Gitman Chapter11

Chapter 11
Bond Valuation
11.1 Learning Goal 1
1) The real rate of interest is the risk free rate minus the inflation premium.
Answer: TRUE
Question Status: New
2) The risk premium component of a bondʹs market interest rate is related to the characteristics of the
particular bond and its issuer.
Answer: TRUE
Question Status: Previous Edition
3) The risk-free rate of return considers the expected rate of inflation.
Answer: TRUE
4) Municipal bonds have higher yields than bonds issued by the U. S. Government.
Answer: FALSE
5) The higher a bondʹs Moodyʹs or Standard & Poors rating, the higher its yield.
Answer: FALSE
6) Changes in the inflation rate have a direct and pronounced effect on market interest rates.
Answer: TRUE
7) The required return on a bond is equal to
A) the real rate of return plus a risk premium plus an expected inflation premium.
B) the real rate of return plus the coupon rate plus an inflation rate.
C) the risk-free rate plus a risk premium plus an expected inflation premium.
D) the real rate plus a risk premium.
Answer: A
Chapter 11 Bond Valuation 193
8) The risk-free rate of return is equal to the
A) real rate plus a risk premium.
B) required return minus the inflation premium.
C) real rate plus the inflation premium.
D) required return minus the real rate.
Answer: C
9) Rank the following taxable bonds from lowest yielding to highest yielding.
I. U.S. Treasury bonds
II. Corporate bonds
III. Agency bonds
A) I, II, III
B) II, I, III
C) III, II, I
D) I, III, II
Answer: D
10) Which of the following statements concerning bonds are correct?
I. Municipal bond interest is federally tax-free.
II. Bond yields are related to bond ratings.
III. General obligation bonds yield more than revenue bonds.
IV. At the time of issue, callable bonds have higher yields than noncallable bonds.
A) I and III only
B) II and IV only
C) I, II and IV only
D) I, II and III only
Answer: C
194 Gitman/Joehnk · Fundamentals of Investing, Tenth Edition
11) Which of the following risks are included in the risk premium?
I. interest rate risk
II. liquidity risk
III. financial risk
IV. purchasing power risk
A) I and II only
B) II and III only
C) III and IV only
D) I and IV only
Answer: B
12) Which one of the following will tend to cause domestic interest rates to rise?
A) an increase in the money supply
B) a decrease in the rate of inflation
C) a decrease in the federal budget deficit
D) an increase in interest rates overseas
Answer: D
13) The single most important factor that influences the behavior of market interest rates is
A) inflation.
B) business profits.
C) the supply of new bonds.
D) the stock market.
Answer: A
14) Which one of the following statements concerning interest rates is correct?
A) A decrease in the money supply will cause interest rates to decline.
B) A federal budget surplus will cause interest rates to decline.
C) Economic expansions will cause interest rates to decline.
D) Rising interest rates in foreign countries will cause U.S. interest rates to decline.
Answer: B
1) The relationship between the rate of return and the time to maturity of similar-risk securities is
known as the term structure of interest rates.
Answer: TRUE
2) A yield curve depicts the term structure of interest rates for similar-risk securities.
Answer: TRUE
3) Predicting the direction of interest rate movements is relatively easy.
Answer: FALSE
4) Treasury bond yields are commonly used as the basis for yield curves because they are low risk
and homogeneous in nature.
Answer: TRUE
5) A normal yield curve is flat or downward sloping.
Answer: FALSE
6) The real rate of return is the same for all maturities.
Answer: TRUE
7) According to the expectations hypothesis, if investors anticipate higher rates of inflation in the
future, the yield curve will be downsloping.
Answer: FALSE
8) According to the liquidity preference theory, borrowers should pay a higher interest rate for
long-term borrowing than for short-term borrowing.
Answer: TRUE
9) A down-sloping yield curve indicates that interest rates are about to rise.
Answer: FALSE
10) A steep yield curve is generally considered a bullish sign for bonds.
Answer: TRUE
11) The yield curve depicts the relationship between a bondʹs yield to maturity and its
A) duration.
B) term to call.
C) term to maturity.
D) volatility.
Answer: C
12) An inverted yield curve
A) means that long-term bonds are yielding more than short-term bonds.
B) exists when intermediate-term bonds have higher yields than either short-term or long-term
bonds.
