CHAPTER 5

TRUE-FALSE QUESTIONS

(F) 1. The coupon rate is always the same as the market rate of interest for a bond.
(T) 2. The price of a bond and the market rate of interest are inversely related.
(F) 3. The price of a bond is the present value of future payments discounted at the coupon
rate.

(T) 4. Yield to maturity assumes reinvestment of coupons at the same yield.

(T) 5. The realized yield may be influenced by coupon reinvestment rates.

(F) 6. If market interest rates have increased since a bond was purchased the coupon rate will
also increase.
(T) 7. A zero coupon bond has no reinvestment risk.

(T) 8. The higher the coupon rate, the lower the bond price volatility.

(T) 9. Price risk is an aspect of bond volatility.

(F) 10. Short-term bonds have greater price risk compared to long-term bonds.

(T) 11. The price risk of a bond tends to offset reinvestment risk somewhat as market interest
rates vary.

(T) 12. A short-term bond’s price risk is not as large as a long term bond’s price risk.

(T) 13. Price risk is one aspect of interest rate risk.

(T) 14. Price risk is of no concern to the investor if the bond is held to maturity.

(F) 15. Duration is a measure of interest rate volatility.

(T) 16. The duration of a zero coupon bond equals the term to maturity of the bond.

(T) 17. The duration of a coupon bond must be shorter than its term to maturity.

(F) 18. If the coupon rate equals the market rate, a bond is likely to be selling at a discount.

(F) 19. Once bonds are issued, the coupon rate varies inversely with bond prices.

(F) 20. Bonds with lower coupon rates have a shorter duration than similar bonds with high
coupon rates.

(F) 21. Curation matching eliminates the risk to an investor’s real rate of return.

(F) 22. Duration matching eliminates all risk.

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(F) 23. A zero-coupon bond bears no interest.

(T) 24. Expected yield is essentially a forecast.

(F) 25. A bond with a 9% coupon and a 10% required return will sell at a premium to par.

(F) 26. Ceteris paribus, the holder of a fairly priced premium bond must expect a capital gain
over their holding period.

(T) 27. The higher the starting interest rate the lower the bond’s price sensitivity.

(T) 28. All else equal, the greater a security's coupon, the lower the security's price sensitivity
to a change in interest rate.

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 MULTIPLE CHOICE QUESTIONS

(b) 1. Which of the following statements is true?

a. Bond prices and interest rates move together.
b. Coupon rates are fixed at the time of issue on standard bonds.
c. Short-term securities have large price swings relative to long-term securities.
d. The higher the coupon, the lower the price of a bond.

(a) 2. Which of the following statements is true about bonds?

a. The higher the coupon rate, the shorter the duration.
b. The yield on a bond is usually fixed.
c. A bond's coupon rate is equal to its face value.
d. Most bonds pay interest annually.

(c) 3. $5,000 invested at 6%, compounded quarterly, will be worth how much after 5 years?
a. $6,691
b. $16,036
c. $6,734
d. $5,386

(a) 4. Tom deposits $10,000 in a savings deposit paying 4% compounded monthly. What
amount would he have at the end of seven years?
a. $13,225
b. $13,159
c. $13,179
d. $13,325

(c) 5. Judy would like to accumulate $70,000 by the time her son starts college in ten years.
What amount would she need to deposit now in a deposit account earning 6%,
compounded yearly, to accumulate her savings goal?
a. $4,200
b. $39,513
c. $39,088
d. $125,359

(c) 6. If a $1000 par value bond has an 8% coupon (annual payments) rate, a 4-year maturity,
and similar bonds are yielding 11%, what is the price of the bond?
a. $1,000.00
b. $880.22
c. $906.93
d. $910.35

(a) 7. A corporate bond, paying $65 interest at the end of each year for 6 years, has a face
value of $1,000. If market rates on newly issued similarly rated corporate bonds are
now 7.5%, what is the current market price of this bond?
a. $953.06
b. $1,000.00
c. $1,048.41
d. $936.42

