Chapter 17

BOND YIELDS AND PRICES

Multiple Choice Questions

Bond Yields

1. One percentage point of a bond yield represents:

a. 1 basis point
b. 10 basis points
c. 100 basis points
d. 1000 basis points

(c, easy)

2. Subtracting the inflation rate from the market interest rate results in an
approximate:

a. inflation-adjusted rate of interest

b. real risk-free rate of interest
c. real risky rate of interest
d. inflation-adjusted yield

(b, moderate)

3. For risk-free securities, the nominal interest rate is a function of:

a. actual and expected inflation rates

b. expected inflation rate and expected return
c. real rate of interest and expected inflation rate
d. market rate of return and real rate of interest

(c, moderate)

4. Under the Fisher hypothesis, if a one point increase in the inflation rate is
anticipated:

a. nominal rates on short-term securities would rise by one point.

b. nominal rates on short-term securities would fall by one point.
c. nominal rates on short-term securities would fall by less than one point.
d. nominal rates on short-term securities would rise by less than one point.

(a, moderate)

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 5. Which of the following regarding the current yield on a bond is not true?

a. The current yield is superior to the coupon rate because it uses market
price instead of face value.
b. The current yield is reported daily in The Wall Street Journal.
c. The current yield does not account for difference between purchase price
and redemption value.
d. The current yield shows the bond’s expected rate of return if held to
maturity.

(d, moderate)

6. The yield to maturity consists solely of interest income if:

a. the bond is a zero coupon bond.

b. the bond was purchased at par.
c. the bond was purchased above par.
d. the bond was purchased below par.

(b, easy)

7. In order to have a yield to maturity greater than the coupon rate, the bond
must be:

a. selling at a discount.
b. selling at par.
c. selling at a premium.
d. a zero coupon bond.

(a, easy)

8. Typically, a yield to call calculation will use:

a. market interest rates rate than the coupon rate.

b. current market price rather than the maturity value.
c. the end of the deferred call period rather than remaining years on the term.
d. all of the above will be used.

(c, moderate)

9. When interest rates rise,

a. bond prices rise.

b. bond prices fall.
c. prices of newly issued bonds are lowered.
d. interest rates of existing bonds are raised.

(b, easy)

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 10. If a bond is callable, this means:

a. the issuer may change the coupon rate.

b. the investor may convert the bond into stock.
c. the issuer may redeem the bond early.
d. the investor may cash in the bond at any time.

(c, easy)

11. The YTM calculation assumes:

a. reinvestment of interest is at the coupon rate.

b. no reinvestment of interest.
c. reinvestment of interest is at YTM rate.
d. reinvestment of interest is at the risk-free rate.

(c, difficult)

12. The face value of most bonds is:

a. $100
b. $500
c. $1000
d. $10,000

(c, easy)

13. The Fisher hypothesis is an approximation of the

a. risk-free interest rate.

b. real risk-free interest rate.
c. inflation rate.
d. risk premium.

(a, moderate)

14. Bonds with deferred call features

a. can be retired at any time prior to maturity on condition that the issuer
gives notice.
b. can only be retired after a specified period following the date of issue.
c. can be retired at any time, but the issuer will have to pay an additional
premium..
d. generally have no call premium.

(b, moderate)

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 15. When calculating the yield-to-call on a bond, the stream of interest
payments is __________ and the par value is replaced by the __________.

a. lengthened to the call period . . . call price.

b. shortened to the call period . . . call price.
c. not used in the calculation . . . current market price.
d. shortened to the call period . . . current market price.

(b, moderate)

16. An increase in reinvestment rate risk

a. is caused by an increase in interest rates.

b. leads to a decline in coupon rates.
c. results from a decline in interest rates.
d. results from an increase in inflation.

(c, difficult)

17. The yield-to-call is like the yield-to-maturity except for the

a. coupon payments and maturity value.

b. number of periods to maturity and maturity value.
c. number of periods to maturity and inflation premium.
d. coupon rate and coupon payments.

(d, moderate)

18. The yield to maturity is 8 percent. If the yield increases by 50 basis

points, the new yield is :

a. 8.005 percent.
b. 8.050 percent.
c. 8.500 percent.
d. 13.000 percent.

(c, moderate)

19. A bond is selling at a discount if the:

a. yield-to-maturity is greater than the coupon rate.

b. yield-to-maturity is less than the coupon rate.
c. market price is greater than the par value.
d. yield-to-call is less than the coupon rate.

(a, moderate)

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 20. The real rate of interest is almost always:

a. the opportunity cost of foregoing consumption.

b. greater than the nominal rate of interest.
c. equal to the nominal rate of interest.
d. easily affected by risk factors.