C) rewards long-term investors for the additional risk they are assuming.
D) generally results from actions by the Federal Reserve to control inflation.
Answer: D
13) The expectations hypothesis states that investors
A) require higher long-term interest rates today if they expect higher inflation rates in the future.
B) expect higher long-term interest rates because of the lack of liquidity for long-term bonds.
C) require the real rate of return to rise in direct proportion to the length of time to maturity.
D) normally expect the yield curve to be downsloping.
Answer: A
14) According to the expectations hypothesis, investorsʹ expectations of decreasing inflation will result
in
A) a downward-sloping yield curve.
B) an upward-sloping yield curve.
C) a flat yield curve.
D) a humped yield curve.
Answer: A
15) Long-term bonds are __________ than short-term bonds.
A) less risky
B) more liquid
C) subject to more uncertainty
D) less sensitive to interest rate changes
Answer: C
16) The liquidity preference theory supports __________ yield curves.
A) upsloping
B) flat
C) humped
D) downsloping
Answer: A
17) The market segmentation theory holds that
A) an increase in demand for long-term borrowings leads to an inverted yield curve.
B) expectations about the future level of interest rates is the major determinant of the shape of
the yield curve.
C) the yield curve reflects the maturity preferences of financial institutions and investors.
D) the shape of the yield curve is always downsloping.
Answer: C
18) According to the market segmentation theory, an inverted yield curve is created when the demand
for short-term bonds is __________ than the supply of short -term bonds and the demand for
long-term bonds is __________ the supply of long -term bonds.
A) greater; equal to
B) greater; less than
C) less; greater than
D) less; equal to
Answer: B
19) At any given time, the yield curve is affected by
I. lender preferences.
II. inflationary expectations.
III. liquidity preferences.
IV. short- and long-term supply and demand conditions.
A) I and IV only
B) II, III, and IV only
C) I, II and III only
D) I, II, III and IV
Answer: D
20) If the yield curve begins to rise sharply, it is usually an indication that
A) stocks are offering low returns as the economy enters a recession.
B) inflation rates have peaked and are about to decline.
C) bond prices are expected to increase.
D) inflation is starting to increase, or is expected to do so in the near future.
Answer: D
21) If inflation is expected to decline significantly, conservative bondholders should
A) expect interest rates to rise.
B) expect a flat yield curve for the intermediate-term.
C) buy long-term bonds today.
D) move to the short-end of the yield curve today.
Answer: C
22) Explain how a yield curve is constructed and what its shape reveals about interest rates.
Answer: A yield curve plots a bondʹs term to maturity to its yield to maturity at any given point in
time. A particular yield curve exists for only a short period of time. As the markets change,
so do yield curves. Yield curves are constructed by plotting the yields for a group of bonds
that are similar in all respects except maturity. The most common yield curve is
upward-sloping, which means that long-term yields are higher than short-term yields. An
inverted curve indicates that short-term interest rates are higher than long-term rates. A
humped curve indicates that intermediate-term bonds have the highest yields. A flat curve
indicates that yields are pretty much the same regardless of the bond term.
1) If a bondʹs yield to maturity is lower than its coupon rate, the bond will sell at a discount.
Answer: FALSE
2) A bondʹs discount or premium will tend to increase as the bond approaches its maturity date.
Answer: FALSE
3) The price of a bond is equal to the present value of the bondʹs future cash flows.
Answer: TRUE
4) A significant portion of a coupon bondʹs total return is derived from the reinvestment of the
interest payments.
Answer: TRUE
5) An 8% annual bond with a par value of $1,000, fifteen years to maturity, and a current price of $850
has a yield to maturity of
A) 7.49%.
B) 9.94%.
C) 9.97%.
D) 10.99%.
Answer: C
6) What is the current price of a 9%, $1,000 annual coupon bond that has eighteen years to maturity
and a yield to maturity of 9.631%?
A) $898
B) $935
C) $942
D) $947
Answer: D
7) What is the coupon rate of an annual bond that has a yield to maturity of 8.5%, a current price of
$942.32, a par value of $1,000 and matures in thirteen years?
A) 7.67%
B) 7.75%
C) 8.33%
D) 8.50%
Answer: B
8) What is the current price of a $1,000, 6% coupon bond that pays interest semi -annually if the bond
matures in ten years and has a yield-to-maturity of 7.1325%?