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(c) 8. A $1000 bond with an 8.2% coupon rate, interest paid semiannually, and maturing in
six years is currently yielding 7.6% in the market. What is the current price of the
bond?
a. $1,027.08
b. $1,131.19
c. $1,028.48
d. $972.00

(b) 9. A $1000 bond with a coupon rate of 7% matures in eight years. The bond is now
selling for $950, what is the expected yield to maturity on the bond?
a. 6.5%
b. 7.9%
c. 9.0%
d. 8.3%

(c) 10. A $1000 bond with a coupon rate of 10%, interest paid semiannually, matures in eight
years and sells for $1120. What is the yield to maturity?
a. 10.8%
b. 11.0%
c. 7.9%
d. 7.6%

(c) 11. When a bond's coupon rate is equal to the market rate of interest, the bond will sell for
a. a discount.
b. a premium.
c. par.
d. a premium or discount depending on maturity

(b) 12. A bond currently selling at a premium price above face value
a. has a yield equal to its coupon rate.
b. has a yield below its coupon rate.
c. has a yield above its coupon rate.
d. has no risk.

(c) 13. If market interest rates fall after a bond is issued, the
a. face value of the bond increases.
b. investor will sell the bond.
c. market value of the bond is increasing.
d. market value of the bond is decreasing.

(d) 14. Duration is a measure of

a. a bond's price.
b. a bond's contractual maturity.
c. the bond’s reinvestment risk.
d. bond price volatility.

(a) 15. Bond A has a duration of 5.6 while bond B has a duration of 6.0. Bond B
a. will have greater price variability, given a change in interest rates, relative to
bond A.
b. will have a longer maturity than bond A.
c. will have a higher coupon rate than bond A.

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 d. will have less price variability, given a change in interest rates, relative to bond
A.

(a) 16. A 3-year zero coupon bond selling at $900 and yielding 12.18 percent has a duration of
a. 3 years.
b. 2.78 years.
c. 2.50 years.
d. 2 years.

(a) 17. A $1000 2-year 10% coupon bond is priced at $1000 in the market. The duration is
a. less than two years.
b. more than two years.
c. 10%.
d. 2 years.

(b) 18. The duration of a $1000, 2-year, 7% coupon bond (interest paid annually) is _____
when market rates are 8%?
a. 2.036
b. 1.934
c. 1.902
d. 1.856

(c) 19. As bond maturity _________, so does the _________ and ________.
a. decreases; coupon rate; price volatility.
b. decreases; duration; face value.
c. increases; duration; price volatility.
d. increases; risk; coupon rate.

(a) 20. In a fixed-rate bond, the variable which changes to give investors the market rate of
return is the
a. price.
b. coupon rate.
c. coupon amount.
d. face value.

(d) 21. A $1,000 par, 8% Treasury bond maturing in three years is priced to yield 7%. Its
market price (assuming semiannual compounding) is
a. $974.21
b. $813.50
c. $927.50
d. $1,026.64

(b) 22. Which of the following risks will not affect zero coupon bonds?
a. price risk
b. reinvestment risk
c. credit risk
d. default risk

(c) 23. A bond yield measure should capture all of the following except
a. coupon payments.
b. reinvestment income.

49
 c. changing coupon rate levels.
d. capital gains or losses.

(a) 24. The yield to maturity measure assumes that coupon interest is reinvested at
a. the yield to maturity.
b. the changing market rates.
c. the coupon rate.
d. the treasury bond rate.

