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True/False Questions 1. If interest rates increase, the value of a fixed income contract decreases and vice versa. Answer: True Page: 69 Level: Easy 2. At equilibrium a security's required rate of return will be less than its expected rate of return. Answer: False Page: 65 Level: Easy 3. If a security's realized return is negative, it must have been true that the expected return was greater than the required return. Answer: False Page: 65 Level: Medium 4. If the present value of a security's cash flows is below its current market price the security is undervalued. Answer: True Page: 64 Level: Easy 5. A bond with an 11% coupon and a 9% required return will sell at a premium to par. Answer: True Page: 67 Level: Easy 6. A bond with a 10% coupon and an 8% required return will sell at a discount from par. Answer: False Page: 67 Level: Easy 7. Discount bonds always have higher rrr than premium bonds, that is why the discount bonds cost less. Answer: False Page: 68 Level: Easy 8. The duration of a four year maturity 10% coupon bond is less than four years. Answer: True Page: 78 Level: Easy 9. The longer the time to maturity the lower the security's price sensitivity to an interest rate change, ceteris paribus. Answer: False Page: 72 Level: Easy

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10. The greater a security's coupon the lower the security's price sensitivity to an interest rate change, ceteris paribus. Answer: True Page: 74 Level: Easy 11. 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. Answer: False Page: 72 Level: Medium 12. Any security that returns a greater percentage of the price sooner is less price volatile. Answer: True Page: 74 Level: Easy 13. A zero coupon bond has a duration equal to its maturity and convexity equal to zero. Answer: True Page: 78, Appendix 3C Level: Medium 14. The lower the level of interest rates the greater is a bond's price sensitivity to interest rate changes. Answer: True Page: 70 Level: Medium 15. The higher a bond's coupon, the lower the bond's price volatility. Answer: True Page: 74 Level: Easy 16. Higher interest rates lead to lower bond convexity, all else equal. Answer: True Page: Appendix 3C Level: Medium 17. Zero coupon bonds will always have a lower price than equivalent maturity, equivalent default risk coupon bonds. Answer: True Page: 73 Level: Easy 18. If the rrr on a particular bond rises, the FPV of those bonds will rise also. Answer: False Page: 63 Level: Easy

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Multiple Choice Questions 19. The required rate of return on a bond is A) the interest rate that equates the current market price of the bond with the present value of all future cash flows received. B) equivalent to the current yield for non par bonds. C) less than the Err for discount bonds and greater than the Err for premium bonds. D) inversely related to a bond's risk and coupon. E) none of the above Answer: E Page: 62-63 Level: Medium 20. Duration is A) the elasticity of a security's value to small coupon changes. B) the weighted average time to maturity of the bond's cash flows C) the time until the investor recovers the price of the bond in today's dollars D) greater than maturity for deep discount bonds and less than maturity for premium bonds E) the second derivative of the bond price formula with respect to the ytm. Answer: B Page: 74-75 Level: Medium 21. Which of the following bond terms are generally positively related to bond price volatility? I. coupon rate II. maturity III. ytm IV. payment frequency A) B) C) D) E) II and IV only I and III only II and III only II only II, III and IV only

Answer: D Page: 69-74 Level: Difficult

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22. The interest rate used to find the fair present value of a financial security is the A) Expected rate of return B) Required rate of return C) Realized rate of return D) Realized yield to maturity E) Current yield Answer: B Page: 63 Level: Easy 23. A security has an expected return less than its required return. This security is A) Selling at a premium to par B) Selling at a discount to par C) Selling for more than its FPV D) Selling for less than its FPV E) A zero coupon bond Answer: C Page: 64 Level: Medium 24. 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? A) The bond was purchased at a premium to par B) The coupon rate was 8% C) The required return was greater than 6% D) The coupons were reinvested at a higher rate than expected E) The bond must have been a zero coupon bond Answer: D Page: 68 Level: Medium 25. You would want to purchase a security if P _____ FPV or Err _____ rrr. A) ≥, ≤ B) ≥, ≥ C) ≤, ≥ D) ≤, ≤ Answer: C Page: 64 Level: Difficult

