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Multiple Choice Questions 1. The current yield on a bond is equal to ________.

A) annual interest divided by the current market price B) the yield to maturity C) annual interest divided by the par value D) the internal rate of return E) none of the above 2. If a 7% coupon bond is trading for $975.00, it has a current yield of ____________ percent. A) 7.00 B) 6.53 C) 7.24 D) 8.53 E) 7.18 3. If a 6% coupon bond is trading for $950.00, it has a current yield of ____________ percent. A) 6.5 B) 6.3 C) 6.1 D) 6.0 E) 6.6 4. If an 8% coupon bond is trading for $1025.00, it has a current yield of ____________ percent. A) 7.8 B) 8.7 C) 7.6 D) 7.9 E) 8.1 5. If a 7.5% coupon bond is trading for $1050.00, it has a current yield of ____________ percent. A) 7.0 B) 7.4 C) 7.1 D) 6.9 E) 6.7

6. A coupon bond pays annual interest, has a par value of $1,000, matures in 4 years, has a coupon rate of 10%, and has a yield to maturity of 12%. The current yield on this bond is ___________. A) 10.65% B) 10.45% C) 10.95% D) 10.52% E) none of the above 7. A coupon bond pays annual interest, has a par value of $1,000, matures in 12 years, has a coupon rate of 11%, and has a yield to maturity of 12%. The current yield on this bond is ___________. A) 10.39% B) 10.43% C) 10.58% D) 10.66% E) none of the above 8. Of A) B) C) D) E) the following four investments, ________ is considered the safest. commercial paper corporate bonds U. S. Agency issues Treasury bonds Treasury bills

9. To earn a high rating from the bond rating agencies, a firm should have A) a low times interest earned ratio B) a low debt to equity ratio C) a high quick ratio D) B and C E) A and C 10. At issue, coupon bonds typically sell ________. A) above par value B) below par C) at or near par value D) at a value unrelated to par E) none of the above 11. Accrued interest A) is quoted in the bond price in the financial press.

B) must be paid by the buyer of the bond and remitted to the seller of the bond. C) must be paid to the broker for the inconvenience of selling bonds between maturity dates. D) A and B. E) A and C. 12. The invoice price of a bond that a buyer would pay is equal to A) the asked price plus accrued interest. B) the asked price less accrued interest. C) the bid price plus accrued interest. D) the bid price less accrued interest. E) the bid price. 13. An 8% coupon U. S. Treasury note pays interest on May 30 and November 30 and is traded for settlement on August 15. The accrued interest on the $100,000 face value of this note is _________. A) $491.80 B) $800.00 C) $983.61 D) $1,661.20 E) none of the above 14. A coupon bond is reported as having an ask price of 113% of the $1,000 par value in the Wall Street Journal. If the last interest payment was made two months ago and the coupon rate is 12%, the invoice price of the bond will be ____________. A) $1,100 B) $1,110 C) $1,150 D) $1,160 E) none of the above 15. The bonds of Ford Motor Company have received a rating of "D" by Moody's. The "D" rating indicates A) the bonds are insured B) the bonds are junk bonds C) the bonds are referred to as "high yield" bonds D) A and B E) B and C

16. The bond market A) can be quite "thin". B) primarily consists of a network of bond dealers in the over the counter market. C) consists of many investors on any given day. D) A and B. E) B and C. 17. Ceteris paribus, the price and yield on a bond are A) positively related. B) negatively related. C) sometimes positively and sometimes negatively related. E) not related. E) indefinitely related. 18. The ______ is a measure of the average rate of return an investor will earn if the investor buys the bond now and holds until maturity. A) current yield B) dividend yield C) P/E ratio D) yield to maturity E) discount yield 19. The _________ gives the number of shares for which each convertible bond can be exchanged. A) conversion ratio B) current ratio C) P/E ratio D) conversion premium E) convertible floor 20. A coupon bond is a bond that _________. A) pays interest on a regular basis (typically every six months) B) does not pay interest on a regular basis but pays a lump sum at maturity C) can always be converted into a specific number of shares of common stock in the issuing company D) always sells at par E) none of the above 21. A ___________ bond is a bond where the bondholder has the right to cash in the bond before maturity at a specified price after a specific

date. A) callable B) coupon C) put D) Treasury E) zero-coupon 22. Callable bonds A) are called when interest rates decline appreciably. B) have a call price that declines as time passes. C) are called when interest rates increase appreciably. D) A and B. E) B and C. 23. A Treasury bond due in one year has a yield of 5.7%; a Treasury bond due in 5 years has a yield of 6.2%. A bond issued by Ford Motor Company due in 5 years has a yield of 7.5%; a bond issued by Shell Oil due in one year has a yield of 6.5%. The default risk premiums on the bonds issued by Shell and Ford, respectively, are A) 1.0% and 1.2% B) 0.7% and 1.5% C) 1.2% and 1.0% D) 0.8% and 1.3% E) none of the above 24. A Treasury bond due in one year has a yield of 4.6%; a Treasury bond due in 5 years has a yield of 5.6%. A bond issued by Lucent Technologies due in 5 years has a yield of 8.9%; a bond issued by Mobil due in one year has a yield of 6.2%. The default risk premiums on the bonds issued by Mobil and Lucent Technologies, respectively, are: A) 1.6% and 3.3% B) 0.5% and .7% C) 3.3% and 1.6% D) 0.7% and 0.5% E) none of the above 25. A Treasury bond due in one year has a yield of 6.2%; a Treasury bond due in 5 years has a yield of 6.7%. A bond issued by Xerox due in 5 years has a yield of 7.9%; a bond issued by Exxon due in one year has a yield of 7.2%. The default risk premiums on the bonds issued by Exxon and Xerox, respectively, are A) 1.0% and 1.2% B) 0.5% and .7%

C) 1.2% and 1.0% D) 0.7% and 0.5% E) none of the above 26. Floating-rate bonds are designed to ___________ while convertible bonds are designed to __________. A) minimize the holders' interest rate risk; give the investor the ability to share in the price appreciation of the company's stock B) maximize the holders' interest rate risk; give the investor the ability to share in the price appreciation of the company's stock C) minimize the holders' interest rate risk; give the investor the ability to benefit from interest rate changes D) maximize the holders' interest rate risk; give investor the ability to share in the profits of the issuing company E) none of the above 27. A coupon bond that pays interest annually is selling at par value of $1,000, matures in 5 years, and has a coupon rate of 9%. The yield to maturity on this bond is: A) 8.0% B) 8.3% C) 9.0% D) 10.0% E) none of the above 28. A coupon bond that pays interest annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be ______ if the coupon rate is 7%. A) $712.99 B) $620.92 C) $1,123.01 D) $886.28 E) $1,000.00 29. A coupon bond that pays interest annually, has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be _________ if the coupon rate is 12%. A) $922.77 B) $924.16 C) $1,075.82 D) $1,077.20 E) none of the above

30. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be __________ if the coupon rate is 8%. A) $922.78 B) $924.16 C) $1,075.80 D) $1,077.20 E) none of the above 31. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 5 years, and has a yield to maturity of 10%. The intrinsic value of the bond today will be ________ if the coupon rate is 12%. A) $922.77 B) $924.16 C) $1,075.80 D) $1,077.22 E) none of the above 32. A coupon bond that pays interest of $100 annually has a par value of $1,000, matures in 5 years, and is selling today at a $72 discount from par value. The yield to maturity on this bond is __________. A) 6.00% B) 8.33% C) 12.00% D) 60.00% E) none of the above 33. You purchased an annual interest coupon bond one year ago that now has 6 years remaining until maturity. The coupon rate of interest was 10% and par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. The amount you paid for this bond one year ago was A) $1,057.50. B) $1,075.50. C) $1,088.50. D) $1.092.46. E) $1,104.13. 34. You purchased an annual interest coupon bond one year ago that had 6 years remaining to maturity at that time. The coupon interest

rate was 10% and the par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the yield to maturity continued to be 8%, your annual total rate of return on holding the bond for that year would have been _________. A) 7.00% B) 7.82% C) 8.00% D) 11.95% E) none of the above 35. Consider two bonds, A and B. Both bonds presently are selling at their par value of $1,000. Each pays interest of $120 annually. Bond A will mature in 5 years while bond B will mature in 6 years. If the yields to maturity on the two bonds change from 12% to 10%, ____________. A) both bonds will increase in value, but bond A will increase more than bond B B) both bonds will increase in value, but bond B will increase more than bond A C) both bonds will decrease in value, but bond A will decrease more than bond B D) both bonds will decrease in value, but bond B will decrease more than bond A E) none of the above 36. A zero-coupon bond has a yield to maturity of 9% and a par value of $1,000. If the bond matures in 8 years, the bond should sell for a price of _______ today. A) 422.41 B) $501.87 C) $513.16 D) $483.49 E) none of the above 37. You have just purchased a 10-year zero-coupon bond with a yield to maturity of 10% and a par value of $1,000. What would your rate of return at the end of the year be if you sell the bond? Assume the yield to maturity on the bond is 11% at the time you sell. A) 10.00% B) 20.42% C) 13.8% D) 1.4% E) none of the above

38. A Treasury bill with a par value of $100,000 due one month from now is selling today for $99,010. The effective annual yield is __________. A) 12.40% B) 12.55% C) 12.62% D) 12.68% E) none of the above 39. A Treasury bill with a par value of $100,000 due two months from now is selling today for $98,039, with an effective annual yield of _________. A) 12.40% B) 12.55% C) 12.62% D) 12.68% E) none of the above 40. A Treasury bill with a par value of $100,000 due three months from now is selling today for $97,087, with an effective annual yield of _________. A) 12.40% B) 12.55% C) 12.62% D) 12.68% E) none of the above 41. A coupon bond pays interest semi-annually, matures in 5 years, has a par value of $1,000 and a coupon rate of 12%, and an effective annual yield to maturity of 10.25%. The price the bond should sell for today is ________. A) $922.77 B) $924.16 C) $1,075.80 D) $1,077.20 E) none of the above 42. A convertible bond has a par value of $1,000 and a current market price of $850. The current price of the issuing firm's stock is $29 and the conversion ratio is 30 shares. The bond's market conversion value is ______. A) $729

B) C) D) E)

$810 $870 $1,000 none of the above

43. A convertible bond has a par value of $1,000 and a current market value of $850. The current price of the issuing firm's stock is $27 and the conversion ratio is 30 shares. The bond's conversion premium is _________. A) $40 B) $150 C) $190 D) $200 E) none of the above 48. A 10% coupon bond, annual payments, 10 years to maturity is callable in 3 years at a call price of $1,100. If the bond is selling today for $975, the yield to call is _________. A) 10.26% B) 10.00% C) 9.25% D) 13.98% E) none of the above 49. A 12% coupon bond, semiannual payments, is callable in 5 years. The call price is $1,120; if the bond is selling today for $1,110, what is the yield to call? A) 12.03%. B) 10.86%. C) 10.95%. D) 9.14%. E) none of the above. 50. A 10% coupon, annual payments, bond maturing in 10 years, is expected to make all coupon payments, but to pay only 50% of par value at maturity. What is the expected yield on this bond if the bond is purchased for $975? A) 10.00%. B) 6.68%. C) 11.00%. D) 8.68%. E) none of the above. 51. You purchased an annual interest coupon bond one year ago with 6 years remaining to maturity at the time of purchase. The coupon

interest rate is 10% and par value is $1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the bond's yield to maturity had changed to 7%, your annual total rate of return on holding the bond for that year would have been _________. A) 7.00% B) 8.00% C) 9.95% D) 11.95% E) none of the above 52. The ________ is used to calculate the present value of a bond. A) nominal yield B) current yield C) yield to maturity D) yield to call E) none of the above 53. The yield to maturity on a bond is ________. A) below the coupon rate when the bond sells at a discount, and equal to the coupon rate when the bond sells at a premium. B) the discount rate that will set the present value of the payments equal to the bond price. C) based on the assumption that any payments received are reinvested at the coupon rate. D) none of the above. E) A, B, and C. 54. A bond will sell at a discount when __________. A) the coupon rate is greater than the current yield and the current yield is greater than yield to maturity B) the coupon rate is greater than yield to maturity C) the coupon rate is less than the current yield and the current yield is greater than the yield to maturity D) the coupon rate is less than the current yield and the current yield is less than yield to maturity E) none of the above is true. 55. Consider a 5-year bond with a 10% coupon that has a present yield to maturity of 8%. If interest rates remain constant, one year from now the price of this bond will be _______. A) higher B) lower C) the same

D) cannot be determined E) $1,000 56. A bond has a par value of $1,000, a time to maturity of 20 years, a coupon rate of 10% with interest paid annually, a current price of $850 and a yield to maturity of 12%. Intuitively and without the use calculations, if interest payments are reinvested at 10%, the realized compound yield on this bond must be ________. A) 10.00% B) 10.9% C) 12.0% D) 12.4% E) none of the above 57. A bond with a 12% coupon, 10 years to maturity and selling at 88 has a yield to maturity of _______. A) over 14% B) between 13% and 14% C) between 12% and 13% D) between 10% and 12% E) less than 12% 58. Using semiannual compounding, a 15-year zero coupon bond that has a par value of $1,000 and a required return of 8% would be priced at approximately ______. A) $308 B) $315 C) $464 D) $555 E) none of the above 59. The yield to maturity of a 20-year zero coupon bond that is selling for $372.50 with a value at maturity of $1,000 is ________. A) 5.1% B) 8.8% C) 10.8% D) 13.4% E) none of the above 60. Which one of the following statements about convertibles is true? A) The longer the call protection on a convertible, the less the security is worth.