(d) 25. Calculate the realized return on a $1,000 face value, 9 percent coupon bond (annual)
purchased for $800 and sold one year later for $850.
a. 9%
b. 11.25%
c. 14.5%
d. 17.5%

(b) 26. If a 7% coupon (semiannual) bond purchased at par sells 2 years later for $990, what is
the realized rate of return (annualized)?
a. 8%
b. 6.52%
c. 7.32%
d. 5.75%

(c) 27. Calculate the percentage volatility of a $1,000 face value 8% coupon bond whose price
has varied from $1,020 to $1,050.
a. 30
b. 5
c. 3
d. 50

(d) 28. Which of the following statements is true?

a. Bond prices vary directly with interest rates.
b. Bond price volatility varies inversely with maturity.
c. Low coupon bonds have lower bond volatility than high coupon bonds.
d. At higher interest rates bond price volatility is less.

(c) 29. Interest rate risk is

a. measured by duration.
b. the extent that coupon rates vary with time.
c. the potential variability in the realized rate of return caused by changes in market
rates.
d. the potential variability in the bond maturity caused by changing discount rates.

(a) 30. Price risk and reinvestment risk

a. offset one another to a certain extent as interest rates change.
b. are two bond risks related to credit risk.
c. work together to magnify the price impact of a change in interest rate.
d. are nonexistent on zero coupon bonds that are not held to maturity.

(b) 31. Jane needs to guarantee she earns the current promised yield. She should invest in
a. high quality, 20 year bonds.

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 b. high quality coupon bonds with a duration of five years.
c. high quality coupon bonds maturing in five years.
d. high credit risk bonds maturing in less than five years.
(c) 32. Which of the following statements about duration is true?
a. Short duration bonds are always preferable to long duration bonds.
b. The duration of a bond is some time longer than the maturity of the bond.
c. Duration is the investment period necessary to offset price risk and reinvestment
risk.
d. A bond sold at the duration point will always be priced at $1,000.

(b) 33. What is the price of a $1,000 face value bond with a 10% coupon if the market rate is
10%?
a. more than $1,000
b. $1,000
c. less than $1,000
d. cannot determine without know the maturity

(c) 34. What is the price of a $1,000 face value bond with a 10% coupon if the market rate is
10% and the bond matures in 5 years? (Assume semiannual compounding).
a. $829.60
b. $1,000.00
c. $926.40
d. $1,040.80

(b) 35. Tom purchased a bond last year for $1,240, received $60 in interest return, and sold the
bond for $1300 one year later. What is Tom's realized annual rate of return?
a. 4.8%
b. 9.7%
c. 9.2%
d. More than 10%.

(c) 36. The bond yield to maturity calculation is

a. the guaranteed rate of return to an investor.
b. the same as the coupon rate.
c. the expected rate of return on the bond.
d. the realized rate of return on the bond.

(c) 37. An investor worried about interest rate risk should

a. not purchase coupon bonds.
b. select bonds whose maturity matches the investor's investment holding period.
c. select bonds whose duration matches the investor's investment holding period.
d. invest only in U.S. Treasury bonds.

(d) 38. An investor who selects coupon bond maturities matching his/her holding period
a. has eliminated price risk, but not reinvestment risk.
b. has eliminated just one part of interest rate risk.
c. cannot precisely predict the rate of return on the bond.
d. All of the above.

(c) 39. Reinvestment risk is the variability of return associated with

a. the variability of bond maturities.

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b. the variability of bond coupon payments.
c. the variability of rates of return on reinvested coupons.
d. the variability of the market price on the bond.

52
(c) 40. In today’s dollars a bond returns 5% of the investor’s price paid in the first year, 4% in
the second year, 3% in the third year and the rest in the fourth year. What is the bond’s
duration?
a. 4.00 years
b. 3.86 years
c. 3.74 years
d. 3.65 years

(a) 41. If an investor has a 5 year investment horizon and chooses a 6 year duration bond and
interest rates fall then the investor has a potential return
a. greater than the expected return.
b. equal to the expected return.
c. less than the expected return.
d. equal to the promised yield to maturity.

(c) 42. If an investor has a 6 year investment horizon and chooses a 4 year duration bond and
interest rates fall then the investor has a potential return.
a. greater than the expected return.
b. equal to the expected return.
c. less than the expected return.
d. equal to the promised yield to maturity.

