FINE 2000 Study Guide - Midterm Guide: Risk-Free Interest Rate, Risk Premium, Yield Curve

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16 Jul 2016

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Must discount the expected future cash flows at an appropriate discount rate. Price of bond = pv of coupon payments + pv of principle r = discount rate; required rate of return, ytm, cost of capital. Discount rate is made up of risk free rate + risk premium. Risk free rate is return on us gov bond b/c that security is considered most safe. Payment at the maturity is called the face value or par value: assume coupon is unless otherwise stated. Annualized rate of return = (annualized coupon income + price change) / investment. Ann coupon income = (1 + period coupon rate)^# of periods. After tax interest income = income(1 -tax rate) After tax capital income = cap gain -cap gain/2(tax rate) Look at sensitivity of price changes for bond yields, as maturity increases. Longer maturity has more volatile price changes for a given change in yield.

Related Questions

The current dividend yield on Clayton's Metals common stock is3.2 percent. The company just paid a $1.48 annual dividend andannounced plans to pay $1.54 next year. The dividend growth rate isexpected to remain constant at the current level. What is therequired rate of return on this stock?

7.25 percent

7.82 percent

8.08 percent

8.75 percent

8.39 percent

Which one of the following is computed by dividing next year'sannual dividend by the current stock price?

total yield

dividend yield

yield to maturity

growth rate

capital gains yield

The bonds issued by Stainless Tubs bear an 8 percent coupon,payable semiannually. The bonds mature in 11 years and have a$1,000 face value. Currently, the bonds sell for $952. What is theyield to maturity?

7.92 percent

9.20 percent

8.69 percent

7.87 percent

8.08 percent

Which one of the following applies to a premium bond?

Coupon rate > yield-to-maturity > current yield.

Coupon rate > current yield > yield to maturity.

Coupon rate < yield to maturity < current yield.

Yield to maturity > current yield > coupon rate.

Coupon rate = current yield = yield-to-maturity.

Please answer all the questions. Thank you.

crimsoncod794

Bond valuation

The process of bond valuation is based on the fundamental concept that the current price of a security can be determined by calculating the present value of the cash flows that the security will generate in the future.

There is a consistent and predictable relationship between a bondâs coupon rate, its par value, a bondholderâs required return, and the bondâs resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bondâs intrinsic value and its par value. These result from the relationship between a bondâs coupon rate and a bondholderâs required rate of return.

Remember, a bondâs coupon rate partially determines the interest-based return that a bond (might/will)...........pay, and a bondholderâs required return reflects the return that a bondholder(would like/is obligated).............to receive from a given investment.

The mathematics of bond valuation imply a predictable relationship between the bondâs coupon rate, the bondholderâs required return, the bondâs par value, and its intrinsic value. These relationships can be summarized as follows:

â¢	When the bondâs coupon rate is equal to the bondholderâs required return, the bondâs intrinsic value will equal its par value, and the bond will trade at par.
â¢	When the bondâs coupon rate is greater to the bondholderâs required return, the bondâs intrinsic value will (be less than/exceed/equal)................ its par value, and the bond will trade at a premium.
â¢	When the bondâs coupon rate is less than the bondholderâs required return, the bondâs intrinsic value will be less than its par value, and the bond will trade (at a premium/at par/at a discount).............................

For example, assume Liam wants to earn a return of 5.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 8.75% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bondâs intrinsic value(Link to the formula : http://q4pws.aplia.com/q4pws/rest/1.0/image/image9594/img.png?data=q4%3AREMOTE_URL%3Ahttp%3A%2F%2Faplia-prod-webjboss-372923237.us-east-1.elb.amazonaws.com%2Fproblemsetassets%2Fq4_export%2Ffinance%2Fq4problems%2F3061500.08.xml%2CV5%2C291%2C1%2CSTUDENT%2CSTUDENT%2C0%2Cq4pws-aplia-7.6.4-G2f8d8babd91356776c6b2ec65d5e2a2153b4d346-B36-2015.12.16-03%3A57-PM-PST&oauth_signature=jG%2Fu63kSgI9xRhXign5JItWfpAQ%3D&oauth_version=1.0&oauth_nonce=3573483745&oauth_signature_method=HMAC-SHA1&oauth_consumer_key=q4-callback&oauth_timestamp=1454953012

Complete the following table by identifying the appropriate corresponding variables used in the equation.

unknown --------------------- variable name ---------------------variable value

A --------------------- (Bondholders required return/Bonds annual coupon payment/Bonds semiannual coupon payment)---------------------($21.88/$65.63/$87.50/$43.75)

B--------------------- (Bonds par value/bonds annual coupon payment/semiannual coupon payment) ---------------------$1000

C--------------------- semiannual required return -------------------- ($5.75/$3.81/$4.38/$2.5)

Based on this equation and the data, it is (reasonable/unreasonable)...................to expect that Liamâs potential bond investment is currently exhibiting an intrinsic value greater than $1,000.

Now, consider the situation in which Liam wants to earn a return of 5.75%, but the bond being considered for purchase offers a coupon rate of 8.75%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ($757/$866/$1407/$1082).................is (equal to/greater than/less than).............................its par value, so that the bond is trading at (par/a discount/a premium)..............................

Given your computation and conclusions, which of the following statements is true?

(a)When the coupon rate is greater than Liamâs required return, the bond should trade at a discount.