B) The more volatile the underlying stock, the greater the value of the conversion feature. C) The smaller the spread between the dividend yield on the stock and the yield-to-maturity on the bond, the more the convertible is worth. D) The collateral that is used to secure a convertible bond is one reason convertibles are more attractive than the underlying stock. E) Convertibles are not callable. 61. Consider a $1,000 par value 20-year zero coupon bond issued at a yield to maturity of 10%. If you buy that bond when it is issued and continue to hold the bond as yields decline to 9%, the imputed interest income for the first year of that bond is A) zero. B) $14.87. C) $45.85. D) $7.44. E) none of the above. 62. The bond indenture includes A) the coupon rate of the bond. B) the par value of the bond. C) the maturity date of the bond. D) all of the above. E) none of the above. 63. A Treasury bond quoted at 107:16 107:18 has a bid price of _______ and an asked price of _____. A) $107.16, $107.18 B) $1,071.60, $1,071.80 C) $1,075.00, $1,075.63 D) $1,071.80, $1,071.60 E) $1,070.50, $1,070.56 64. Bearer bonds are A) bonds traded without any record of ownership. B) helpful to tax authorities in the enforcement of tax collection. C) rare in the United States today. D) all of the above. E) both A and C. 65. Most corporate bonds are traded

A) on a formal exchange operated by the New York Stock Exchange. B) by the issuing corporation. C) over the counter by bond dealers linked by a computer quotation system. D) on a formal exchange operated by the American Stock Exchange. E) on a formal exchange operated by the Philadelphia Stock Exchange. 66. The process of retiring high-coupon debt and issuing new bonds at a lower coupon to reduce interest payments is called A) deferral. B) reissue. C) repurchase. D) refunding. E) none of the above. 67. Convertible bonds A) give their holders the ability to share in price appreciation of the underlying stock. B) offer lower coupon rates than similar nonconvertible bonds. C) offer higher coupon rates than similar nonconvertible bonds. D) both A and B are true. E) both A and C are true. 68. TIPS are A) securities formed from the coupon payments only of government bonds. B) securities formed from the principal payments only of government bonds. C) government bonds with par value linked to the general level of prices. D) government bonds with coupon rate linked to the general level of prices. E) zero-coupon government bonds. 69. Altman's Z scores are assigned based on a firm's financial characteristics and are used to predict A) required coupon rates for new bond issues. B) bankruptcy risk. C) the likelihood of a firm becoming a takeover target. D) the probability of a bond issue being called. E) none of the above. 70. When a bond indenture includes a sinking fund provision

A) firms must establish a cash fund for future bond redemption. B) bondholders always benefit, because principal repayment on the scheduled maturity date is guaranteed. C) bondholders may lose because their bonds can be repurchased by the corporation at below-market prices. D) both A and B are true. E) none of the above is true. 71. Subordination clauses in bond indentures A) may restrict the amount of additional borrowing the firm can undertake. B) are sometimes referred to as "me-first" rules. C) provide higher priority to senior creditors in the event of bankruptcy. D) all of the above are true. E) both B and C are true. 72. Collateralized bonds A) rely on the general earning power of the firm for the bond's safety. B) are backed by specific assets of the issuing firm. C) are considered the safest assets of the firm. D) all of the above are true. E) both B and C are true. 73. Debt securities are often called fixed-income securities because A) the government fixes the maximum rate that can be paid on bonds. B) they are held predominantly by older people who are living on fixed incomes. C) they pay a fixed amount at maturity. D) they promise either a fixed stream of income or a stream of income determined by a specific formula. E) they were the first type of investment offered to the public, which allowed them to fix their income at a higher level by investing in bonds. 74. A zero-coupon bond is one that A) effectively has a zero percent coupon rate. B) pays interest to the investor based on the general level of interest rates, rather than at a specified coupon rate. C) pays interest to the investor without requiring the actual coupon to be mailed to the corporation. D) is issued by state governments because they don't have to pay interest. E) is analyzed primarily by focusing (zeroing in) on the coupon

rate. 75. Swingin' Soiree, Inc. is a firm that has its main office on the Right Bank in Paris. The firm just issued bonds with a final payment amount that depends on whether the Seine River floods. This type of bond is known as A) a contingency bond B) a catastrophe bond C) an emergency bond D) an incident bond E) an eventuality bond 76. One year ago, you purchased a newly issued TIPS bond that has a 6% coupon rate, five years to maturity, and a par value of $1,000. The average inflation rate over the year was 4.2%. What is the amount of the coupon payment you will receive and what is the current face value of the bond? A) $60.00, $1,000 B) $42.00, $1,042 C) $60.00, $1,042 D) $62.52, $1,042 E) $102.00, $1,000 77. Bond analysts might be more interested in a bond's yield to call if A) the bond's yield to maturity is insufficient. B) the firm has called some of its bonds in the past. C) the investor only plans to hold the bond until its first call date. D) interest rates are expected to rise. E) interest rates are expected to fall. 78. What is the relationship between the price of a straight bond and the price of a callable bond? A) The straight bond's price will be higher than the callable bond's price for low interest rates. B) The straight bond's price will be lower than the callable bond's price for low interest rates. C) The straight bond's price will change as interest rates change, but the callable bond's price will stay the same. D) The straight bond and the callable bond will have the same price. E) There is no consistent relationship between the two types of bonds.

79. Three years ago you purchased a bond for $974.69. The bond had three years to maturity, a coupon rate of 8%, paid annually, and a face value of $1,000. Each year you reinvested all coupon interest at the prevailing reinvestment rate shown in the table below. Today is the bond's maturity date. What is your realized compound yield on the bond? A) B) C) D) E) 6.43% 7.96% 8.23% 8.97% 9.13%

80. Which of the following is not a type of international bond? A) Samurai bonds B) Yankee bonds C) bulldog bonds D) Elton bonds E) All of the above are international bonds. 81. A coupon bond that pays interest annually has a par value of $1,000, matures in 6 years, and has a yield to maturity of 11%. The intrinsic value of the bond today will be ______ if the coupon rate is 7.5%. A) $712.99 B) $851.93 C) $1,123.01 D) $886.28 E) $1,000.00 82. A coupon bond that pays interest annually has a par value of $1,000, matures in 8 years, and has a yield to maturity of 9%. The intrinsic value of the bond today will be ______ if the coupon rate is 6%. A) $833.96 B) $620.92 C) $1,123.01 D) $886.28 E) $1,000.00 83. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 6 years, and has a yield to maturity of 9%. The intrinsic value of the bond today will be __________ if the coupon rate is 9%. A) $922.78 B) $924.16 C) $1,075.80 D) $1,000.00

E) none of the above 84. A coupon bond that pays interest semi-annually has a par value of $1,000, matures in 7 years, and has a yield to maturity of 11%. The intrinsic value of the bond today will be __________ if the coupon rate is 8.8%. A) $922.78 B) $894.51 C) $1,075.80 D) $1,077.20 E) none of the above 85. A coupon bond that pays interest of $90 annually has a par value of $1,000, matures in 9 years, and is selling today at a $66 discount from par value. The yield to maturity on this bond is __________. A) 9.00% B) 10.15% C) 11.25% D) 12.32% E) none of the above 86. A coupon bond that pays interest of $40 semi annually has a par value of $1,000, matures in 4 years, and is selling today at a $36 discount from par value. The yield to maturity on this bond is __________. A) 8.69% B) 9.09% C) 10.43% D) 9.76% E) none of the above 87. You purchased an annual interest coupon bond one year ago that now has 18 years remaining until maturity. The coupon rate of interest was 11% and par value was $1,000. At the time you purchased the bond, the yield to maturity was 10%. The amount you paid for this bond one year ago was A) $1,057.50 B) $1,075.50 C) $1,083.65 D) $1.092.46 E) $1,104.13 88. You purchased an annual interest coupon bond one year ago that had 9 years remaining to maturity at that time. The coupon interest

rate was 10% and the par value was $1,000. At the time you purchased the bond, the yield to maturity was 8%. If you sold the bond after receiving the first interest payment and the yield to maturity continued to be 8%, your annual total rate of return on holding the bond for that year would have been _________. A) 8.00% B) 7.82% C) 7.00% D) 11.95% E) none of the above

89. Consider two bonds, F and G. Both bonds presently are selling at their par value of $1,000. Each pays interest of $90 annually. Bond F will mature in 15 years while bond G will mature in 26 years. If the yields to maturity on the two bonds change from 9% to 10%, ____________. A) both bonds will increase in value, but bond F will increase more than bond G B) both bonds will increase in value, but bond G will increase more than bond F C) both bonds will decrease in value, but bond F will decrease more than bond G D) both bonds will decrease in value, but bond G will decrease more than bond F E) none of the above 90. A zero-coupon bond has a yield to maturity of 12% and a par value of $1,000. If the bond matures in 18 years, the bond should sell for a price of _______ today. A) 422.41 B) $501.87 C) $513.16 D) $130.04 E) none of the above 91. A zero-coupon bond has a yield to maturity of 11% and a par value of $1,000. If the bond matures in 27 years, the bond should sell for a price of _______ today. A) $59.74 B) $501.87 C) $513.16 D) $483.49 E) none of the above

92. You have just purchased a 12-year zero-coupon bond with a yield to maturity of 9% and a par value of $1,000. What would your rate of return at the end of the year be if you sell the bond? Assume the yield to maturity on the bond is 10% at the time you sell. A) 10.00% B) 20.42% C) -1.4% D) 1.4% E) none of the above 93. You have just purchased a 7-year zero-coupon bond with a yield to maturity of 11% and a par value of $1,000. What would your rate of return at the end of the year be if you sell the bond? Assume the yield to maturity on the bond is 9% at the time you sell. A) 10.00% B) 23.8% C) 13.8% D) 1.4% E) none of the above 94. A convertible bond has a par value of $1,000 and a current market price of $975. The current price of the issuing firm's stock is $42 and the conversion ratio is 22 shares. The bond's market conversion value is ______. A) $729 B) $924 C) $870 D) $1,000 E) none of the above 95. A convertible bond has a par value of $1,000 and a current market price of $1105. The current price of the issuing firm's stock is $20 and the conversion ratio is 35 shares. The bond's market conversion value is ______. A) $700 B) $810 C) $870 D) $1,000 E) none of the above 96. A convertible bond has a par value of $1,000 and a current market value of $950. The current price of the issuing firm's stock is $22

and the conversion ratio is 40 shares. The bond's conversion premium is _________. A) $40 B) $70 C) $190 D) $200 E) none of the above 97. A convertible bond has a par value of $1,000 and a current market value of $1150. The current price of the issuing firm's stock is $65 and the conversion ratio is 15 shares. The bond's conversion premium is _________. A) $40 B) $150 C) $175 D) $200 E) none of the above 98. If a 7% coupon bond that pays interest every 182 days paid interest 32 days ago, the accrued interest would be A) 5.67 B) 7.35 C) 6.35 D) 6.15 E) 7.12 99. If a 7.5% coupon bond that pays interest every 182 days paid interest 62 days ago, the accrued interest would be A) 11.67 B) 12.35 C) 12.77 D) 11.98 E) 12.15 100. If a 9% coupon bond that pays interest every 182 days paid interest 112 days ago, the accrued interest would be A) 27.69 B) 27.35 C) 26.77 D) 27.98 E) 28.15 101. A 7% coupon bond with an ask price of 100:00 pays interest every 182 days. If the bond paid interest 32 days ago, the invoice price of the bond would be

A) B) C) D) E)