(a, moderate)

21. The __________ equates the present value of the total future dollars
expected to be available at the end of a specific time period, given certain
assumptions, to the price of the bond.

a. horizon return
b. promised return
c. expected return
d. coupon return

(a, moderate)

22. Find the price of a 10 percent coupon bond with three years to maturity if
the yield to maturity is now 12 percent. Use semiannual discounting.

a. $1196.70 Solution: Use 6 percent and 6 periods

b. $950.85 Price = 50(4.917) + 1000(0.705)
c. $952.20 = 950.85
d. $999.80

(b, difficult)

23. The YTM for a zero-coupon bond with 10 years to maturity and selling for
$450 is

a. 9.00 percent. Solution: YTM = [MV/P]1/2n - 1

b. 8.15 percent. = [1000/450]1/20 – 1
c. 2.22 percent. = 0.04733 per half year
d. 4.07 percent. YTM = 0.04733(2) = 0.0815

(b, difficult)

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 24. If bond investors do not reinvest the coupons received during the life of
the bond, then the

a. RCY will be less than the YTM.

b. RCY will exceed the YTM.
c. nominal yield will be greater than the YTM.
d. current yield will equal the YTM.

(b, difficult)

25. Reinvestment rate risk increases with a ________ coupon rate and a
________ term to maturity.

a. low . . . short
b. low . . . long
c. high . . . long
d. zero . . . short

(c, moderate)

26. Which of the following statements regarding the realized compound yield
(RCY) is true?

a. The RYC will always be higher than the YTM.

b. The RYC will always be lower than the YTM.
c. The RYC does not assume coupons are reinvested at the YTM.
d. The RYC assumes price is below par.

(c, moderate)

Bond Prices

27. Which of the following statements regarding changes in bond prices

relative to changes in market yields is true?

a. Short-term bond prices will increase more than long-term bond prices if
market yields increase.
b. Short-term bond prices will increase less than long-term bond prices if
market yields decrease.
c. Short-term bond prices will increase more than long-term bond prices if
market yields decrease.
d. Short-term bond prices will remain constant and long-term bond prices
will increase if market yields decrease.

(b, difficult)

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 28. Which of the following bonds would you expect to have the greatest price
volatility?

a. 10%, 10 year bond

b. 10%, 5 year bond
c. 5%, 10 year bond
d. 5%, 5 year bond

(c, difficult)

29. Which of the following statements about the risk premium affecting
market interest rates is FALSE? The risk premium

a. is often referred to as the yield differential.

b. is the compensation required for the risk involved.
c. can be zero.
d. is not associated with the issuer's own particular situation.

(d, difficult)

Bond Price Changes

30. All other factors constant, the -------------- of a bond, the shorter the
duration.

a. longer the term

b. higher the coupon rate
c. higher the risk
d. higher the rating

(b, moderate)

31. Duration can be used to:

a. minimize default risk

b. minimize reinvestment risk.
c. minimize interest rate risk.
d. maximize return.

(c, moderate)

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 32. The duration of a zero coupon bond:

a. is less than its term.

b. is equal to its term.
c. is greater than its term.
d. is impossible to determine.

(b, easy)

33. Duration is based upon:

a. future value concepts.

b. compound interest.
c. present value concepts.
d. the Fisher hypothesis.

(c, moderate)

34. Which of the following statements about bond prices is FALSE?

a. Bond price volatility and time to maturity are directly related.

b. A decrease in yields raises prices more than an increase in yields lowers
prices.
c. Bond price fluctuations and bond coupons are directly related.
d. Bond prices move inversely to bond yields.

(c, difficult)

35. Maturity constant, increases in interest rates ___ bond prices by

proportionately __ amounts than decreases in rates ___ bond prices.

a. increase . . . smaller . . . increase

b. decrease . . . smaller . . . increase
c. decrease . . . larger . . . increase
d. increase . . . larger . . . decrease

(b, difficult)

36. Convexity is important in bond analysis because

a. the price-yield relationship is imprecise.

b. the relationship between bond maturity and interest rate changes is
convex.
c. the relationship between bond price changes and duration is an
approximation.
d. bonds have a convex relationship with duration.

(c, moderate)

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 37. Convexity is largest for bonds with _________ coupons, ________
maturities, and ________ yields to maturity.

a. low . . . long . . . low

b. high . . . long . . . low
c. low . . . short . . . low
d. high . . . short . . . high

(a, difficult)

38. Which of the following bond relationships is NOT inverse?

a. Coupon and duration

b. Duration and yield to maturity
c. Interest rate changes and bond prices
d. Duration and maturity

(d, difficult)

39. Duration tells us the

a. actual price volatility from a bond.

b. stated life of a bond.
c. weighted average maturity of a bond.
d. true rate of return to be earned on a bond.

(c, moderate)

40. For all bonds paying coupons, duration is

a. less than maturity.

b. greater than maturity.
c. about equal to maturity.
d. not related to maturity.