A) $567
B) $920
C) $1,030
D) $1,080
Answer: B
9) What is the yield-to-maturity of a $1,000, 7% semi-annual coupon bond that matures in 2 years
and currently sells for $997.07?
A) 6.87%
B) 7.04%
C) 7.16%
D) 7.31%
Answer: C
10) Which of the following are needed to determine the appropriate value of a bond?
I. required rate of return
II. time to maturity
III. frequency of interest payments
IV. coupon rate
A) II and III only
B) III and IV only
C) II, III and IV only
Answer: D
11) A $1,000 par value, 12-year annual bond carries a coupon rate of 7%. If the current yield of this
bond is 7.995%, its market price to the nearest dollar is
A) $876.
B) $925.
C) $1,075.
D) $1,125.
Answer: A
Question Status: Revised
1) There is normally an indirect relationship between the coupon rate of a bond and the bondʹs yield.
Answer: FALSE
2) Generally speaking, long-term bonds have lower yields than short-term bonds.
Answer: FALSE
3) A basis point is 1/10 of 1%.
Answer: FALSE
4) Bond yields are set by the bond issuer.
Answer: FALSE
5) The required return defines the yield at which a bond should be trading and serves as the discount
rate in the bond valuation process.
Answer: TRUE
6) Positive convexity applies to noncallable bonds because the prices of noncallable bonds go down
faster than they go up.
Answer: FALSE
7) The actual return earned on a bond is highly dependent upon the reinvestment rate of the coupons.
Answer: TRUE
8) Yield-to-call assumes a bond is called on the last possible date.
Answer: FALSE
9) The greater of the yield-to-call or the yield-to-maturity is used as the appropriate indicator of
value.
Answer: FALSE
10) Yield to call is a useful measure for bonds selling at a premium, but not for bonds selling at a
discount.
Answer: TRUE
Question Status: Revised
11) Which one of the following statements is correct concerning bond investors?
A) Aggressive investors want to lock in high interest rates.
B) Aggressive investors purchase bonds when they believe interest rates will rise.
C) Conservative investors seek capital gains.
D) Conservative investors buy bonds when interest rates are high.
Answer: D
12) If you are an income-oriented investor and you feel that interest rates are relatively high and will
decline in the future, you should purchase
A) zero-coupon, long-term bonds.
B) long-term, non-callable bonds.
C) short-term, zero-coupon bonds.
D) long-term, freely callable bonds.
Answer: B
13) Which of the following statements concerning the current yield is correct?
A) It is of great interest to aggressive bond investors seeking capital gains.
B) It is of great interest to conservative bond investors seeking current income.
C) It shows the rate of return an investor will receive by holding a bond to maturity.
D) It can be determined by dividing interest income by the par value of a bond.
Answer: B
14) Which of the following statements are correct concerning yield-to-maturity (YTM)?
I. YTM considers both interest income and price appreciation.
II. YTM assumes the bond is called at the earliest possible date.
III. YTM is a compounded rate of return.
IV. YTM assumes all interest payments are reinvested at the YTM rate.
A) I and IV only
B) I, III and IV only
C) II, III and IV only
D) I, II and III only
Answer: B
15) Which one of the following statements is true about a $1,000, 6% annual coupon bond that is selling
for $1,012?
A) The current yield is less than 6%.
B) The current yield is 6%.
C) The yield-to-maturity is greater than 6%.
D) The yield-to-maturity is 6%.
Answer: A
16) The conventional way to calculate the bond-equivalent yield (BEY) for a bond is to
A) divide the coupon rate by 2.
B) multiply the semi-annual yield by 2.
C) subtract the approximate yield from the promised yield.
D) calculate the effective annual yield.
Answer: B
17) The actual return on a bond is dependent upon which of the following?
I. the coupon rate
II. the reinvested interest rate
III. any changes in par value
IV. any changes in market price
A) I, II and III only
B) II, III and IV only
C) I, III and IV only
D) I, II and IV only
Answer: D
18) The reinvestment rate assumption is more important
I. the longer the time to maturity.
II. the shorter the time to maturity.
III. the higher the coupon rate.
IV. the lower the coupon rate.
A) I and III
B) I and IV
C) II and III
D) II and IV
Answer: A
19) Yield-to-call is
A) commonly used for bonds with deferred-call provisions.