1,005.67 1,007.35 1,006.35 1,006.15 1,007.12

102. A 7.5% coupon bond with an ask price of 100:00 pays interest every 182 days. If the bond paid interest 62 days ago, the invoice price of the bond would be A) 1,011.67 B) 1,012.35 C) 1,012.77 D) 1,011.98 E) 1,012.15 103. A 9% coupon bond with an ask price of 100:00 pays interest every 182 days. If the bind paid interest 112 days ago, the invoice price of the bond would be A) 1,027.69 B) 1,027.35 C) 1,026.77 D) 1,027.98 E) 1,028.15 104. One year ago, you purchased a newly issued TIPS bond that has a 5% coupon rate, five years to maturity, and a par value of $1,000. The average inflation rate over the year was 3.2%. What is the amount of the coupon payment you will receive and what is the current face value of the bond? A) $50.00, $1,000 B) $32.00, $1,032 C) $50.00, $1,032 D) $32.00, $1,050 E) $51.60, $1,032 105. One year ago, you purchased a newly issued TIPS bond that has a 4% coupon rate, five years to maturity, and a par value of $1,000. The average inflation rate over the year was 3.6%. What is the amount of the coupon payment you will receive and what is the current face value of the bond? A) $40.00, $1,000 B) $41.44, $1,036 C) $40.00, $1,036

D) $36.00, $1,040 E) $76.00, $1,000 Essay Questions 106. If you are buying a coupon bond between interest paying dates, is the amount you would pay to your broker for the bond more or less than the amount quoted in the financial quotation pages? Discuss the differences and how these differences arise. Difficulty: Easy Answer: If you are buying a bond between interest paying dates, you will pay more than the amount quoted in the financial pages. You will pay that price plus the interest that has accrued since the last interest paying date. That interest belongs to the seller of the bond and will be remitted to the seller by the broker. When the next interest paying date arrives, you will receive the entire coupon payment. The rationale for this question is be certain that the student understands the mechanism involved in the payment of interest on coupon bonds and the pricing of bonds. 107. Discuss the taxation ramifications of zero coupon bonds. How has this taxation procedure changed over the years? How has this change affected the demand for these bonds? Difficulty: Moderate Answer: The only return on a zero coupon bond is the capital gain realized when the bond is sold. Initially, the investor was required to pay capital gains tax only when the bond was sold. However, the IRS later decided that part of this capital gain each year was really imputed interest and thus now one must pay tax on this imputed interest income (income that the investor has not yet received). As a result, zero coupon bonds are no longer particularly attractive for individual investors and institutional investors subject to income tax. However, zeros remain attractive to institutional investors not subject to income taxes, such as pension plans and endowments. 108. Why are many bonds callable? What is the disadvantage to the investor of a callable bond? What does the investor receive in exchange for a bond being callable? How are bond valuation

calculations affected if bonds are callable? Difficulty: Moderate Answer: Many bonds are callable to give the issuer the option of calling the bond in and refunding (reissuing) the bond if interest rates decline. Bonds issued in a high interest rate environment will have the call feature. Interest rates must decline enough to offset the cost of floating a new issue. The disadvantage to the investor is that the investor will not receive that long stream of constant income that the bondholder would have received with a noncallable bond. In return, the yields on callable bonds are usually slightly higher than the yields on noncallable bonds of equivalent risk. When the bond is called, the investor receives the call price (an amount greater than par value). The bond valuation calculation should include the call price rather than the par value as the final amount received; also, only the cash flows until the first call should be discounted. The result is that the investor should be looking at yield to first call, not yield to maturity, for callable bonds.

109. You purchased a zero-coupon bond that has a face value of $1,000, five years to maturity and a yield to maturity of 7.3%. It is one year later and similar bonds are offering a yield to maturity of 8.1%. You will sell the bond now. You have a tax rate of 40% on regular income and 15% on capital gains. Calculate the following for this bond. the purchase price of the bond the current price of the bond the imputed interest income the capital gain (or loss) on the bond the before-tax rate of return on this investment the after-tax rate of return on this investment Difficulty: Difficult

Answer: Calculations are shown in the table below.


Purchase Price of the Bond N=5 I=7.3 PMT=0 FV=10 00 CPT PV=703. 07

Current Price of the Bond N=4 I=8.1 PMT=0 FV=10 00 CPT PV=732. 31

Imputed Interest Income Find price at original YTM N=4 I=7.3 PMT=0 FV=10 00 CPT PV=754. 40

Change in price at original YTM = imputed interest income = $754.40 - $703.07 = $51.33 Capital Gain (Loss) Change in price due to interest rate change = $732.31-754.40=-$22.09 Note: total change in price=imputed interest income + capital gain (loss) $732.31-703.07=$29.24=$51.33-22.09 Before-tax Rate of Return ($732.31-703.07)/$703.07=4.16%

After-tax Rate of Return tax on imputed interest income=$51.33*.4=$20.53 tax on capital gain (loss)=-$22.09*.15=$3.31 (savings due to capital loss) After-tax return=($732.31-703.0720.53+3.31)/$703.07=1.71%

This question tests the depth of the student's understanding of the concepts and mechanics of zero-coupon bonds.

Multiple Choice Questions 1. The term structure of interest rates is: A) The relationship between the rates of interest on all securities. B) The relationship between the interest rate on a security and its time to maturity. C) The relationship between the yield on a bond and its default rate. D) All of the above. E) None of the above. 2. The yield curve shows at any point in time: A) The relationship between the yield on a bond and the duration of the bond. B) The relationship between the coupon rate on a bond and time to maturity of the bond. C) The relationship between yield on a bond and the time to maturity on the bond. D) All of the above. E) None of the above. 3. An inverted yield curve implies that: A) Long-term interest rates are lower than short-term interest rates. B) Long-term interest rates are higher than short-term interest rates. C) Long-term interest rates are the same as short-term interest rates. D) Intermediate term interest rates are higher than either short- or long-term interest rates. E) none of the above. 4. An A) B) C) upward sloping yield curve is a(n) _______ yield curve. normal. humped. inverted.

D) flat. E) none of the above. 5. According to the expectations hypothesis, a normal yield curve implies that A) interest rates are expected to remain stable in the future. B) interest rates are expected to decline in the future. C) interest rates are expected to increase in the future. D) interest rates are expected to decline first, then increase. E) interest rates are expected to increase first, then decrease. 6. Which of the following is not proposed as an explanation for the term structure of interest rates: A) The expectations theory. B) The liquidity preference theory. C) The market segmentation theory. D) Modern portfolio theory. E) A, B, and C. 7. The expectations theory of the term structure of interest rates states that A) forward rates are determined by investors' expectations of future interest rates. B) forward rates exceed the expected future interest rates. C) yields on long- and short-maturity bonds are determined by the supply and demand for the securities. D) all of the above. E) none of the above. 8. Which of the following theories state that the shape of the yield curve is essentially determined by the supply and demands for longand short-maturity bonds? A) Liquidity preference theory. B) Expectations theory. C) Market segmentation theory. D) All of the above. E) None of the above. 9. If forward rates are known with certainty and all bonds are fairly priced A) all bonds would have the same yield to maturity. B) all short-maturity bonds would have lower prices than all longmaturity bonds. C) all bonds would have the same price. D) all bonds would provide equal 1-year rates of return. E) none of the above.

10. According to the "liquidity preference" theory of the term structure of interest rates, the yield curve usually should be: A) inverted. B) normal. C) upward sloping. D) A and B. E) B and C. Use the following to answer questions 11-14: Suppose that all investors expect that interest rates for the 4 years will be as follows: Ye ar 0 1 2 3 Forward Interest Rate (today)5% 7% 9% 10%

11. What is the price of 3-year zero coupon bond with a par value of $1,000? A) $863.83 B) $816.58 C) $772.18 D) $765.55 E) none of the above 12. If you have just purchased a 4-year zero coupon bond, what would be the expected rate of return on your investment in the first year if the implied forward rates stay the same? (Par value of the bond = $1,000) A) 5% B) 7% C) 9% D) 10% E) none of the above 13. What is the price of a 2-year maturity bond with a 10% coupon rate paid annually? (Par value = $1,000) A) $1,092.97

B) C) D) E)

$1,054.24 $1,000.00 $1,073.34 none of the above

14. What is the yield to maturity of a 3-year zero coupon bond? A) 7.00% B) 9.00% C) 6.99% D) 7.49% E) none of the above Use the following to answer questions 15-18: The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. Maturity (Years) 1 2 3 4 Price $943.40 $881.68 $808.88 $742.09

15. What is, according to the expectations theory, the expected forward rate in the third year? A) 7.00% B) 7.33% C) 9.00% D) 11.19% E) none of the above 16. What is the yield to maturity on a 3-year zero coupon bond? A) 6.37% B) 9.00% C) 7.33% D) 10.00% E) none of the above 17. What is the price of a 4-year maturity bond with a 12% coupon rate paid annually? (Par value = $1,000) A) $742.09 B) $1,222.09

C) $1,000.00 D) $1,141.92 E) none of the above 18. You have purchased a 4-year maturity bond with a 10% coupon rate paid annually. The bond has a par value of $1,000. What would the price of the bond be one year from now if the implied forward rates stay the same? A) $808.88 B) $1,108.88 C) $1,000 D) $1,042.78 E) none of the above 19. The market segmentation theory of the term structure of interest rates A) theoretically can explain all shapes of yield curves. B) definitely holds in the "real world". C) assumes that markets for different maturities are separate markets. D) A and B. E) A and C. 20. Given the following pattern of forward rates: Year 1 2 3 Forward Rate 5% 6% 6.5%

If one year from now the term structure of interest rates changes so that it looks exactly the same as it does today, what would be your holding period return if you purchased a 3-year zero coupon bond today and held it for one year? A) 6% B) 8% C) 9% D) 5% E) none of the above 21. An upward sloping yield curve A) is an indication that interest rates are expected to increase. B) incorporates a liquidity premium.

C) reflects the confounding of the liquidity premium with interest rate expectations. D) all of the above. E) none of the above. 22. The "break-even" interest rate for year n that equates the return on an n-period zero-coupon bond to that of an n-1-period zero-coupon bond rolled over into a one-year bond in year n is defined as A) the forward rate. B) the short rate. C) the yield to maturity. D) the discount rate. E) None of the above. 23. When computing yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the: A) Coupon rate. B) Current yield. C) Yield to maturity at the time of the investment. D) Prevailing yield to maturity at the time interest payments are received. E) The average yield to maturity throughout the investment period. 24. Which one of the following statements is true? A) The expectations hypothesis indicates a flat yield curve if anticipated future short-term rates exceed the current short-term rate. B) The basic conclusion of the expectations hypothesis is that the long-term rate is equal to the anticipated long-term rate. C) The liquidity preference hypothesis indicates that, all other things being equal, longer maturities will have lower yields. D) The segmentation hypothesis contends that borrows and lenders are constrained to particular segments of the yield curve. E) None of the above. 25. The concepts of spot and forward rates are most closely associated with which one of the following explanations of the term structure of interest rates. A) Segmented Market theory B) Expectations Hypothesis C) Preferred Habitat Hypothesis D) Liquidity Premium theory E) None of the above 26.

