior to the maturity date. These securities are said to have a bullet maturity structure. Panelist 2: If coupon Treasury bonds or corporate bonds are issued with the terms specifying that the principal be repaid over time at the option of the issuer, then these bonds are putable bonds; if the principal is to be repaid over time at the option of the bondholder, then the bonds are termed callable bonds.

Are the statements made by Panelist 1 and Panelist 2 correct? Incorrect Incorrect A. When bonds are sold in a bought deal, the transaction takes place on the: Which of the following does NOT represent a secondary market offering? When bonds are sold: Which of the following does NOT represent a primary market offering? A debt security that is collateralized by various corporate bonds would be a n: Which of the following statements regarding sovereign bonds is least accurate?

When a central government issues securities, those securities can only be denominated in the local currency regardless of where the bonds are issued. A central government can issue sovereign bonds in its national bond market, in another country's foreign bond market, or in the Eurobond market. Although the currency denomination of a government security is generally that of the home country, a central government's bonds will be rated by bond rating agencies as to perceived credit risk.

A CDO issued to profit on the spread between the return on the underlying assets and the return paid to investors is referred to as a n: A corporation may issue asset backed securities because: All of the reasons are valid. The asset-backed pool may be overcollateralized to provide a credit enhancement. The assets are typically placed in a special purpose vehicle to shield them from the firm's creditors. ABSs typically have lower debt ratings than the firm's other borrowings. There are several types of external credit enhancements. Which of the following is a general problem associated with external credit enhancements?

External credit enhancements: The issuance of asset backed securities ABSs versus straight debt would be desirable if: To reduce the cost of long-term borrowing, a corporation with a below average credit rating could: Which of the following reasons is the best reason NOT to enhance the credit quality of an asset backed security ABS pool? Which of the following statements about asset backed securities ABSs is most accurate?

The credit rating of an ABS must be the same as that of the issuer. Residential mortgages represent the largest type of asset that has been securitized. There is an inverse relationship between credit enhancements and ratings. Which of the following statements about special purpose vehicles SPVs is least accurate?

SPVs are also known as bankruptcy remote entities and allow the asset backed security pool to have a higher credit rating than the issuing entity. SPVs shield the assets of the asset backed security from creditors. They are only used in asset backed security transactions. Which of the following statements about special purpose vehicles SPVs is most accurate? SPVs have no role in the asset backed credit rating process. SPVs are used exclusively for asset backed transactions.

If bankruptcy occurs, a judge could rule that the SPVs assets can be considered general assets of the corporation. Which of the following entities play a critical role in the ability to create an asset backed security with a higher credit rating than the corporation? Rating agencies. Investment banks. Special purpose vehicles SPVs. A CMO: Paul Blackburn is describing mortgage backed securities and makes the following statements: A mortgage pass-through security is formed by pooling a large number of mortgages and issuing certificates that represent ownership shares in the pool.

Because each mortgage borrower has the right to prepay the mortgage, the value of a passthrough security behaves as if the security has an embedded put feature. A collateralized mortgage obligation with sequential tranches is created by pooling mortgage pass-through certificates. Securities are issued in different tranches that have proportionate claims on the cash flows from the pass-through certificates.

Are Blackburn's statements correct? Which of the following statements accurately describes direct and dealer paper? The majority of direct paper issuers are financial companies. Direct paper is rated, whereas dealer paper is not. Direct paper tends to incur more issue costs versus dealer paper. Which of the following statements concerning taxable bonds is TRUE? Corporates have the lowest yields, followed by Treasuries, then by corporates, which provide the highest returns.

Treasuries have the lowest yields, followed by corporates, then by agencies, which provide the highest returns. Treasuries have the lowest yields, followed by agencies, then by corporates, which provide the highest returns. Support for the revenue bonds comes from: Issuers of revenue bonds are not always obligated to pay principal and interest. Interest on some municipal bonds is not excluded from federal income taxes.

In a competitive Treasury-bill auction, not all bidders pay the same price. Consider three municipal bonds issued by the Greater Holmen Metropolitan Capital Improvement District, a local authority that carries an issuer rating of single-A from the major debt rating agencies. All three bonds have the same coupon rate and maturity date. Series W was issued to finance the rebuilding and expansion of local schools and is backed by the District's authority to levy property tax. Series X was issued to build a water purification plant for the region. The District charges fees to the surrounding municipalities for their use of the plant.

These fees are the only source of the interest and principal payments on the bonds. Series Y was issued to raise funds for the general use of the District in its ordinary maintenance projects and is backed by the District's authority to levy property tax. These bonds carry a third party guarantee of principal and interest payments. What is most likely the order of the market yields on these three bond issues, from highest to lowest? A municipal bond guarantee is a form of insurance provided by a third party other than the issuer.

Revenue bonds have lower yields than general obligation bonds because there are more revenue bands and they have higher liquidity. Bonds with municipal bond guarantees are more liquid in the secondary market and generally have lower required yields. The corporate bond sector is more important in the US than in Japan and Germany.

The equivalent taxable yield is: The coupon rate on a tax- exempt bond is 5. Both bonds sell at par. At what tax bracket marginal tax rate would an investor be indifferent between the two bonds? If the after-tax yields are equal, then: Why do most professionals consider the Wilshire a better index of the performance of the broad stock market than the Dow Jones Industrial Average? LO 2- 2 While the DJIA has 30 large corporations in the index, it does not represent the overall market nearly as well as the more than stocks contained in The Wilshire index. The DJIA is just too small. The Federal funds rate?

TED Spread? The Fed funds rate is the rate of interest on very shortterm loans among financial institutions in the U. Why are corporations more apt to hold preferred stock than are other potential investors? Which gives you the higher after- tax yield if your tax bracket is: LO 2- 1. The taxable bond. The after-tax yield of taxable bond is the same as that of the municipal bond. Stock C would sell for Zero b. In the absence of a split. With a zero tax bracket. Consider the three stocks in the following table. Calculate the rate of return on a price.

Calculate the rate of return of the price. The after-tax yield for the taxable bond is: What must happen to the divisor for the price. What is Donnelly's main line of business? Now go to Key Statistics. How many shares of the company's stock are outstanding? What is the total market value of the firm? What were its profits in the most recent fiscal year?

Shares Outstanding: What Is its mission? What information and advice does it offer to beginners? FINRA is dedicated to investor protection and market integrity through effective and efficient regulation of the securities industry. Before undertaking any investment program, though, it is critical that you assess your current situation and form goals. You'll need to take an accurate measurement of your finances to determine how much you can invest reasonably. Then you'll need to ask yourself a few key questions: What are your goals and what will they cost? When do you want to achieve each goal?

What is its mission? IOSCO develops, implements, and promotes adherence to internationally recognized standards for securities regulation, and is working intensively with the G20 and the Financial Stability Board FSB on the global regulatory reform agenda.

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