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26. A 6 year annual payment corporate bond has a market price of $1050. 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 $5.14 C) Underpriced by $5.14 D) Overpriced by $11.32 E) Underpriced by $11.32 Answer: B Page: 67 Level: Medium Rationale: FPV = 100× PVIFA[9%,6yrs] + 1000× PVIF(9%,6 yrs) = $1044.86 27. An 8 year annual payment corporate bond has a market price of $934. It pays annual interest of $60 and its required rate of return is 7%. By how much is the bond mispriced? A) $0.00 B) Overpriced by $6.29 C) Underpriced by $6.29 D) Overpriced by $9.54 E) Underpriced by $9.54 Answer: C Page: 67 Level: Medium Rationale: FPV = 60× PVIFA[7%,8yrs] + 1000× PVIF(7%,8 yrs) = $940.29 28. A 10 year corporate bond pays has a 7.5% coupon rate. What is the bond's price if the required return is 7% and the bond pays interest semiannually? A) $1175.32 B) $1181.47 C) $1035.53 D) $1052.97 E) $1222.18 Answer: C Page: 67 Level: Medium Rationale: Price = 37.50× PVIFA(3.5%,20) + 1000× PVIF(3.5%,20)

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29. A 12 year $1,000 par corporate bond pays $35 interest every six months. What is the bond's price if the bond's promised ytm is 6.5%? A) $1121.32 B) $640.28 C) $755.24 D) $1040.79 E) $1041.22 Answer: E Page: 67 Level: Medium Rationale: Price = 35× PVIFA(3.25%,24) + 1000× PVIF(3.25%,24) 30. A corporate bond has a coupon rate of 10% and a required return of 10%. This bond's price is A) $924.18 B) $1000.00 C) $879.68 D) $1124.83 E) Not possible to determine from the information given Answer: B Page: 68 Level: Easy 31. 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 A) Greater than it’s FPV B) Less than par C) Less than its Err D) Less than its FPV E) $1000.00 Answer: D Page: 67 Level: Medium 32. A 4 year annual payment 5% coupon Treasury bond has a price of $1023. The bond's annual Err must be A) 5.00% B) 5.50% C) 4.36% D) 4.52% E) 5.23% Answer: C Page: 65 Level: Medium Rationale: 1023 = 50× PVIFA(Err%,4) + 1000× PVIF(Err%,4),trial and error or calculator

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33. An 8 year annual payment corporate bond has a required return of 10% and a 9% coupon. Its market value is $15 over its FPV. What is the bond's Err? A) 10.11% B) 9.85% C) 9.71% D) 10.23% E) 8.73% Answer: C Page: 65 Level: Difficult Rationale: FPV = 946.65= 90× PVIFA(10%,8yrs) + 1000× PVIF(10%,8yrs) ; (946.65+15) = 90× PVIFA(Err,8yrs) + 1000× PVIF(Err,8yrs), trial and error or calculator 34. Corporate Bond A returns 5% of its cost in PV terms in each of the first five years and 75% of its value in the sixth year. Corporate Bond B returns 8% of its cost in PV terms in each of the first five years and 60% of its cost in the sixth year. If A and B have the same required return, which of the following is/are true? I. Bond A has a bigger coupon than Bond B II. Bond A has a longer duration than Bond B III. Bond A is less price volatile than Bond B IV. Bond B has a higher FPV than Bond A. A) B) C) D) E) III only I, III and IV only I, II and IV only II and IV only I, II, II and IV are all true

Answer: D Page: 74-76 Level: Difficult 35. A corporate bond returns 6% of its cost (in PV terms) in the first year, 5% in the second year, 4% 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) 3.88 years Answer: A Page: 77 Level: Medium Rationale: 3.68 = (6%*1) + (5%*2) + (4%*3) + (85%*4)

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36. A semiannual payment bond with a $1,000 par has a 6% quoted coupon rate, a 6% promised ytm and 5 years to maturity. What is the bond' duration? A) 4.47 years B) 4.39 years C) 5.00 years D) 4.21 years E) 4.35 years Answer: B Page: 77 Level: Medium Rationale: Σ[(t*CFt / (1.03)t ] / (2*$1,000) 37. An annual payment bond with a $1,000 par has a 4.5% quoted coupon rate, a 5% promised ytm and 4 years to maturity. What is the bond' duration? A) 4.00 years B) 3.20 years C) 3.85years D) 3.62 years E) 3.75 years Answer: E Page: 78 Level: Medium Rationale: Σ[(t*CFt / (1.05)t ] / $982.27 38. If an N year security recovered the same percentage of its cost in PV terms each year the duration would be A) N B) 0 C) sum of the years / N D) N!/N2 E) None of the above Answer: C Page: 75-77 Level: Difficult 39. The _____ the coupon and the _____ the maturity; the _____ the duration of a bond, ceteris paribus. A) Larger, longer, longer B) Larger, longer, shorter C) Smaller, shorter, longer D) Smaller, shorter, shorter E) None of the above Answer: E Page: 80-81 Level: Difficult