Par Value Time to Maturity Coupon Current Price Yield to Maturity

$1,000 20 years 10% (paid annually) $850 12%

Given the bond described above, if interest were paid semi-annually (rather than annually), and the bond continued to be priced at $850, the resulting effective annual yield to maturity would be: A) Less than 12% B) More than 12% C) 12% D) Cannot be determined E) None of the above 27. Interest rates might decline A) because real interest rates are expected to decline. B) because the inflation rate is expected to decline. C) because nominal interest rates are expected to increase. D) A and B. E) B and C. 28. Statistical estimation of the yield curve contains apparent pricing error. These error terms are probably a result of A) tax effects. B) call provisions. C) out of date price quotes. D) all of the above. E) none of the above. 29. Forward rates ____________ future short rates because ____________. A) are equal to; they are both extracted from yields to maturity. B) are equal to; they are perfect forecasts. C) differ from; they are imperfect forecasts. D) differ from; forward rates are estimated from dealer quotes while future short rates are extracted from yields to maturity. E) are equal to; although they are estimated from different sources they both are used by traders to make purchase decisions. 30. The pure yield curve can be estimated A) by using zero-coupon bonds. B) by using coupon bonds if each coupon is treated as a separate

"zero." C) by using corporate bonds with different risk ratings. D) by estimating liquidity premiums for different maturities. E) A and B. 31. The market segmentation and preferred habitat theories of term structure A) are identical. B) vary in that market segmentation is rarely accepted today. C) vary in that market segmentation maintains that borrowers and lenders will not depart from their preferred maturities and preferred habitat maintains that market participants will depart from preferred maturities if yields on other maturities are attractive enough. D) A and B. E) B and C. 32. The yield curve A) is a graphical depiction of term structure of interest rates. B) is usually depicted for U. S. Treasuries in order to hold risk constant across maturities and yields. C) is usually depicted for corporate bonds of different ratings. D) A and B. E) A and C. Use the following to answer questions 33-36: Year 1 2 3 4 5 1-Year Forward Rate 5.8% 6.4% 7.1% 7.3% 7.4%

33. What should the purchase price of a 2-year zero coupon bond be if it is purchased at the beginning of year 2 and has face value of $1,000? A) $877.54 B) $888.33 C) $883.32

D) $893.36 E) $871.80 34. What would the yield to maturity be on a four-year zero coupon bond purchased today? A) 5.80% B) 7.30% C) 6.65% D) 7.25% E) none of the above. 35. Calculate the price at the beginning of year 1 of a 10% annual coupon bond with face value $1,000 and 5 years to maturity. A) $1,105.47 B) $1,131.91 C) $1,177.89 D) $1,150.01 E) $719.75 36. What should be the holding period return of a 9% annual coupon bond with face value $1000 and five years to maturity if it is purchased at the beginning of year 1 and sold at the beginning of year 2, assuming that rates do not change. A) 6.0% B) 7.1% C) 6.8% D) 7.4% E) none of the above. 37. Given the yield on a 3 year zero-coupon bond is 7.2% and forward rates of 6.1% in year 1 and 6.9% in year 2, what must be the forward rate in year 3? A) 7.2% B) 8.6% C) 6.1% D) 6.9% E) none of the above. 38. Consider two annual coupon bonds, each with two years to maturity. Bond A has a 7% coupon and a price of $1000.62. Bond B has a 10% coupon and sells for $1,055.12. Find the two one-period forward rates that must hold for these bonds. A) 6.97%, 6.95% B) 6.95%, 6.95% C) 6.97%, 6.97% D) 6.08%, 7.92%

E) 7.00%, 10.00% 39. An A) B) C) D) inverted yield curve is one with a hump in the middle. constructed by using convertible bonds. that is relatively flat. that plots the inverse relationship between bond prices and bond yields. E) that slopes downward.

40. Assuming the forecasts implicit in a yield curve come to pass, an inverted yield curve would be most favorable for A) short-term borrowers. B) long-term borrowers. C) short-term lenders. D) long-term lenders. E) nobody - Neither a borrower nor a lender be. 41. Investors can use publicly available financial date to determine which of the following? A) B) C) D) E) I) II) III) IV) the shape of the yield curve future short-term rates the direction the Dow indexes are heading the actions to be taken by the Federal Reserve

I and II I and III I, II, and III I, III, and IV I, II, III, and IV

42. Which of the following is a reason that bond prices do not conform exactly to the present value of the bond's cash flows? I. I) A call feature affects the bond's price. II. II) After-tax cash flows may be different for different investors. III. III) The IRS may impute a built-in interest payment. IV. IV) Some investors might choose to sell the bond before its maturity date. A) B) C) D) I and II I, II, and III I and IV I, II, and IV

E) I, II, III and IV 43. A liquidity premium A) compensates long-term investors for the uncertainty about future selling prices. B) compensates short-term investors for the uncertainty about future selling prices. C) compensates long-term investors for the lack of liquidity in bond markets. D) compensates short-term investors for the lack of liquidity in bond markets. E) is almost never observed in the markets. 44. The Liquidity Preference Theory states that A) stocks are preferred to bonds because they are generally more liquid. B) treasury Bonds are preferred to corporate bonds because they are more liquid. C) the liquidity premium is expected to be positive because shortterm investors dominate the market. D) bonds of large corporations are preferred because they have the highest liquidity. E) liquidity premiums can be measured precisely. 45. Which of the following combinations will result in a sharply increasing yield curve? A) increasing expected short rates and increasing liquidity premiums B) decreasing expected short rates and increasing liquidity premiums C) increasing expected short rates and decreasing liquidity premiums D) increasing expected short rates and constant liquidity premiums E) constant expected short rates and increasing liquidity premiums 46. The yield curve is a component of A) the Dow Jones Industrial Average. B) the consumer price index. C) the index of leading economic indicators. D) the producer price index. E) the inflation index. 47. The most recently issued Treasury securities are called A) on the run.

B) C) D) E)

off the run. on the market. off the market. none of the above.

Use the following to answer questions 48-51: Suppose that all investors expect that interest rates for the 4 years will be as follows: Ye ar 0 1 2 3 Forward Interest Rate (today)3% 4% 5% 6%

48. What is the price of 3-year zero coupon bond with a par value of $1,000? A) $889.08 B) $816.58 C) $772.18 D) $765.55 E) none of the above

49. If you have just purchased a 4-year zero coupon bond, what would be the expected rate of return on your investment in the first year if the implied forward rates stay the same? (Par value of the bond = $1,000) A) 5% B) 3% C) 9% D) 10% E) none of the above 50. What is the price of a 2-year maturity bond with a 5% coupon rate paid annually? (Par value = $1,000) A) $1,092.97 B) $1,054.24

C) $1,028.51 D) $1,073.34 E) none of the above 51. What is the yield to maturity of a 3-year zero coupon bond? A) 7.00% B) 9.00% C) 6.99% D) 4% E) none of the above Use the following to answer questions 52-55: The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000. Maturity (Years) 1 2 3 4 Price $925.16 $862.57 $788.66 $711.00

52. What is, according to the expectations theory, the expected forward rate in the third year? A) 7.23 B) 9.37% C) 9.00% D) 10.9% E) none of the above 53. What is the yield to maturity on a 3-year zero coupon bond? A) 6.37% B) 9.00% C) 7.33% D) 8.24% E) none of the above 54. What is the price of a 4-year maturity bond with a 10% coupon rate paid annually? (Par value = $1,000) A) $742.09

B) C) D) E)

$1,222.09 $1,035.66 $1,141.84 none of the above

55. You have purchased a 4-year maturity bond with a 9% coupon rate paid annually. The bond has a par value of $1,000. What would the price of the bond be one year from now if the implied forward rates stay the same? A) $995.63 B) $1,108.88 C) $1,000 D) $1,042.78 E) none of the above 56. Given the following pattern of forward rates: Year 1 2 3 Forward Rate 4% 5% 5.5%

If one year from now the term structure of interest rates changes so that it looks exactly the same as it does today, what would be your holding period return if you purchased a 3-year zero coupon bond today and held it for one year? A) 6% B) 4% C) 3% D) 6% E) none of the above 57. Par Value Time to Maturity Coupon Current Price $1,000 18 years 9% (paid annually) $917.99

Yield to Maturity

10%

Given the bond described above, if interest were paid semi-annually (rather than annually), and the bond continued to be priced at $917.99, the resulting effective annual yield to maturity would be: A) Less than 10% B) More than 10% C) 10% D) Cannot be determined E) None of the above Use the following to answer questions 58-60: Year 1 2 3 4 5 1-Year Forward Rate 5% 5.5% 6.0% 6.5% 7.0%

58. What should the purchase price of a 2-year zero coupon bond be if it is purchased at the beginning of year 2 and has face value of $1,000? A) $877.54 B) $888.33 C) $883.32 D) $894.21 E) $871.80 59. What would the yield to maturity be on a four-year zero coupon bond purchased today? A) 5.75% B) 6.30% C) 5.65% D) 5.25% E) none of the above. 60. Calculate the price at the beginning of year 1 of an 8% annual coupon bond with face value $1,000 and 5 years to maturity.

A) $1,105.47 B) $1,131.91 C) $1084.25 D) $1,150.01 E) $719.75 61. Given the yield on a 3 year zero-coupon bond is 7% and forward rates of 6% in year 1 and 6.5% in year 2, what must be the forward rate in year 3? A) 7.2% B) 8.6% C) 8.5% D) 6.9% E) none of the above. Short Answer Questions 62. Discuss the three theories of the term structure of interest rates. Include in your discussion the differences in the theories, and the advantages/disadvantages of each. Answer: The expectations hypothesis is the most commonly accepted theory of term structure. The theory states that the forward rate equals the market consensus expectation of future short-term rates. Thus, yield to maturity is determined solely by current and expected future one-period interest rates. An upward sloping, or normal, yield curve would indicate that investors anticipate an increase in interest rates. An inverted, or downward sloping, yield curve would indicate an expectation of decreased interest rates. A horizontal yield curve would indicate an expectation of no interest rate changes. The liquidity preference theory of term structure maintains that short-term investors dominate the market; thus, in general, the forward rate exceeds the expected short-term rate. In other words, investors prefer to be liquid to illiquid, all else equal, and will demand a liquidity premium in order to go long term. Thus, liquidity preference readily explains the upward sloping, or normal, yield curve. However, liquidity preference does not readily explain other yield curve shapes. Market segmentation and preferred habitat theories indicate that the markets for different maturity debt instruments are segmented. Market segmentation maintains that the rates for the different maturities are determined by the intersection of the supply and demand curves for the different maturity instruments. Market segmentation readily explains all shapes of yield curves. However,

market segmentation is not observed in the real world. Investors and issuers will leave their preferred maturity habitats if yields are attractive enough on other maturities. The purpose of this question is to ascertain that students understand the various explanations (and deficiencies of these explanations) of term structure. Difficulty: Moderate 63. Term structure of interest rates is the relationship between what variables? What is assumed about other variables? How is term structure of interest rates depicted graphically? Answer: Term structure of interest rates is the relationship between yield to maturity and term to maturity, all else equal. The "all else equal" refers to risk class. Term structure of interest rates is depicted graphically by the yield curve, which is usually a graph of U. S. governments of different yields and different terms to maturity. The use of U. S. governments allows one to examine the relationship between yield and maturity, holding risk constant. The yield curve depicts this relationship at one point in time only. This question is designed to ascertain that students understand the relationships involved in term structure, the restrictions on the relationships, and how the relationships are depicted graphically. Difficulty: Moderate 64. Although the expectations of increases in future interest rates can result in an upward sloping yield curve; an upward sloping yield curve does not in and of itself imply the expectations of higher future interest rates. Explain. Answer: The effects of possible liquidity premiums confound any simple attempt to extract expectation from the term structure. That is, the upward sloping yield curve may be due to expectations of interest rate increases, or due to the requirement of a liquidity premium, or both. The liquidity premium could more than offset expectations of decreased interest rates, and an upward sloping yield would result. The purpose of this question is to assure that the student understands the confounding of the liquidity premium with the expectations hypothesis, and that the interpretations of term structure are not clear-cut.

Difficulty: Moderate 65. Explain what the following terms mean: spot rate, short rate, and forward rate. Which of these is (are) observable today? Answer: From the answer to Concept Check 2, on page 516: The nperiod spot rate is the yield to maturity on a zero-coupon bond with a maturity of n periods. The short rate for period n is the one-period interest rate that will prevail in period n. The forward rate for period n is the short rate that would satisfy a break-even condition equating the total returns on two n-period investment strategies. The first strategy is an investment in an n-period zero-coupon bond. The second is an investment in an n-1 period zero-coupon bond rolled over into an investment in a one-period zero. Spot rates and forward rates are observable today, but because interest rates evolve with uncertainty, future short rates are not. In the special case in which there is no uncertainty in future interest rates, the forward rate calculated from the yield curve would equal the short rate that will prevail in that period. This question checks whether the student understands the difference between each kind of rate. It is based on Concept Check 2 on page 492. Difficulty: Moderate 66. Answer the following questions that relate to bonds. A 2-year zero-coupon bond is selling for $890.00. What is the yield to maturity of this bond? The price of a 1-year zero coupon bond is $931.97. What is the yield to maturity of this bond? Calculate the forward rate for the second year. How can you construct a synthetic one-year forward loan (you are agreeing now to loan in one year)? State the strategy and show the corresponding cash flows. Assume that you can purchase and sell fractional portions of bonds. Show all calculations and discuss the meaning of the transactions. Answer: Calculations are shown in the table below. Calculations for YTM of the 2-year zero: N=2, PV=-890.00, PMT=0, FV=1000, CPT I6.0. Calculations for YTM of the 1-year zero: N=1, PV=-931.97, PMT=0, FV=1000, CPT I7.3.