(b)A bond should trade at a par value when the coupon rate is greater than Liam's required return

(c) When the coupon rate is greater than Liamâs required return, the bond's intrinsic value will be less than it's par value

(d) When the coupon rate is greater than Liamâs required return, the bond should trade at a premium

Money, Banking, and Financial Markets, 3/e- quiz, Stephen G.Cecchetti, Kermit L. Schoenholtz
Question Details
Pls solve the quiz and EXPLAIN YOUR ANSWERS, I NEED TO LEARN THECALCULATIONS. Thank you.

Multiple Choice Quiz
1
If the annual interest rate is 5% (.05), the price of a one yearTreasury bill would be:
(Hint: T-Bills have $100 face value)
A) $95.00
B) $97.50
C) $95.24
D) $96.10
2
If the annual interest rate is 5%, the price of a three-monthTreasury bill would be:
(Hint: T-Bills have $100 face value)
A) $98.79
B) $95.00
C) $98.75
D) $97.59
3
If a consol is offering an annual coupon of $50 and the annualinterest rate is 6%, the price of the consol is:
A) $47.17
B) $813.00
C) $833.33
D) None of the above
4
A $1000 face value bond purchased for $965.00, with an annualcoupon of $60, and 20 years to maturity has:
A) A current yield equal to 6.22%.
B) A current yield equal to 6.00%.
C) A coupon rate equal to 6.22%.
D) A yield to maturity and current yield equal to 6.00%.
E) A yield to maturity and coupon rate equal to 6.00%.
5
A $1000 face value bond, with an annual coupon of $40, one year tomaturity and a purchase price of $980:
A) Has a current yield that equals 4.00%.
B) Has a coupon rate that equals 4.80%.
C) Has a current yield that equals 4.08% and a yield to maturitythat equals 6.12%.
D) Has a current yield that equals 4.08% and a yield to maturitythat equals 4.0%.
6
If a one year bond has a face value of $100 and is purchased for$94, and is held to maturity:
A) The holding period return will equal the yield tomaturity.
B) The yield to maturity will exceed the holding periodreturn.
C) The yield to maturity will be 6.38%.
D) a and c.
7
A 30-year Treasury bond as a face value of $1,000, price of $1,200with a $50 coupon payment. Assume the price of this bond decreasesto $1,100 over the next year. The one-year holding period return isequal to:
A) -9.17%
B) -8.33%
C) -4.17%
D) -3.79%

8
If a one-year zero-coupon bond has a face value of $100, ispurchased for $94, and is held to maturity:
A) The holding period return will exceed the yield tomaturity.
B) The yield to maturity will exceed the holding periodreturn.
C) The yield to maturity will be 6.38%.
D) The holding period return will be 6.38%.

9
Consider a zero-coupon bond with a $1,100 payment in one year.Suppose the interest rate decreases from 10% to 8%. The price ofthis bond:
A) Increases from $1,000 to $1,018.
B) Increases from $1,000 to $1,375.
C) Decreases from $110 to $88.
D) Decreases from $1,210 to $1,188.
10
Consider a $1,000 face value bond with a $55 coupon payment and 1year to maturity. Calculate the current yield, coupon rate and theyield to maturity if the bond is purchased for $940.
A) Current yield = 5.50%, coupon rate = 5.50%, yield to maturity =12.23%.
B) Current yield = 5.85%, coupon rate = 5.50%, yield to maturity =12.23%.
C) Current yield = 5.85%, coupon rate = 5.00%, yield to maturity =6.38%.
D) Current yield = 5.50%, coupon rate = 5.00%, yield to maturity =6.38%.

11
Consider a $1,000 face value bond with a $55 coupon payment and 1year to maturity. Calculate the current yield, coupon rate and theyield to maturity if the bond is purchased for $1,130.
A) Current yield = 5.50%, coupon rate = 4.87%, yield to maturity =5.00%.
B) Current yield = 5.50%, coupon rate = 5.50%, yield to maturity =-6.64%.
C) Current yield = 4.87%, coupon rate = 5.50%, yield to maturity =-6.64%.
D) Current yield = 4.87%, coupon rate = 5.00%, yield to maturity =-5.00%.

12
If the U.S. government's borrowing needs increase, all otherfactors constant:
A) The demand for bonds will decrease.
B) The price of bonds will increase.
C) The supply of bonds will increase.
D) The yields on bonds will decrease.
13
Consider a two-year, 4.5% coupon bond with a $500 face value thatis originally purchased for $475. Calculate the holding periodreturn of this bond if it is sold after one year at a price of$485.
A) 6.84%
B) 6.50%
C) 11.58%
D) 3.05%
14
Consider a two-year, 8% coupon bond with a $1,500 face value thatis originally purchased for $1,490. Calculate the holding periodreturn of this bond if it is sold after one year at a price of$1,505.
A) 8.67%
B) 9.06%
C) 1.54%
D) 6.38%
15
If the risk on foreign government bonds increases relative to U.S.government bonds, the price of U.S. government bonds should:
A) Not change since U.S. government bonds are free of defaultrisk.
B) Decrease since people will bail out of all governmentbonds.
C) Increase as the demand for these bonds increases.
D) Not be affected because the two types of bonds are traded indifferent markets.

FINE 2000 Study Guide - Midterm Guide: Risk-Free Interest Rate, Risk Premium, Yield Curve

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