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Exam 3: Interest Rates and Security Valuation

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Question 21

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A 10-year annual payment corporate bond has a market price of $1,050. It pays annual interest of $100 and its required rate of return is 9%. By how much is the bond mispriced?

A) $0.00
B) Overpriced by $14.18
C) Underpriced by $14.18
D) Overpriced by $9.32
E) Underpriced by $9.32 PV = 100  PVIFA [9%, 10 yrs] + 1000  PVIF (9%, 10 yrs) = $1064.18

F) A) and B)
G) A) and C)

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Question 22

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A corporate bond returns 12% of its cost (in PV terms) in the first year, 11% in the second year, 10% in the third year and the remainder in the fourth year. What is the bond's duration in years?

A) 3.68 years
B) 2.50 years
C) 4.00 years
D) 3.75 years
E) 3.32 years 3.32 = (12% * 1) + (11% * 2) + (10% * 3) + (67% * 4)

F) B) and D)
G) All of the above

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Question 23

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Ignoring default risk, if a bond's expected return is greater than its required return, then the bond's market price must be greater than the present value of the bond's cash flows.

The interest rate used to find the present value of a financial security is the

The preferred stock of ACE pays a constant $1.00 per share dividend. The common stock of ACME just paid a $1.00 dividend per share, but its dividend is expected to grow at 4% per year forever. ABLE common stock also just paid a dividend of $1.00 per share but its dividend is expected to grow at 10% per year for 5 years and then grow at 4% per year forever. All three stocks have a 12% required return. How much should you be willing to pay for a share of each stock? Which stock will give you the best return? Explain.

How does an increase in interest rates affect a security's duration?

If interest rates increase, the value of a fixed income contract decreases and vice versa.

For a given interest rate change, a 20-year bond's price change will be twice that of a 10-year bond's price change.

A bond that pays interest semiannually has a 6% promised yield and a price of $1045. Annual interest rates are now projected to increase 50 basis points. The bond's duration is 5 years. What is the predicted new bond price after the interest rate change? (Watch your rounding.)

The required rate of return on a bond is

A 10-year annual payment corporate coupon bond has an expected return of 11% and a required return of 10%. The bond's market price is

An investor is considering purchasing a Treasury bond with a 16-year maturity, a 6% coupon and a 7% required rate of return. The bond pays interest semiannually. a) What is the bond's modified duration? b) If annual promised yields decrease 30 basis points immediately after the purchase, what is the predicted price change in dollars based on the bond's duration?

A bond that you held to maturity had a realized return of 8%, but when you bought it, it had an expected return of 6%. If no default occurred, which one of the following must be true?

If an N year security recovered the same percentage of its cost in PV terms each year the duration would be

A 9-year maturity AAA-rated corporate bond has a 6% coupon rate. The bond's promised yield is currently 5.75% and the bond sells for its FPV. The bond pays interest semiannually and has an annual duration of 7.1023 years. a) What is the bond's convexity? b) If promised yields decrease to 5.45%, what is the bond's predicted new price, including convexity? c) Based on your result in b), would you prefer to have a bond with more or less convexity? Explain.

You have 5 years until you need to take your money out of your investments to make a planned expenditure. Right now bonds are promising an 8% return. You buy a 5-year duration bond. After you buy the bond, interest rates fall to 6% and stay there for the full five years. You reinvest the coupons and earn 6%. Will your realized return be more or less than the originally promised 8%? Explain.

An 8-year corporate bond has a 7% coupon rate. What should be the bond's price if the required return is 6% and the bond pays interest semiannually?

An investor owned a 9% annual payment coupon bond for 6 years that was originally purchased at a 9% required return. She did not reinvest any coupons (she kept the money under her mattress). She redeemed the bond at par. What was her annual realized rate of return? What if she did reinvest the coupons but only earned 5% on each coupon? Why are your answers not equal to 9%?

Suppose two bonds of equivalent risk and maturity have different prices such that one is a premium bond and one is a discount bond. The premium bond must have a greater expected return than the discount bond.

At equilibrium a security's required rate of return will be less than its expected rate of return.