Calculations for f2: (1.06)2/(1.073) 1 = .047157502, f2 = 4.7157502% As shown by the calculations below, you purchase enough 2-year zeros to offset the cost of the 1-year zero. At time 1 the 1year zero matures and you get $1,000. At time 2 the 2-year zeros mature and you have to pay 1.047157502 * $1,000 = $1,047.16. You are effectively borrowing $1,000 a year from now and paying $1,047.16 a year from then. The rate on this forward loan is $1,047.16/$1,000 1 = .04716, which equals the forward rate for the second year (f2). Cash Flow -$931.97 $890.00 * 1.047157502 = $931.97 $0.00

Strategy Buy a 1-year zero-coupon bond Sell 1.047157502 2-year zeros Net Cash Flow

This question is similar to an example in the chapter and to Concept Check 7 on page 499. It is an advanced question that measures the student's understanding of forward rates and the opportunities they present for the creation of synthetic loans. Difficulty: Difficult

Multiple Choice Questions 1. The duration of a bond is a function of the bond's A) coupon rate. B) yield to maturity. C) time to maturity. D) all of the above. E) none of the above. 2. Ceteris paribus, the duration of a bond is positively correlated with the bond's A) time to maturity. B) coupon rate.

C) yield to maturity. D) all of the above. E) none of the above. 3. Holding other factors constant, the interest-rate risk of a coupon bond is higher when the bond's: A) term-to-maturity is lower. B) coupon rate is higher. C) yield to maturity is lower. D) current yield is higher. E) none of the above. 4. The "modified duration" used by practitioners is equal to the Macaulay duration A) times the change in interest rate. B) times (one plus the bond's yield to maturity). C) divided by (one minus the bond's yield to maturity). D) divided by (one plus the bond's yield to maturity). E) none of the above. 5. Given the time to maturity, the duration of a zero-coupon bond is higher when the discount rate is A) higher. B) lower. C) equal to the risk free rate. D) The bond's duration is independent of the discount rate. E) none of the above. 6. The interest-rate risk of a bond is A) the risk related to the possibility of bankruptcy of the bond's issuer. B) the risk that arises from the uncertainty of the bond's return caused by changes in interest rates. C) the unsystematic risk caused by factors unique in the bond. D) A and B above. E) A, B, and C above.

7. Which of the following two bonds is more price sensitive to changes in interest rates? A) B) C) D) 1) A par value bond, X, with a 5-year-to-maturity and a 10% coupon rate. 2) A zero-coupon bond, Y, with a 5-year-to-maturity and a 10% yield-to-maturity.

Bond X because of the higher yield to maturity. Bond X because of the longer time to maturity. Bond Y because of the longer duration. Both have the same sensitivity because both have the same yield to maturity. E) None of the above 8. Holding other factors constant, which one of the following bonds has the smallest price volatility? A) 5-year, 0% coupon bond B) 5-year, 12% coupon bond C) 5 year, 14% coupon bond D) 5-year, 10% coupon bond E) Cannot tell from the information given. 9. Which of the following is not true? A) Holding other things constant, the duration of a bond increases with time to maturity. B) Given time to maturity, the duration of a zero-coupon decreases with yield to maturity. C) Given time to maturity and yield to maturity, the duration of a bond is higher when the coupon rate is lower. D) Duration is a better measure of price sensitivity to interest rate changes than is time to maturity. E) All of the above. 10. The duration of a 5-year zero-coupon bond is A) smaller than 5. B) larger than 5. C) equal to 5. D) equal to that of a 5-year 10% coupon bond. E) none of the above. 11. The basic purpose of immunization is to A) eliminate default risk. B) produce a zero net interest-rate risk. C) offset price and reinvestment risk.

D) A and B. E) B and C. 12. The duration of a par value bond with a coupon rate of 8% and a remaining time to maturity of 5 years is A) 5 years. B) 5.4 years. C) 4.17 years. D) 4.31 years. E) none of the above. 13. The duration of a perpetuity with a yield of 8% is A) 13.50 years. B) 12.11 years. C) 6.66 years. D) cannot be determined. E) none of the above. 14. A seven-year par value bond has a coupon rate of 9% and a modified duration of A) 7 years. B) 5.49 years. C) 5.03 years. D) 4.87 years. E) none of the above. 15. Par value bond XYZ has a modified duration of 6. Which one of the following statements regarding the bond is true? A) If the market yield increases by 1% the bond's price will decrease by $60. B) If the market yield increases by 1% the bond's price will increase by $50. C) If the market yield increases by 1% the bond's price will decrease by $50. D) If the market yield increases by 1% the bond's price will increase by $60. E) None of the above. 16. Which of the following bonds has the longest duration? A) An 8-year maturity, 0% coupon bond. B) An 8-year maturity, 5% coupon bond. C) A 10-year maturity, 5% coupon bond. D) A 10-year maturity, 0% coupon bond. E) Cannot tell from the information given.

17. Which one of the following par value 12% coupon bonds experiences a price change of $23 when the market yield changes by 50 basis points? A) The bond with a duration of 6 years. B) The bond with a duration of 5 years. C) The bond with a duration of 2.7 years. D) The bond with a duration of 5.15 years. E) None of the above. 18. Which one of the following statements is true concerning the duration of a perpetuity? A) The duration of 15% yield perpetuity that pays $100 annually is longer than that of a 15% yield perpetuity that pays $200 annually. B) The duration of a 15% yield perpetuity that pays $100 annually is shorter than that of a 15% yield perpetuity that pays $200 annually. C) The duration of a 15% yield perpetuity that pays $100 annually is equal to that of 15% yield perpetuity that pays $200 annually. D) the duration of a perpetuity cannot be calculated. E) None of the above. 19. The two components of interest-rate risk are A) price risk and default risk. B) reinvestment risk and systematic risk. C) call risk and price risk. D) price risk and reinvestment risk. E) none of the above. 20. The duration of a coupon bond A) does not change after the bond is issued. B) can accurately predict the price change of the bond for any interest rate change. C) will decrease as the yield to maturity decreases. D) all of the above are true. E) none of the above is true. 21. Indexing of bond portfolios is difficult because A) the number of bonds included in the major indexes is so large that it would be difficult to purchase them in the proper proportions. B) many bonds are thinly traded so it is difficult to purchase them at a fair market price. C) the composition of bond indexes is constantly changing. D) all of the above are true.

E) both A and B are true. 22. You have an obligation to pay $1,488 in four years and 2 months. In which bond would you invest your $1,000 to accumulate this amount, with relative certainty, even if the yield on the bond declines to 9.5% immediately after you purchase the bond? A) a 6-year; 10% coupon par value bond B) a 5-year; 10% coupon par value bond C) a 5-year; zero-coupon bond D) a 4-year; 10% coupon par value bond E) none of the above 23. Duration measures A) weighted average time until a bond's half-life. B) weighted average time until cash flow payment. C) the time required to recoup one's investment, assuming the bond was purchased for $1,000. D) A and C. E) B and C. 24. Duration A) assesses the time element of bonds in terms of both coupon and term to maturity. B) allows structuring a portfolio to avoid interest-rate risk. C) is a direct comparison between bond issues with different levels of risk. D) A and B. E) A and C. 25. Identify the bond that has the longest duration (no calculations necessary). A) 20-year maturity with an 8% coupon. B) 20-year maturity with a 12% coupon. C) 15-year maturity with a 0% coupon. D) 10-year maturity with a 15% coupon. E) 12-year maturity with a 12% coupon. 26. When interest rates decline, the duration of a 10-year bond selling at a premium A) increases. B) decreases. C) remains the same. D) increases at first, then declines. E) decreases at first, then increases.

27. An 8%, 30-year corporate bond was recently being priced to yield 10%. The Macaulay duration for the bond is 10.20 years. Given this information, the bond's modified duration would be________. A) 8.05 B) 9.44 C) 9.27 D) 11.22 E) none of the above 28. An 8%, 15-year bond has a yield to maturity of 10% and duration of 8.05 years. If the market yield changes by 25 basis points, how much change will there be in the bond's price? A) 1.85% B) 2.01% C) 3.27% D) 6.44% E) none of the above 29. One way that banks can reduce the duration of their asset portfolios is through the use of A) fixed rate mortgages. B) adjustable rate mortgages. C) certificates of deposit. D) short-term borrowing. E) none of the above. 30. The duration of a bond normally increases with an increase in A) term to maturity. B) yield to maturity. C) coupon rate. D) all of the above. E) none of the above. 31. Which one of the following is an incorrect statement concerning duration? A) The higher the yield to maturity, the greater the duration B) The higher the coupon, the shorter the duration. C) The difference in duration is small between two bonds with different coupons each maturing in more than 15 years. D) The duration is the same as term to maturity only in the case of zero-coupon bonds. E) All of the statements are correct.

32. Immunization is not a strictly passive strategy because A) it requires choosing an asset portfolio that matches an index. B) there is likely to be a gap between the values of assets and liabilities in most portfolios. C) it requires frequent rebalancing as maturities and interest rates change. D) durations of assets and liabilities fall at the same rate. E) none of the above. 33. Contingent immunization A) is a mixed-active passive bond portfolio management strategy. B) is a strategy whereby the portfolio may or may not be immunized. C) is a strategy whereby if and when some trigger point value of the portfolio is reached, the portfolio is immunized to insure an minimum required return. D) A and B. E) A, B, and C. 34. Some of the problems with immunization are A) duration assumes that the yield curve is flat. B) duration assumes that if shifts in the yield curve occur, these shifts are parallel. C) immunization is valid for one interest rate change only. D) durations and horizon dates change by the same amounts with the passage of time. E) A, B, and C. 35. If a bond portfolio manager believes A) in market efficiency, he or she is likely to be a passive portfolio manager. B) that he or she can accurately predict interest rate changes, he or she is likely to be an active portfolio manager. C) that he or she can identify bond market anomalies, he or she is likely to be a passive portfolio manager. D) A and B. E) A, B, and C. 36. According to experts, most pension funds are underfunded because A) their liabilities are of shorter duration than their assets. B) their assets are of shorter duration than their liabilities. C) they continually adjust the duration of their liabilities. D) they continually adjust the duration of their assets. E) they are too heavily invested in stocks. 37. Cash flow matching on a multiperiod basis is referred to as a

A) B) C) D) E)

immunization. contingent immunization. dedication. duration matching. rebalancing.

38. Immunization through duration matching of assets and liabilities may be ineffective or inappropriate because A) conventional duration strategies assume a flat yield curve. B) duration matching can only immunize portfolios from parallel shifts in the yield curve. C) immunization only protects the nominal value of terminal liabilities and does not allow for inflation adjustment. D) both A and C are true. E) all of the above are true. 39. The curvature of the price-yield curve for a given bond is referred to as the bond's A) modified duration. B) immunization. C) sensitivity. D) convexity. E) tangency.

40. Consider a bond selling at par with modified duration of 10.6 years and convexity of 210. A 2 percent decrease in yield would cause the price to increase by 21.2%, according to the duration rule. What would be the percentage price change according to the durationwith-convexity rule? A) 21.2% B) 25.4% C) 17.0% D) 10.6% E) none of the above. 41. A substitution swap is an exchange of bonds undertaken to A) change the credit risk of a portfolio. B) extend the duration of a portfolio. C) reduce the duration of a portfolio. D) profit from apparent mispricing between two bonds. E) adjust for differences in the yield spread.

42. A rate anticipation swap is an exchange of bonds undertaken to A) shift portfolio duration in response to an anticipated change in interest rates. B) shift between corporate and government bonds when the yield spread is out of line with historical values. C) profit from apparent mispricing between two bonds. D) change the credit risk of the portfolio. E) increase return by shifting into higher yield bonds. 43. An analyst who selects a particular holding period and predicts the yield curve at the end of that holding period is engaging in A) a rate anticipation swap. B) immunization. C) horizon analysis. D) an intermarket spread swap. E) none of the above. 44. The process of unbundling and repackaging the cash flows from one or more bonds into new securities is called A) speculation. B) immunization. C) reverse hedging. D) interest rate arbitrage. E) financial engineering. 45. An active investment strategy A) implies that market prices are fairly set. B) attempts to achieve returns greater than those commensurate with the risk borne. C) attempts to achieve the proper return that is commensurate with the risk borne. D) requires portfolio managers, while a passive investment strategy does not. E) occurs when bond portfolio managers are hyperactive. 46. Interest-rate risk is important to A) active bond portfolio managers. B) passive bond portfolio managers. C) both active and passive bond portfolio managers. D) neither active nor passive bond portfolio managers. E) obsessive bond portfolio managers. 47. Which of the following are true about the interest-rate sensitivity of bonds?