B) calculated using the time to call and the par value of the bond.
C) based solely on the call premium and ignores interest payments.
D) always less than the yield-to-maturity.
Answer: A
20) The value of a bond can be calculated several different ways, depending on the investorʹs
objectives. Conservative, income-oriented bondholders will typically use
A) promised yield, whereas aggressive bond traders are likely to use expected return.
B) expected return, whereas aggressive bond traders are likely to use promised yield.
C) realized yield, whereas aggressive bond traders are likely to use holding period return.
D) holding period return, whereas aggressive bond traders are likely to use realized yield.
Answer: A
21) The yield-to-maturity (YTM) approach fails to consider which of the following risks?
I. reinvestment risk
II. price or market risk
A) I only
B) II only
C) Both I and II
D) Neither I nor II
Answer: C
22) Explain the differences between yield-to-maturity and yield-to-call.
Answer: The yield-to-maturity is based on holding a bond until it matures at which time the face
value is paid. The yield-to-call is based on holding a bond until the first date at which the
bond is freely callable at which time the call price will be paid. This price could be equal to
the face value or it could include a call premium.
1) Bond duration refers to the remaining life of a bond.
Answer: FALSE
2) An increase in interest rates has a negative effect on bond prices and a positive effect on the
reinvestment of coupons.
Answer: TRUE
3) The duration of a bond portfolio is the weighted average of the durations of the individual bonds
included in the portfolio.
Answer: TRUE
4) The duration and the volatility of a bond are inversely related.
Answer: FALSE
5) When yield swings are relatively small, a bondʹs duration is a viable predictor of its price volatility.
Answer: TRUE
6) A bond portfolio manager believes that interest rates are about to increase. Given this belief, the
manager should buy long duration bonds and sell short duration bonds.
Answer: FALSE
7) When the weighted-average duration of an investorʹs bond portfolio is exactly equal to the
investorʹs desired investment horizon, then the bond portfolio is said to be immunized.
Answer: TRUE
8) As applied to bonds, duration refers to
A) the average maturity of a diversified portfolio of corporate bonds.
B) the point in the life of a bond when its price exactly offsets its reinvestment risk.
C) the average price and annual reinvestment rate of return for a bond.
D) the point in the life of a bond when its yield-to-maturity equals its expected yield.
Answer: B
9) Based on the concept of bond duration, which one of the following statements is correct?
A) Lower coupons result in shorter durations.
B) Longer maturities mean shorter durations.
C) Higher yields (YTMs) lead to longer durations.
D) Longer durations mean greater volatility.
Answer: D
10) Which one of the following bonds would have a duration that exactly matches its time to maturity?
A) discount bond
B) premium bond
C) zero-coupon bond
D) U.S. Treasury bond
Answer: C
11) Which of the following statements concerning duration are correct?
I. Duration is a weighted-average life of a bond.
II. The Macaulay duration considers the timing of a bondʹs cash flows.
III. The Macaulay duration uses the YTM of a bond to discount the cash flows.
IV. For coupon bonds, duration will be less than the actual time to maturity.
A) I, II and III only
B) II, III and IV only
C) I, III and IV only
Answer: D
12) The duration of a bond will decrease as the time to maturity __________ and/or as the YTM on the
bond __________
A) increases; increases.
B) increases; decreases.
C) decreases; increases.
D) decreases; decreases.
Answer: C
13) A $1,000, 6% annual coupon bond matures in three years. The bond is currently priced at $993.35
and has a YTM of 6.25%. What is the Macaulay duration?
A) 1.00 years
B) 2.67 years
C) 2.83 years
D) 2.89 years
Answer: C
14) A portfolio consists of three bonds as follows.
Amount Invested Bond Duration
Bond A $1,000 6.8 years
Bond B $4,000 2.4 years
Bond C $5,000 14.1 years
What is the duration of the bond portfolio?
A) 7.77 years
B) 8.69 years
C) 9.03 years
D) 14.1 years
Answer: B
15) A bond matures in 30 years, has a 20 year duration and a yield to maturity of 9.32%. The change in
the level of the market interest rate is 0.47%. The modified duration is
A) 9.4 years.