(d) 43. If a bond investor receives all the coupon payments on time and the face value on the
contract maturity date, investor's return could still vary because of
a. default risk
b. price risk
c. liquidity risk
d. reinvestment risk.

(d) 44. The two main factors that affect interest rate risk are
a. default risk and reinvestment risk.
b. liquidity risk and reinvestment risk.
c. price risk and political risk.
d. price risk and reinvestment risk.

(c) 45. The sum of time weighted discounted cash flows divided by the price of the security is
the
a. volatility of the security.
d. present value of the security cash flows.
c. duration of the security.
d. always greater than the maturity of the security.

(c) 46. An increase in market interest rates will

I. reduce bond sale prices
II. increase bond sale prices
III. increase reinvestment income
IV. decrease reinvestment income

a. I and IV only
b. II and III only
c. I and III only

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 d. II and IV only.

(b) 47. If an investor has a 6 year investment horizon and chooses a bond with a 10 year
duration then if interest rates increase one time then
a. the bond’s sale price drop will be less than the extra reinvestment income.
b. the bond’s sale price drop will be more than the extra reinvestment income.
c. the bond’s sale price increase will be less than the lost reinvestment income.
d. the bond’s sale price increase will be more than the lost reinvestment income.

(d) 48. In a fixed rate bond, the variable which changes to provide the current market rate of
return to investors is
a. face value
b. coupon rate
c. maturity
d. price

(b) 49. All of the following are contractually fixed except

a. par value
b. yield
c. maturity
d. coupon

(c) 50. If an investor has an 8 year investment horizon and chooses a bond with a 6year
duration then if interest rates decrease one time then
a. the bond’s sale price drop will be less than the extra reinvestment income.
b. the bond’s sale price drop will be more than the extra reinvestment income.
c. the bond’s sale price increase will be less than the lost reinvestment income.
d. the bond’s sale price increase will be more than the lost reinvestment income.

(b) 51. As maturity increases a bond’s duration

a. increases at an increasing rate
b. increases at a decreasing rate
c. decreases at an increasing rate
d. decreases at a decreasing rate

Use the following information for questions 52-54.

A 10-year semiannual payment bond with a par value of $1,000 has a 7% coupon annual rate.
Currently this bond is selling at par. Use the above information to answer the following three
questions.

(d) 52. What is the duration of this par bond?

a. 10.00 years
b. 8.392 years
c. 8.452 years
d. 7.355 years

(c) 53. If the Federal Reserve announces a QE and, therefore, interest rates unexpectedly fall. This
bond’s YTM drops by 100 basis points. What is the new duration?
a. 10.00 years
b. 9.592 years
c. 7.461 years

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 d. 6.352 years

(b ) 54. When increases of market interest rates cause an increase in YTM, ceteris paribus, the
price volatility of this bond should
a. Increase
b. Decrease
c. Remain unchanged

(d ) 55. A semiannual payment bond with a $1,000 par has a 5% coupon rate, a 6% YTM, and 5
years to maturity. What is the bond’s duration?
a. 5.00 years
b. 4.85 years
c. 4.76 years
d. 4.47 years

(d ) 56. A semiannual payment bond with a $1,000 par has a 7% coupon rate, a 6% YTM, and 5
years to maturity. What is the bond’s duration?
a. 4.85 years
b. 4.57 years
c. 4.46 years
d. 4.32 years

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 ESSAY QUESTIONS

1. Name and discuss the variables that determine the price or value of a fixed-rate coupon bond.
Answer: The market value of a bond is the present value sum of future coupon payments over
the life of the bond plus the maturity par value of the bond discounted at the market rate of return.