V. I) Bond prices and yields are inversely related. VI. II) Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of short-term bonds. VII.III) Interest-rate risk is directly related to the bond's coupon rate. VIII.IV) The sensitivity of a bond's price to a change in its yield to maturity is inversely related to the yield to maturity at which the bond is currently selling. A) B) C) D) E) I and II I and III I, II, and IV II, III, and IV I, II, III, and IV

48. Which of the following researchers have contributed significantly to bond portfolio management theory? A) B) C) D) E) I) II) III) IV) V) Sidney Homer Harry Markowitz Burton Malkiel Martin Liebowitz Frederick Macaulay

I and II III and V III, IV, and V I, III, IV, and V I, II, III, IV, and V

49. According to the duration concept A) only coupon payments matter. B) only maturity value matters. C) the coupon payments made prior to maturity make the effective maturity of the bond greater than its actual time to maturity. D) the coupon payments made prior to maturity make the effective maturity of the bond less than its actual time to maturity. E) discount rates don't matter. 50. Duration is important in bond portfolio management because I) II) it can be used in immunization strategies. it provides a gauge of the effective average maturity of

A) B) C) D) E)

the portfolio. III) it is related to the interest rate sensitivity of the portfolio. IV) it is a good predictor of interest rate changes. I and II I and III III and IV I, II, and III I, II, III, and IV

51. Two bonds are selling at par value and each has 17 years to maturity. The first bond has a coupon rate of 6% and the second bond has a coupon rate of 13%. Which of the following is true about the durations of these bonds? A) The duration of the higher-coupon bond will be higher. B) The duration of the lower-coupon bond will be higher. C) The duration of the higher-coupon bond will equal the duration of the lower-coupon bond. D) There is no consistent statement that can be made about the durations of the bonds. E) The bond's durations cannot be determined without knowing the prices of the bonds. 52. Which of the following offers a bond index? A) Merrill Lynch B) Salomon Smith Barney C) Lehman D) All of the above E) All but Merrill Lynch 53. Which of the following two bonds is more price sensitive to changes in interest rates? 1) A par value bond, A, with a 12-year-to-maturity and a 12% coupon rate. 2) A zero-coupon bond, B, with a 12-year-to-maturity and a 12% yield-to-maturity. A) Bond A because of the higher yield to maturity. B) Bond A because of the longer time to maturity. C) Bond B because of the longer duration. D) Both have the same sensitivity because both have the same yield to maturity. E) None of the above 54. Which of the following two bonds is more price sensitive to changes in interest rates?

1. 1) A par value bond, D, with a 2-year-to-maturity and a 8% coupon rate. 2. 2) A zero-coupon bond, E, with a 2-year-to-maturity and a 8% yield-to-maturity. A) B) C) D) Bond D because of the higher yield to maturity. Bond E because of the longer duration Bond D because of the longer time to maturity. Both have the same sensitivity because both have the same yield to maturity. E) None of the above 55. Holding other factors constant, which one of the following bonds has the smallest price volatility? A) 7-year, 0% coupon bond B) 7-year, 12% coupon bond C) 7 year, 14% coupon bond D) 7-year, 10% coupon bond E) Cannot tell from the information given. 56. Holding other factors constant, which one of the following bonds has the smallest price volatility? A) 20-year, 0% coupon bond B) 20-year, 6% coupon bond C) 20 year, 7% coupon bond D) 20-year, 9% coupon bond E) Cannot tell from the information given. 57. The duration of a 15-year zero-coupon bond is A) smaller than 15. B) larger than 15. C) equal to 15. D) equal to that of a 15-year 10% coupon bond E) none of the above. 58. The duration of a 20-year zero-coupon bond is A) equal to smaller than 20. B) larger than 20. C) smaller than 20. D) equal to that of a 20-year 10% coupon bond E) none of the above. 59. The duration of a perpetuity with a yield of 10% is A) 13.50 years. B) 11 years.

C) 6.66 years. D) cannot be determined. E) none of the above. 60. The duration of a perpetuity with a yield of 6% is A) 13.50 years. B) 12.11 years. C) 17.67 years. D) cannot be determined. E) none of the above. 61. Par value bond F has a modified duration of 9. Which one of the following statements regarding the bond is true? A) If the market yield increases by 1% the bond's price will decrease by $90. B) If the market yield increases by 1% the bond's price will increase by $90. C) If the market yield increases by 1% the bond's price will decrease by $60. D) If the market yield decreases by 1% the bond's price will increase by $60. E) None of the above. 62. Par value bond GE has a modified duration of 11. following statements regarding the bond is true? A) If the market yield increases by 1% the bond's by $55. B) If the market yield increases by 1% the bond's by $55. C) If the market yield increases by 1% the bond's by $110. D) If the market yield increases by 1% the bond's by $110. E) None of the above. Which one of the price will decrease price will increase price will decrease price will increase

63. Which of the following bonds has the longest duration? A) A 15-year maturity, 0% coupon bond. B) A 15-year maturity, 9% coupon bond. C) A 20-year maturity, 9% coupon bond. D) A 20-year maturity, 0% coupon bond. E) Cannot tell from the information given. 64. Which of the following bonds has the longest duration? A) A 12-year maturity, 0% coupon bond.

B) C) D) E)

A 12-year maturity, 8% coupon bond. A 4-year maturity, 8% coupon bond. A 4-year maturity, 0% coupon bond. Cannot tell from the information given.

65. A 10%, 30-year corporate bond was recently being priced to yield 12%. The Macaulay duration for the bond is 11.3 years. Given this information, the bond's modified duration would be A) 8.05 B) 10.09 C) 9.27 D) 11.22 E) none of the above 66. A 6%, 30-year corporate bond was recently being priced to yield 8%. The Macaulay duration for the bond is 8.4 years. Given this information, the bond's modified duration would be A) 8.05 B) 9.44 C) 9.27 D) 7.78 E) none of the above 67. A 9%, 16-year bond has a yield to maturity of 11% and duration of 9.25 years. If the market yield changes by 32 basis points, how much change will there be in the bond's price? A) 1.85% B) 2.01% C) 2.67% D) 6.44% E) none of the above 68. A 7%, 14-year bond has a yield to maturity of 6% and duration of 7 years. If the market yield changes by 44 basis points, how much change will there be in the bond's price? A) 1.85% B) 2.91% C) 3.27% D) 6.44% E) none of the above 69. Consider a bond selling at par with modified duration of 12 years and convexity of 265. A 1 percent decrease in yield would cause the price to increase by 12%, according to the duration rule. What

would be the percentage price change according to the durationwith-convexity rule? A) 21.2% B) 25.4% C) 17.0% D) 13.3% E) none of the above. 70. Consider a bond selling at par with modified duration of 22-years and convexity of 415. A 2 percent decrease in yield would cause the price to increase by 44%, according to the duration rule. What would be the percentage price change according to the durationwith-convexity rule? A) 21.2% B) 25.4% C) 17.0% D) 52.3% E) none of the above. 71. The duration of a par value bond with a coupon rate of 6.5% and a remaining time to maturity of 4 years is A) 3.65 years. B) 3.45 years. C) 3.85 years. D) 4.00 years. E) none of the above. 72. The duration of a par value bond with a coupon rate of 7% and a remaining time to maturity of 3 years is A) 3 years. B) 2.71years. C) 2.81 years. D) 2.91 years. E) none of the above. 73. The duration of a par value bond with a coupon rate of 8.7% and a remaining time to maturity of 6 years is A) 6.0 years. B) 5.1 years. C) 4.27 years. D) 3.95 years. E) none of the above.

Essay Questions 74. Discuss duration. Include in your discussion what duration measures, how duration relates to maturity, what variables affect duration, and how duration is used as a portfolio management tool (include some of the problems associated with the use of duration as a portfolio management tool). Difficulty: Moderate Answer: Duration is a measure of the time it takes to recoup one's investment in a bond, assuming that one purchased the bond for $1,000. Duration is shorter than term to maturity on coupon bonds as cash flows are received prior to maturity. Duration equals term to maturity for zero-coupon bonds, as no cash flows are received prior to maturity. Duration measures the price sensitivity of a bond with respect interest rate changes. The longer the maturity of the bond, the lower the coupon rate of the bond, and the higher the yield to maturity of the bond, the greater the duration. Interest-rate risk consists of two components: price risk and reinvestment risk. These two risk components move in opposite direction; if duration equals horizon date, the two types of risk exactly offset each other, resulting in zero net interest-rate risk. This portfolio management strategy is immunization. Some of the problems associated with this strategy are: the portfolio is protected against one interest rate change only; thus, once interest rates change, the portfolio must be rebalanced to maintain immunization; duration assumes a horizontal yield curve (not the shape most commonly observed); duration also assumes that any shifts in the yield curve are parallel (resulting in a continued horizontal yield curve); in addition, the portfolio manager may have trouble locating acceptable bonds that produce immunized portfolios; finally, both duration and horizon dates change with the mere passage of time, but not in a lockstep fashion, thus rebalancing is required. Although immunization is considered a passive bond portfolio management strategy, considerable rebalancing must occur, as indicated above. The portfolio manager must consider the tradeoffs between the transaction costs and not being perfectly immunized at all times. The rationale for the question is to be certain that the student thoroughly understands duration, how duration is used as a portfolio management tool, and the deficiencies of duration as a portfolio management tool. 75. Discuss contingent immunization. Is this form of bond portfolio

management strategy an active, passive, or combination of both, strategy? Difficulty: Moderate Answer: Contingent immunization is portfolio management technique where the portfolio owner is willing to accept an average annual return over a period of time that is lower than that currently available. The portfolio manager may actively manage the portfolio until (if) the portfolio declines in value to the point that the portfolio must be immunized in order to earn the minimum average required return. Thus, the portfolio will be immunized contingent upon reaching that level. If that level is not reached, the portfolio will not be immunized, and the average annual returns will be greater than those required. Thus, this strategy is considered to be a combination active/passive bond portfolio management strategy. The rationale behind this question is to ascertain that the student understands contingent immunization, how the tool is implemented, and the possible ramifications of the use of the technique. 76. Discuss rate anticipation swaps as a bond portfolio management strategy. Difficulty: Moderate Answer: Rate anticipation swap is an active bond portfolio management strategy, based on predicting future interest rates. If a portfolio manager believes that interest rates will decline, the manager will swap into bonds of greater duration. Conversely, if the portfolio manager believes that interest rates will increase, the portfolio manager will swap into bonds of shorter duration. This strategy is an active one, resulting in high transactions costs, and the success of this strategy is predicated on the bond portfolio manager's ability to predict correctly interest rate changes consistently over time (a difficult task, indeed). The rationale behind this question is to ascertain if the student understands the risk of one of the most common types of active bond portfolio management strategies and the relationship of this strategy to duration. 77. You manage a portfolio for Ms. Greenspan, who has instructed you to be sure her portfolio has a value of at least $350,000 at the end

of six years. The current value of Ms. Greenspan's portfolio is $250,000. You can invest the money at a current interest rate of 8%. You have decided to use a contingent immunization strategy. What amount would need to be invested today to achieve the goal, given the current interest rate? Suppose that four years have passed and the interest rate is 9%. What is the trigger point for Angel's portfolio at this time? (That is, how low can the value of the portfolio be before you will be forced to immunize to be assured of achieving the minimum acceptable return?) Illustrate the situation graphically. If the portfolio's value after 4 years is $291,437 what should you do? Difficulty: Difficult Answer: Calculations are shown below. Amount needed to reach the goal = $350,000/1.086 = $220,559.37 The trigger point = $350,000/1.092 = $294,588.00 The graph should look like the ones in Figure 16.12 on page 550. You should immunize the portfolio because its value is below the trigger point. If the value is $291,437 you will need to earn a rate of 9.59% over the remaining two years to achieve the goal of $350,000: $350,000 = $291,437*(1+r)2. Solving for r yields 9.59%. This question tests the student's understanding of contingent immunization.