(a, easy)

41. With regard to duration, choose the INCORRECT statement.

a. Duration expands with time to maturity but at a decreasing rate.

b. Yield to maturity is directly related to duration.
c. Coupon is inversely related to duration.
d. Duration is a measure of bond price sensitivity to interest rate movements.

(b, moderate)

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 True-False Questions

Bond Yields

1. Treasury bonds are typically used a proxy for the short-term riskless rate.

(F, moderate)

2. The real risk-free rate of interest is the rate that must be offered to
persuade individuals to invest rather than save.

(F, difficult)

3. If the current yield is above the coupon rate, the bond is selling at a
premium.

(F, easy)

4. If two bonds have the same coupon rate and the same term, they will have
the same intrinsic value.

(F, moderate)

5. The horizon return is the bond return to be earned based on assumptions

about reinvestment rates.

(T, moderate, p. 458)

Bond Prices

6. In bond valuation, the appropriate discount rate is the required yield.

(T, moderate)

7. The higher the discount rate used in bond valuation, the lower the bond’s
intrinsic value.

(T, easy)

Bond Price Changes

8. Duration measures the weighted average maturity of a noncallable bond’s

cash flows on a present value basis.

(T, difficult)

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 9. Duration expands with time to maturity at an increasing rate.

(F, difficult)

10. The term used to describe the degree to which duration changes as the
yield to maturity changes is linearity.

(F, moderate)

Short-Answer Questions

Bond Yields

1. What is the reinvestment rate assumption in regard to the yield to

maturity?

(moderate)

Answer: That all receipts of coupon payments are reinvested at the yield to
maturity.

2. Why is the yield to call a more appropriate measure to use for callable
bonds with high coupons rather than the yield to maturity?

(moderate)

Answer: High coupon bonds face a greater chance of being called than low
coupon bonds so investors will more likely to receive the yield to
call than the yield to maturity.

Bond Price Changes

3. What weakness of modified duration does convexity correct?

(moderate)

Answer: Modified duration predictions are linear approximations.

Convexity corrects the answer for the curvature of the price
function.

4. Why does the coupon rate affect the volatility of bond price?

(difficult)

Answer: The higher the coupon rate and payment, other things the same, the
more of the bond’s value comes from the coupon payments and the
less from the maturity value. The coupon payments are received

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 sooner than the maturity value, and, therefore, are affected less by
compounding.

5. For each of the following variables, state whether duration has a direct or
inverse relationship: term to maturity, size of coupon payment, yield to
maturity.

(difficult)

Answer: Term to maturity – direct; size of coupon payment - inverse; yield

to maturity - inverse.

6. How does value of a bond change as it nears its maturity?

(moderate)

Answer: Bond prices will change so that the bond will be worth its face
value on the maturity date.

Critical Thinking/Essay Questions

1. How can duration and convexity assist the portfolio manager in assessing
the interest-rate risk inherent in a bond portfolio?

(difficult)

Answer: The greater the duration and convexity, the greater the interest-rate
risk. Since interest-rate risk is a major source of systematic risk,
this makes the portfolio manager's job easier.

2. What are three reasons that duration is important in bond analysis and
management?

(moderate)

Answer: (a) It measures effective lives of alternative bonds.

(b) It is used in bond management strategies.
(c) It measures bond price sensitivity to interest rate changes.

Problems

1. A 10-year, $1000 corporate bond with a 10 percent coupon rate (interest is

paid semi-annually) is currently selling for $850:

(a) Calculate its current yield.

(b) Calculate its yield to maturity (using a financial calculator)

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 (moderate)

Solution: (a) current yield = coupon______

current market price

= 100/850 = 11.76 percent

(b) = 2 pmts per year, 1000 FV, -850 PV, 20 N, 50 pmt, solve for
interest rate = 12.69 percent

2. Two 10 percent coupon bonds are selling at par. Bond A has a 15 year
maturity and Bond B has a 25 year maturity. If the appropriate required
rate of return for these two bonds drops to 8 percent, calculate the
percentage change in the price of each bond, using a financial calculator.
Assume interest is paid semi-annually.

(difficult)

Solution: Bond A = original price = $1,000; new price = 1000 FV, 8 interest
rate, 50 pmt, 30 N, solve for PV = $1,172.92
Percentage change in price = 1172.92 - 1000
1000 = .1179 = 11.79%

Bond B = original price = $1,000; new price = 1000 FV, 8 interest

rate, 50 pmt, 50 N, solve for PV = $1,214.82
Percentage change = 1214.82 - 1000
1000 = .2148 = 21.48%

3. Calculate the duration of a bond with a 7 percent coupon and a 3-year

maturity currently priced at $1,000. Interest is paid annually.

(difficult)

Solution:

Year Cashflow Present Value PV of CF PV/ Price Year X PV/Price

1 $70 .9346 $65.42 .065 .065

2 $70 .8734 $61.14 .061 .122
3 $1070 .8163 $873.44 .873 2.619
$1000 2.806 years

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