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40. Everything else equal, the duration of a bond is lengthened by I. higher coupons I. II shorter maturity II. III lower interest rates A) B) C) D) E) I only II only III only I and II only I, II and III

Answer: C Page: 80-81 Level: Medium 41. A 4 year maturity 12% coupon annual payment corporate bond with a required rate of return of 12% has a duration of _____ years. A) 3.05 B) 2.97 C) 3.22 D) 3.71 E) 3.40 Answer: E Page: 81 Level: Medium 42. A decrease in interest rates will A) Decrease the bond's FPV B) Increase the bond's duration C) Lower the bond's coupon rate D) Change the bond's payment frequency E) Not affect the bond's duration Answer: B Page: 80 Level: Medium 43. A 10 year maturity coupon bond has a 6-year duration. An equivalent 20 year bond with the same coupon has a duration: A) Equal to 12 years B) Less than 6 years C) Less than 12 years D) Equal to 6 years E) Greater than 20 years Answer: C Page: 81 Level: Easy

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44. A six year maturity bond has a five-year duration. Over the next year maturity will decline by 1 year and duration will decline by A) Less than one year B) More than one year C) 1 year D) N years E) N/(N-1) years Answer: A Page: 81 Level: Medium 45. An annual payment bond has a 6% required return. Interest rates are projected to rise 25 basis points. The bond's duration is 5 years. What is the predicted price change? A) -1.18% B) 4.71% C) 1.25% D) -1.25% E) 1.18% Answer: A Page: 82 Level: Medium Rationale: -5 × (+0.0025/1.06) 46. A bond that pays interest semiannually has a 5% promised yield and a price of $945. Annual interest rates are now projected to fall 25 basis points. The bond's duration is 4.5 years. What is the predicted new bond price after the interest rate change? (Watch your rounding) A) $934.63 B) $955.37 C) $934.88 D) $955.13 E) None of the above Answer: B Page: 82 Level: Medium Rationale: (-4.5/1.025) × -0.0025× $945) + $945

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47. 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) A) $1020.35 B) $1069.65 C) $1070.36 D) $1019.64 E) None of the above Answer: D Page: 82 Level: Medium Rationale: (-5/1.03) × 0.0050× $1045) + $1045 48. Convexity arises because A) Bond's pay interest semiannually B) Coupon changes are the opposite sign of interest rate changes C) Of Federal Reserve policy D) Present values are a nonlinear function of interest rates E) The professor said so Answer: D Page: 84 Level: Medium 49. The duration of a 180 day T-Bill is (in years) A) 0.493 B) 0.246 C) 1 D) 0 E) Indeterminate Answer: A Page: 78 Level: Easy Rationale: 180/365 50. For large interest rate increases, duration _____ the fall in security prices and for large interest rate decreases, duration _____ the rise in security prices. A) Overpredicts, overpredicts B) Overpredicts, underpredicts C) Underpredicts, overpredicts D) Underpredicts, underpredicts E) None of the above Answer: B Page: 83-84 Level: Medium

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Short Answer Questions 51. Is the realized rate of return related to the expected return? The required return? Explain. Answer: Yes and no. The required return determines the initial size of the coupon and the offer price and as the rrr changes, forces the market price to change. As the buy and sell prices change and reinvestment rates on coupons, the realized return will be affected. However, the required return is an ex-ante rate designed to compensate investors for risk. The realized return may be less than or more than the expected or the required. That is the nature of risk. If you repeated the same investment with the same terms over and over, you should, on average earn a realized return equal to the required return. Page: 62 Level: Medium 52. Conceptually, why does a bond's price fall when required returns rise on an existing fixed income security? Answer: Since the cash flows are set by contract, the only way a new investor can expect to earn the new higher required return is to pay less for the bond, so the price has to fall. Traders sell the existing bond in favor of newer higher rate bonds, dropping the price and raising the expected return. Page: 63-64 Level: Easy 53. A 15 year, 7% coupon annual payment corporate bond has a FPV of $1045.62. However you pay $1054.32 for the bond. By how many basis points is your Err different from your rrr? Answer: rrr = 6.51% 1045.62 = 70× [PVIFA15 yr, rrr] + 1000× [PVIF15 yr rrr] Err = 6.42% 1054.32 = 70× [PVIFA15 yr Err] + 1000× [PVIF15 yr, Err] Err is 9 basis points less than your rrr. Page: 64-65 Level: Medium