78. You have purchased a bond for $973.02. The bond has a coupon rate of 6.4%, pays interest annually, has a face value of $1,000, 4 years to maturity, and a yield to maturity of 7.2%. The bond's duration is 3.6481 years. You expect that interest rates will fall by . 3% later today. Use the modified duration to find the approximate percentage change in the bond's price. Find the new price of the bond from this calculation. Use your calculator to do the regular present value calculations to find the bond's new price at its new yield to maturity. What is the amount of the difference between the two answers? Why are your answers different? Explain the reason in words and illustrate it graphically. Difficulty: Difficult Answer: Calculations are shown below. Find new price using modified duration: Modified duration = 3.6481/1.072 = 3.403 years. Approximate percentage price change using modified duration = -3.403*(-.0003) = 1.02%. New Price = $973.02 * 1.0102 = $982.94 ($982.96 if duration isn't rounded) Find new price by taking present value at the new yield to maturity: N=4, I=6.9%, PMT=64, FV=1000, CPT PV=983.03. The answers are different by $0.09. The reason is that using modified duration gives an approximation of the percentage change in price. It should only be used for small changes in yields because of bond price convexity. As you move farther away from the original yield, the slope of the straight line that shows the duration approximation no longer matches the slope of the curved line that shows the actual price changes. This question investigates the depth of the student's understanding of duration, its use in approximating interest rate sensitivity, and the potential shortcomings of using it.

Multiple Choice Questions 1. Which of the following statements regarding risk-averse investors is true? A) They only care about the rate of return. B) They accept investments that are fair games. C) They only accept risky investments that offer risk premiums over the risk-free rate. D) They are willing to accept lower returns and high risk. E) A and B. 2. Which of the following statements is (are) true? A) B) C) D) E) I) Risk-averse investors reject investments that are fair games. II) Risk-neutral investors judge risky investments only by the expected returns. III) Risk-averse investors judge investments only by their riskiness. IV) Risk-loving investors will not engage in fair games. I only II only I and II only II and III only II, III, and IV only

3. In the mean-standard deviation graph an indifference curve has a ________ slope. A) negative B) zero C) positive D) northeast E) cannot be determined 4. In the mean-standard deviation graph, which one of the following statements is true regarding the indifference curve of a risk-averse

investor? A) It is the locus of portfolios that have the same expected rates of return and different standard deviations. B) It is the locus of portfolios that have the same standard deviations and different rates of return. C) It is the locus of portfolios that offer the same utility according to returns and standard deviations. D) It connects portfolios that offer increasing utilities according to returns and standard deviations. E) none of the above. 5. In a return-standard deviation space, which of the following statements is (are) true for risk-averse investors? (The vertical and horizontal lines are referred to as the expected return-axis and the standard deviation-axis, respectively.) IX. I) An investor's own indifference curves might intersect. X. II) Indifference curves have negative slopes. XI. III) In a set of indifference curves, the highest offers the greatest utility. XII.IV) Indifference curves of two investors might intersect. A) B) C) D) E) I and II only II and III only I and IV only III and IV only none of the above

6. Elias is a risk-averse investor. David is a less risk-averse investor than Elias. Therefore, A) for the same risk, David requires a higher rate of return than Elias. B) for the same return, Elias tolerates higher risk than David. C) for the same risk, Elias requires a lower rate of return than David. D) for the same return, David tolerates higher risk than Elias. E) cannot be determined. 7. When an investment advisor attempts to determine an investor's risk tolerance, which factor would they be least likely to assess? A) the investor's prior investing experience B) the investor's degree of financial security C) the investor's tendency to make risky or conservative choices D) the level of return the investor prefers E) the investor's feeling about loss Use the following to answer questions 8-9:

Assume an investor with the following utility function: U = E(r) - 3/2(s2). 8. To maximize her expected utility, she would choose the asset with an expected rate of return of _______ and a standard deviation of ________, respectively. A) 12%; 20% B) 10%; 15% C) 10%; 10% D) 8%; 10% E) none of the above 9. To maximize her expected utility, which one of the following investment alternatives would she choose? A) A portfolio that pays 10 percent with a 60 percent probability or 5 percent with 40 percent probability. B) A portfolio that pays 10 percent with 40 percent probability or 5 percent with a 60 percent probability. C) A portfolio that pays 12 percent with 60 percent probability or 5 percent with 40 percent probability. D) A portfolio that pays 12 percent with 40 percent probability or 5 percent with 60 percent probability. E) none of the above. 10. A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15. The risk-free rate is 6 percent. An investor has the following utility function: U = E(r) - (A/2)s2. Which value of A makes this investor indifferent between the risky portfolio and the risk-free asset? A) 5 B) 6 C) 7 D) 8 E) none of the above 11. According to the mean-variance criterion, which one of the following investments dominates all others? A) E(r) = 0.15; Variance = 0.20 B) E(r) = 0.10; Variance = 0.20 C) E(r) = 0.10; Variance = 0.25 D) E(r) = 0.15; Variance = 0.25 E) none of these dominates the other alternatives. 12. Consider a risky portfolio, A, with an expected rate of return of 0.15 and a standard deviation of 0.15, that lies on a given indifference curve. Which one of the following portfolios might lie on the same

indifference curve? A) E(r) = 0.15; Standard B) E(r) = 0.15; Standard C) E(r) = 0.10; Standard D) E(r) = 0.20; Standard E) E(r) = 0.10; Standard

deviation deviation deviation deviation deviation

= = = = =

0.20 0.10 0.10 0.15 0.20

Use the following to answer questions 13-15: 13. Based on the utility function above, which investment would you select? A) 1 B) 2 C) 3 D) 4 E) cannot tell from the information given 14. Which investment would you select if you were risk neutral? A) 1 B) 2 C) 3 D) 4 E) cannot tell from the information given 15. The variable (A) in the utility function represents the: A) investor's return requirement. B) investor's aversion to risk. C) certainty-equivalent rate of the portfolio. D) minimum required utility of the portfolio. E) none of the above. 16. The exact indifference curves of different investors A) cannot be known with perfect certainty. B) can be calculated precisely with the use of advanced calculus. C) although not known with perfect certainty, do allow the advisor to create more suitable portfolios for the client. D) A and C. E) none of the above. 17. The riskiness of individual assets A) should be considered for the asset in isolation. B) should be considered in the context of the effect on overall portfolio volatility. C) combined with the riskiness of other individual assets (in the proportions these assets constitute of the entire portfolio) should be the relevant risk measure.

D) B and C. E) none of the above. 18. A fair game A) will not be undertaken by a risk-averse investor. B) is a risky investment with a zero risk premium. C) is a riskless investment. D) Both A and B are true. E) Both A and C are true. 19. The presence of risk means that A) investors will lose money. B) more than one outcome is possible. C) the standard deviation of the payoff is larger than its expected value. D) final wealth will be greater than initial wealth. E) terminal wealth will be less than initial wealth. 20. The utility score an investor assigns to a particular portfolio, other things equal, A) will decrease as the rate of return increases. B) will decrease as the standard deviation increases. C) will decrease as the variance increases. D) will increase as the variance increases. E) will increase as the rate of return increases. 21. The certainty equivalent rate of a portfolio is A) the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio. B) the rate that the investor must earn for certain to give up the use of his money. C) the minimum rate guaranteed by institutions such as banks. D) the rate that equates A in the utility function with the average risk aversion coefficient for all risk-averse investors. E) represented by the scaling factor -.005 in the utility function. 22. According to the mean-variance criterion, which of the statements below is correct? A) B) C) D) E) Investment Investment Investment Investment Investment B dominates Investment A. B dominates Investment C. D dominates all of the other investments. D dominates only Investment B. C dominates investment A.

23. Steve is more risk-averse than Edie. On a graph that shows Steve and Edie's indifference curves, which of the following is true? Assume that the graph shows expected return on the vertical axis and standard deviation on the horizontal axis. A) B) C) D) E) I) Steve and Edie's indifference curves might intersect. II) Steve's indifference curves will have flatter slopes than Edie's. III) Steve's indifference curves will have steeper slopes than Edie's. IV) Steve and Edie's indifference curves will not intersect. V) Steve's indifference curves will be downward sloping and Edie's will be upward sloping. I and V I and III III and IV I and II II and IV

24. The Capital Allocation Line can be described as the A) investment opportunity set formed with a risky asset and a riskfree asset. B) investment opportunity set formed with two risky assets. C) line on which lie all portfolios that offer the same utility to a particular investor. D) line on which lie all portfolios with the same expected rate of return and different standard deviations. E) none of the above. 25. Which of the following statements regarding the Capital Allocation Line (CAL) is false? A) The CAL shows risk-return combinations. B) The slope of the CAL equals the increase in the expected return of a risky portfolio per unit of additional standard deviation. C) The slope of the CAL is also called the reward-to-variability ratio. D) The CAL is also called the efficient frontier of risky assets in the absence of a risk-free asset. E) Both A and D are true. 26. Given the capital allocation line, an investor's optimal portfolio is the portfolio that A) maximizes her expected profit. B) maximizes her risk.

C) minimizes both her risk and return. D) maximizes her expected utility. E) none of the above. 27. An investor invests 30 percent of his wealth in a risky asset with an expected rate of return of 0.15 and a variance of 0.04 and 70 percent in a T-bill that pays 6 percent. His portfolio's expected return and standard deviation are __________ and __________, respectively. A) 0.114; 0.12 B) 0.087;0.06 C) 0.295; 0.12 D) 0.087; 0.12 E) none of the above Use the following to answer questions 28-31: You invest $100 in a risky asset with an expected rate of return of 0.12 and a standard deviation of 0.15 and a T-bill with a rate of return of 0.05. 28. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.09? A) 85% and 15% B) 75% and 25% C) 67% and 33% D) 57% and 43% E) cannot be determined 29. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.06? A) 30% and 70% B) 50% and 50% C) 60% and 40% D) 40% and 60% E) cannot be determined 30. A portfolio that has an expected outcome of $115 is formed by A) investing $100 in the risky asset. B) investing $80 in the risky asset and $20 in the risk-free asset. C) borrowing $43 at the risk-free rate and investing the total amount ($143) in the risky asset. D) investing $43 in the risky asset and $57 in the riskless asset. E) Such a portfolio cannot be formed.

31. The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is equal to A) 0.4667. B) 0.8000. C) 2.14. D) 0.41667. E) Cannot be determined. 32. Consider a T-bill with a rate of return of 5 percent and the following risky securities: Security Security Security Security A: E(r) = 0.15; Variance = 0.04 B: E(r) = 0.10; Variance = 0.0225 C: E(r) = 0.12; Variance = 0.01 D: E(r) = 0.13; Variance = 0.0625

From which set of portfolios, formed with the T-bill and any one of the 4 risky securities, would a risk-averse investor always choose his portfolio? A) The set of portfolios formed with the T-bill and security A. B) The set of portfolios formed with the T-bill and security B. C) The set of portfolios formed with the T-bill and security C. D) The set of portfolios formed with the T-bill and security D. E) Cannot be determined. Use the following to answer questions 33-36: You are considering investing $1,000 in a T-bill that pays 0.05 and a risky portfolio, P, constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40, respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an expected rate of return of 0.10 and a variance of 0.0081. 33. If you want to form a portfolio with an expected rate of return of 0.11, what percentages of your money must you invest in the T-bill and P, respectively? A) 0.25; 0.75 B) 0.19; 0.81 C) 0.65; 0.35 D) 0.50; 0.50 E) cannot be determined 34. If you want to form a portfolio with an expected rate of return of 0.10, what percentages of your money must you invest in the T-bill, X, and Y, respectively if you keep X and Y in the same proportions to each other as in portfolio P?

A) B) C) D) E)

0.25; 0.45; 0.30 0.19; 0.49; 0.32 0.32; 0.41; 0.27 0.50; 0.30; 0.20 cannot be determined

35. What would be the dollar values of your positions in X and Y, respectively, if you decide to hold 40% percent of your money in the risky portfolio and 60% in T-bills? A) $240; $360 B) $360; $240 C) $100; $240 D) $240; $160 E) Cannot be determined 36. What would be the dollar value of your positions in X, Y, and the Tbills, respectively, if you decide to hold a portfolio that has an expected outcome of $1,200? A) Cannot be determined B) $54; $568; $378 C) $568; $54; $378 D) $378; $54; $568 E) $108; $514; $378 37. A reward-to-volatility ratio is useful in: A) measuring the standard deviation of returns. B) understanding how returns increase relative to risk increases. C) analyzing returns on variable rate bonds. D) assessing the effects of inflation. E) none of the above. 38. The change from a straight to a kinked capital allocation line is a result of: A) reward-to-volatility ratio increasing. B) borrowing rate exceeding lending rate. C) an investor's risk tolerance decreasing. D) increase in the portfolio proportion of the risk-free asset. E) none of the above. 39. The first major step in asset allocation is: A) assessing risk tolerance. B) analyzing financial statements. C) estimating security betas. D) identifying market anomalies. E) none of the above.