B) 14.1 years.
C) 18.29 years.
D) 27.44 years.
Answer: C
16) The mathematical link between a bondʹs price and interest rate changes is the
A) Macaulay duration.
B) modified duration.
C) yield to market.
D) yield-to-call.
Answer: B
17) A bond has a YTM of 6.5%, a modified duration of 16.9 years, a duration of 18 years and a 30 year
maturity. By what percentage will the bondʹs price change if market interest rates increase by
0.75%?
A) -0.750 percent
B) +0.750 percent
C) +12.675 percent
D) -12.675 percent
Answer: D
18) If the bond market undergoes a large change in yield (for example, more than 100 basis points),
then a bondʹs duration will
A) understate both the price appreciation when rates fall and the price decline when rates
increase.
B) overstate both the price appreciation when rates fall and the price decline when rates
increase.
C) overstate the price appreciation when rates fall and understate the price decline when rates
increase.
D) understate the price appreciation when rates fall and overstate the price decline when rates
increase.
Answer: D
19) The practical application of bond portfolio immunization to investors is that immunization
A) allows aggressive traders to eliminate the price effects caused by interest rate changes.
B) allows investors to derive a specified rate of return from bond investments for a given
investment horizon.
C) eliminates the possibility of losing money due to a company defaulting on its bond payments.
D) allows investors to passively manage their bond portfolio once it is initially immunized.
Answer: B
20) Explain the basic concept of bond duration and why this measure is meaningful to investors.
Answer: Changes in interest rates affect both the price of a bond and the reinvestment rate of the
interest payments. A bondʹs duration is the time-weighted average of its cash flows
discounted at the prevailing yield to maturity on the bond. Duration addresses these
opposing effects and provides investors with a means of determining how a change in
interest rates will affect the price of a bond.
21) Explain the concept of bond immunization and the benefits derived from using this technique.
Answer: Bond immunization is based on the offsetting reactions of bond prices and the reinvestment
of interest payments. These reactions are in response to interest rate changes. Immunization
is achieved when these two forces equally offset each other. The primary benefit of
immunization is the ability of an investor to earn a specified rate of return on a bond
portfolio regardless of what happens to market interest rates over the course of the holding
period.
1) In building a bond ladder, an investor invests an equal amount in a series of bonds with staggered
maturities.
Answer: TRUE
2) When conducting a tax swap, an investor must use identical issues in order for the swap to be
allowed by the IRS.
Answer: FALSE
3) Buying bonds in anticipation of an expected decline in interest rates is a risky strategy.
Answer: TRUE
4) Once a bond portfolio is initially immunized, an investor should maintain the portfolio as it is until
the end of the investment horizon.
Answer: FALSE
5) The main purpose of a bond ladder is to
A) lessen the effects of changes in interest rates.
B) achieve the highest level of capital gains possible.
C) maintain a highly liquid portfolio.
D) offset the effects of bond duration.
Answer: A
6) Active bond trading strategies include
I. buy and hold.
II. trading on forecasted interest rate behavior.
III. bond ladders.
IV. bond swaps.
A) I and III
B) II and IV
C) I, II, and III
D) II, III, and IV
Answer: B
7) Suppose you sell the 10-year, A-rated 7 percent bonds you own, which are yielding 8 percent, and
replace them with an equal amount of 10-year, A-rated 8 percent bonds that are priced to yield 9
percent. In this situation, you are executing
A) an immunization deal.
B) a yield pickup swap.
C) a laddered bid.
D) a spread bid.
Answer: B
8) In a tax swap, a bond investor typically
A) sells an issue which has a capital loss and replaces it with a comparable security.
B) sells an issue that has a capital gain and replaces it with a comparable security.
C) swaps a lower-yielding security for a higher-yielding security.
D) swaps a higher-yielding security for a lower-yielding security.
Answer: A
9) Explain the technique and the purpose of building bond ladders.
Answer: Investors build bond ladders by purchasing roughly equal amounts of bonds with staggered
maturities ranging from short-term to some long-term investment horizon. As the
short-term bonds mature, they are replaced with long term bonds. In this way, the investor
is protected from changes in long-term interest rates while enjoying the the typically higher
yields on long-term bonds. The technique is essentially a form of dollar cost averaging.

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