2. Name and discuss the factors that must be considered when calculating the realized rate of
return on a bond.
Answer: The risks associated with a bond, default and interest rate risk, may cause the realized
return to vary from the expected. Increased default risk increases market discount rates,
causing the bond value to fall if sold before maturity (price risk). As market rates vary over time,
reinvestment risk may cause the realized return to vary from the expected.
3. What are the relationships between bond price volatility and (a) bond maturity; (b) coupon rate?
Answer: As the maturity of a bond increases, the price risk and price volatility increases,
although at a decreasing rate. As the coupon rate decreases, the present value is impacted more by
the maturity value, so price risk increases.
4. Define and discuss interest rate risk. What are the two risk components of interest rate risk and
how do these interact with each other?
Answer: Interest rate risk is the impact of varying market interest rates on the realized rate of
return on a bond. The price risk component causes the market price of the bond to vary inversely with
changing interest rates and directly with longer maturity. Reinvestment risk is the change in
the realized return from the changing future value of the coupons. This causes the expected return
to be different due to varying reinvestment yields on the coupons reinvested. Price risk and
reinvestment risk exactly offset one another at the duration point.

5. What is bond duration and what are the implications of holding a bond to its duration versus
holding the bond to maturity?
Answer: Bond duration is a time-weighted maturity and is the sum of the PV of the time-
weighted cash flows divided by the market price. Holding a bond for its duration period helps
ensure the investor earns the promised yield to maturity. Price and reinvestment risk are offsetting
if duration equals the holding period. An investor holding to maturity eliminates price risk but
still faces reinvestment risk.

6. Formosan Independence Co. issues a 9-year semiannual payment bond with a par value of
$1,000 at a 10% coupon annual rate. The bond’s credit rating is AA. Currently, this bond is
selling at par.

a. What is the duration of this par bond?

b. If Standard & Poors unexpectedly downgrades the bond rating the market interest rates
increase. This bond’s annual YTM increases by 2%. What is the impact on the bond’s price
risk? Show the change in the bonds duration to answer this question.
c. Explain why the change in interest rates in b. changes the bond’s duration.

Answer:
a. Since this bond is a par bond, its YTM must be 10% annually. Using the duration formula

56
 (years)

b. When YTM increases to say 12% annually, the new bond price will be $891.72 and its
duration will be 5.95 years. This means that the increase in market interest rate will lead a
decrease in the bond’s interest rate risk.
c. Duration is a weighted average maturity of the bond’s cash flows. If interest rates increase
the bond’s more distant cash flows drop in present value by more than the drop in present value
of near term cash flows. This makes the near term cash flows have a bigger percentage of the
present value than more distant cash flows. Thus, the near term weights are increased and the
effective or average maturity is shortened and duration and price volatility are reduced at
higher interest rates.

7. Suppose you have a 5 year investment horizon and you are considering one of the following three
bonds:
Bond Duration Maturity
Bond 1 8 years 10 years
Bond 2 5 years 7 years
Bond 3 3 years 6 years
a. If you believe interest rates will fall and you wish to earn more than the promised yield which
of the three bonds above should you choose? Explain why in terms of the change in sale price
and reinvestment income.
b. If you believe interest rates will increase and you wish to earn more than the promised yield
which of the three bonds above should you choose? Explain why in terms of the change in sale
price and reinvestment income.
c. If you do not know which way interest rates may move and you wish to ensure you earn the
promised yield which of the three bonds above should you choose? Explain why in terms of the
change in sale price and reinvestment income.

Answer:
a. Choose Bond 1 because its duration is greater than your investment horizon. If you are right
and interest rates fall the extra gain from the higher sale price will more than offset the loss in the
future value of the reinvestment income that happened due to the lower reinvestment rate. The
maturity of the bond does not matter.
b. Choose Bond 3 because its duration is less than your investment horizon. If you are right and
interest rates increase the extra loss from the reduced sale price will be more than offset by the
extra gain in the future value of the reinvestment income that happened due to the higher
reinvestment rate. The maturity of the bond does not matter.
c. Choose Bond 2 because its duration is equal to your investment horizon. Even if interest rates
change, the change in value of the bond’s price will be exactly offset by the change in the future
value of the reinvestment income. The maturity of the bond does not matter.

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