40. Based on their relative degrees of risk tolerance A) investors will hold varying amounts of the risky asset in their portfolios. B) all investors will have the same portfolio asset allocations. C) investors will hold varying amounts of the risk-free asset in their portfolios. D) A and C. E) none of the above. 41. Asset allocation A) may involve the decision as to the allocation between a risk-free asset and a risky asset. B) may involve the decision as to the allocation among different risky assets. C) may involve considerable security analysis. D) A and B. E) A and C. 42. In the mean-standard deviation graph, the line that connects the risk-free rate and the optimal risky portfolio, P, is called ______________. A) the Security Market Line B) the Capital Allocation Line C) the Indifference Curve D) the investor's utility line E) none of the above

43. Treasury bills are commonly viewed as risk-free assets because A) their short-term nature makes their values insensitive to interest rate fluctuations. B) the inflation uncertainty over their time to maturity is negligible. C) their term to maturity is identical to most investors' desired holding periods. D) Both A and B are true. E) Both B and C are true. Use the following to answer questions 44-47: Your client, Bo Regard, holds a complete portfolio that consists of a portfolio of risky assets (P) and T-Bills. The information below refers to these assets. 44. What is the expected return on Bo's complete portfolio? A) 10.32% B) 5.28%

C) 9.62% D) 8.44% E) 7.58% 45.What A) B) C) D) E) is the standard deviation of Bo's complete portfolio? 7.20% 5.40% 6.92% 4.98% 5.76%

46. What is the equation of Bo's Capital Allocation Line? A) E(rC) = 7.2 + 3.6 * Standard Deviation of C B) E(rC) = 3.6 + 1.167 * Standard Deviation of C C) E(rC) = 3.6 + 12.0 * Standard Deviation of C D) E(rC) = 0.2 + 1.167 * Standard Deviation of C E) E(rC) = 3.6 + 0.857 * Standard Deviation of C 47. What are the proportions of Stocks A, B, and C, respectively in Bo's complete portfolio? A) 40%, 25%, 35% B) 8%, 5%, 7% C) 32%, 20%, 28% D) 16%, 10%, 14% E) 20%, 12.5%, 17.5% 48. To build an indifference curve we can first find the utility of a portfolio with 100% in the risk-free asset, then A) find the utility of a portfolio with 0% in the risk-free asset. B) change the expected return of the portfolio and equate the utility to the standard deviation. C) find another utility level with 0% risk. D) change the standard deviation of the portfolio and find the expected return the investor would require to maintain the same utility level. E) change the risk-free rate and find the utility level that results in the same standard deviation. 49. The Capital Market Line I) is a special case of the Capital Allocation Line. II) represents the opportunity set of a passive investment strategy. III) has the one-month T-Bill rate as its intercept. IV) uses a broad index of common stocks as its risky portfolio.

A) B) C) D) E)

I, III, and IV II, III, and IV III and IV I, II, and III I, II, III, and IV

50. An investor invests 40 percent of his wealth in a risky asset with an expected rate of return of 0.18 and a variance of 0.10 and 60 percent in a T-bill that pays 4 percent. His portfolio's expected return and standard deviation are __________ and __________, respectively. A) 0.114; 0.112 B) 0.087; 0.063 C) 0.096; 0.126 D) 0.087; 0.144 E) none of the above 51. An investor invests 70 percent of his wealth in a risky asset with an expected rate of return of 0.11 and a variance of 0.12 and 30 percent in a T-bill that pays 3 percent. His portfolio's expected return and standard deviation are __________ and __________, respectively. A) 0.086; 0.242 B) 0.087; 0.267 C) 0.295; 0.123 D) 0.087; 0.182 E) none of the above Use the following to answer questions 52-54: You invest $100 in a risky asset with an expected rate of return of 0.11 and a standard deviation of 0.20 and a T-bill with a rate of return of 0.03. 52. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.08? A) 85% and 15% B) 75% and 25% C) 62.5% and 37.5% D) 57% and 43% E) cannot be determined 53. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.08?

A) B) C) D) E)

30% and 70% 50% and 50% 60% and 40% 40% and 60% Cannot be determined.

54. The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is equal to A) 0.47 B) 0.80 C) 2.14 D) 0.40 E) Cannot be determined. Use the following to answer questions 55-57: You invest $1000 in a risky asset with an expected rate of return of 0.17 and a standard deviation of 0.40 and a T-bill with a rate of return of 0.04. 55. What percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.11? A) 53.8% and 46.2% B) 75% and 25% C) 62.5% and 37.5% D) 46.1% and 53.8% E) Cannot be determined. 56. What percentages of your money must be invested in the risk-free asset and the risky asset, respectively, to form a portfolio with a standard deviation of 0.20? A) 30% and 70% B) 50% and 50% C) 60% and 40% D) 40% and 60% E) Cannot be determined. 57. The slope of the Capital Allocation Line formed with the risky asset and the risk-free asset is equal to A) 0.325. B) 0.675. C) 0.912. D) 0.407. E) Cannot be determined.

Essay Questions 58. Discuss the differences between investors who are risk averse, risk neutral, and risk loving. Difficulty: Easy Answer: The investor who is risk averse will take additional risk only if that risk-taking is likely to be rewarded with a risk premium. This investor examines the potential risk-return trade-offs of investment alternatives. The investor who is risk neutral looks only at the expected returns of the investment alternative and does not consider risk; this investor will select the investment alternative with the highest expected rate of return. The risk lover will engage in fair games and gambles; this investor adjusts the expected return upward to take into account the "fun" of confronting risk. The purpose of this question is to ascertain that the student understands the different attitudes toward risk exhibited by different individuals. 59. In the utility function: U = E(r) - -0.005As2, what is the significance of "A"? Difficulty: Easy Answer: A is simply a scale factor indicating the investor's degree of risk aversion. The higher the value of A, the more risk averse the investor. Of course, the investment advisor must spend some time with client, either via personal conversation or the administration of a "risk tolerance quiz" in order to assign the appropriate value of A to a given investor. The rationale for this question is to ascertain whether the student understands the meaning of the variable, A. This variable, as such, is not presented in most investments texts and it is important that the student understands how the investment advisor assigns a value to A. 60. What is a fair game? Explain how the term relates to a risk-averse investor's attitude toward speculation and risk and how the utility function reflects this attitude.

Difficulty: Moderate Answer: A fair game is a prospect that has a zero risk premium. Investors who are risk averse reject investment portfolios that are fair games or worse. They will consider risk-free investments and risky investments with positive risk premiums. The risk-averse investor penalizes the expected rate of return of a risky portfolio by a certain percent to account for the risk involved. The risk-averse investor's utility function favors expected return and disfavors risk, as measured by variance of returns. In the utility function U=E(R) - . 005A*Variance, the risk-averse investor has a positive A value so that the second term reduces the level of utility as the variance increases. This question tests whether the student understands the interrelationships between the terms risk, risk premium, speculation, and fair game, and how these terms are quantified by a utility function. 61. Draw graphs that represent indifference curves for the following investors: Harry, who is a risk-averse investor; Eddie, who is a riskneutral investor; and Ozzie, who is a risk-loving investor. Discuss the nature of each curve and the reasons for its shape. Difficulty: Moderate Answer: The graph for Harry should show upward-sloping curves because he needs to be compensated with additional expected return to maintain a certain level of satisfaction when he takes on more risk. Eddie should have horizontal indifference curves, parallel to the X axis. Since he is risk-neutral, he only cares about expected return. The higher the expected return, the higher his utility. Ozzie's curves will be downward sloping. The fact that he likes risk means that he is willing to forego some expected return to have the opportunity to take on more risk. This question allows the student to review the concepts of attitude toward risk and utility as they related to the resulting indifference curves. 62. Toby and Hannah are two risk-averse investors. Toby is more riskaverse than Hannah. Draw one indifference curve for Toby and one indifference curve for Hannah on the same graph. Show how these curves illustrate their relative levels of risk aversion.

Difficulty: Moderate Answer: The curves may or may not intersect within the range of the graph. Toby's curve will have a steeper slope than Hannah's. The levels of risk aversion can be illustrated by examining the curves' slopes over a fixed range. Because Toby's curve is steeper than Hannah's, for a fixed change in standard deviation on the horizontal axis, he will have a greater change in expected return on the vertical axis. It takes more compensation in the form of expected return to allow Toby to maintain his level of utility than it takes for Hannah. This question tests whether the student understands the nature of indifference curves and how the risk-return tradeoff is related to the level of risk aversion. 63. Discuss the characteristics of indifference curves, and the theoretical value of these curves in the portfolio building process Difficulty: Moderate Answer: Indifference curves represent the trade-off between two variables. In portfolio building, the choice is between risk and return. The investor is indifferent between all possible portfolios lying on one indifference curve. However, indifference curves are contour maps, with all curves parallel to each other. The curve plotting in the most northwest position is the curve offering the greatest utility to the investor. However, this most desirable curve may not be attainable in the market place. The point of tangency between an indifference curve (representing what is desirable) and the capital allocation line (representing what is possible). is the optimum portfolio for that investor. This question is designed to ascertain that the student understands the concepts of utility, what is desirable by the investor, what is possible in the market place, and how to optimize an investor's portfolio, theoretically. 64. Describe how an investor may combine a risk-free asset and one risky asset in order to obtain the optimal portfolio for that investor. Difficulty: Moderate Answer:

The investor may combine a risk-free asset (U. S. T-bills or a money market mutual fund and a risky asset, such as an indexed mutual fund in the proper portions to obtain the desired risk-return relationship for that investor. The investor must realize that the riskreturn relationship is a linear one, and that in order to earn a higher return, the investor must be willing to assume more risk. The investor must first determine the amount of risk that he or she can tolerate (in terms of the standard deviation of the total portfolio, which is the product of the proportion of total assets invested in the risky asset and the standard deviation of the risky asset). One minus this weight is the proportion of total assets to be invested in the risk-free asset. The portfolio return is the weighted averages of the returns on the two respective assets. Such an asset allocation plan is probably the easiest, most efficient, and least expensive for the individual investor to build an optimal portfolio. This question is designed to insure that the student understands ,how using the simple strategy of combining two mutual funds, the investor can build an optimal portfolio, based on the investor's risk tolerance. 65. The optimal proportion of the risky asset in the complete portfolio is given by the equation y* = [E(rP)-rf] / (.01A*Variance of P). For each of the variables on the right side of the equation, discuss the impact the variable's effect on y* and why the nature of the relationship makes sense intuitively. Assume the investor is risk averse. Difficulty: Difficult Answer: The optimal proportion in y is the one that maximizes the investor's utility. Utility is positively related to the risk premium [E(rP)-rf]. This makes sense because the more expected return an investor gets, the happier he is. The variable A represents the degree of risk aversion. As risk aversion increases, A increases. This causes y* to decrease because we are dividing by a higher number. It makes sense that a more risk-averse investor would hold a smaller proportion of his complete portfolio in the risky asset and a higher proportion in the risk-free asset. Finally, the standard deviation of the risky portfolio is inversely related to y*. As P's risk increases, we are again dividing by a larger number, making y* smaller. This corresponds with the risk-averse investor's dislike of risk as measured by standard deviation.

This allows the students to explore the nature of the equation that was derived by maximizing the investor's expected utility. The student can illustrate an understanding of the variables that supersedes the application of the equation in calculating the optimal proportion in P. 66. You are evaluating two investment alternatives. One is a passive market portfolio with an expected return of 10% and a standard deviation of 16%. The other is a fund that is actively managed by your broker. This fund has an expected return of 15% and a standard deviation of 20%. The risk-free rate is currently 7%. Answer the questions below based on this information. 3. a. What is the slope of the Capital Market Line? 4. b. What is the slope of the Capital Allocation Line offered by your broker's fund? 5. c. Draw the CML and the CAL on one graph. 6. d. What is the maximum fee your broker could charge and still leave you as well off as if you had invested in the passive market fund? (Assume that the fee would be a percentage of the investment in the broker's fund, and would be deducted at the end of the year.) 7. e. How would it affect the graph if the broker were to charge the full amount of the fee? Difficulty: Difficult Answer: a. The slope of the CML is (10-7)/16 = 0.1875. b. The slope of the CAL is (15-7)/20= 0.40. c. On the graph, both the CML and the CAL have an intercept equal to the risk-free rate (7%). The CAL, with a slope of 0.40, is steeper than the CML, with a slope of 0.1875. d. To find the maximum fee the broker can charge, the equation (15-7-fee)/20 = 0.1875 is solved for fee. The resulting fee is 4.25%. e. If the broker charges the full amount of the fee, the CAL's slope would also be 0.1875, so it would rotate down and be identical to the CML. This question tests both the application of CAL/CML calculations and the concepts involved.