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54. What is convexity? Why is it important? Answer: Convexity is a measure of the nonlinearity (curvature) of a change in a bond's price caused by a change in interest rates. The level of convexity increases for greater interest rate changes. Duration is a linear estimate of a bond's price change as the interest rate changes from its current level. Due to convexity, the greater the interest rate change the greater the error in using duration to estimate the bond's price change. For a multimillion dollar bond portfolio, the dollar errors can be quite significant. In abnormal markets, bond investors may face more or less risk than the bond's duration would imply. Calculus Answer: Duration is the first derivative of the bond price formula with respect to a change in interest rates. As such, it is accurate only for extremely small changes in interest rates. Duration gives only an approximation of the actual value change for interest rate movements that are normally observed in the market. Page: 85 Level: Difficult 55. 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%? Answer: You can't use the bond price formula in this case because of the lack of reinvestment. First alternative: Do not reinvest the coupons at all PV = $1,000 purchase price (coupon = ytm when purchased) FV = $90x6 = $540 + $1000 par = $1540 $1000 (1+r)6 = $1540 r = 7.46%% Second alternative: Reinvest coupons at 5% PV = $1,000 purchase price (coupon = ytm when purchased) FV = $90 x [FVIFA5%, 6 yrs] + $1000 par = $1,612.17 $1000 (1+r)6 = $1,612.17 r =8.29% The realized returns are less than 9% because the investor did not reinvest the coupons at the required rate of return. In order to earn a compound rate of return equal to the promised yield an investor must reinvest the coupons and earn the promised yield for the remaining time to maturity. Page: 68 Level: Medium

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56. Explain the effects of coupon and maturity on volatility. Answer: The longer the maturity the greater the price sensitivity of an asset with respect to interest rate changes. The larger the coupon payments, or any interim cash flows, the lower the price sensitivity of an asset with respect to asset changes. In general any security that returns a greater proportion of an investment more quickly will be less price volatile because this allows the investor to respond to the interest rate change. Page: 69-74 Level: Easy 57. Which would have a longer duration, a) a 5 year fully amortized installment loan with semiannual payments or b) a 5 year semiannual payment bond, ceteris paribus. Why? Answer: The bond will have a longer duration because you receive interest payments only until maturity, whereas the amortizing loan pays principle and interest throughout the life of the loan. Hence, the loan pays more (%) money back sooner. That makes the loan less volatile than the bond. Page: 76 Level: Easy 58. How does an increase in interest rates affect a security's duration? Answer: At higher interest rates the PV of more distant cash flows is reduced by a greater amount than near term cash flows due to compounding. For example the PV of the 10th cash flow falls more than the PV of the first cash flow if rates rise. This shifts a greater portion of the PV weights to the near term cash flows which in turn results in a shorter duration. The converse is true for falling interest rates. Page: 80 Level: Medium 59. An investor is considering purchasing a Treasury bond with a 20 year maturity, an 8% coupon and a 9% required rate of return. The bond pays interest semiannually. a) What is the bond's modified duration? b) If promised yields rise 25 basis points immediately after the purchase what is the predicted price change in dollars based on the bond's duration? Answer: a) The bond's price is $907.99 and the bond's modified duration is Σ[(t*CFt / (1.045)t ] / ($907.99 * 2) = 9.833 years Modified duration = 9.833 / 1.045 = 9.409876 years b) With an increase of 25 basis points in promised yields: Predicted ∆ Bond Price = -9.409876 × .0025 = -2.35% or a $ price change of -0.0235 × $907.99 = -$21.36 Page: 82-83 Level: Medium

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60. You have 5 years until you need to take your money out of 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. Answer: You will earn the promised 8% return. Because you chose a bond with a duration equal to the five year time period, the loss in reinvestment income from reinvesting the coupons at 6% instead of 8% will just be offset by having a higher than expected sale price of the bond in five years. Page: Appendix 3B Level: Difficult 61. 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. Answer:

Page: Appendix 3C Level: Difficult

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