Chapter 03 Test Bank - Static

Chapter 03 Test Bank - Static KEY
1. The following entities issue bonds to engage in long-term borrowing except
A. the federal government.

B. state and local governments.
C. corporations.
D. individuals.
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Difficulty: Basic
2. The type of bonds where the identities of bond owners are recorded and the coupon interest payments are
sent automatically are called
A. bearer bonds.
B. government bonds.
C. registered bonds.
D. recorded bonds.
Difficulty: Intermediate
3. A government bond issued in Germany has a coupon rate of 5 percent, a face value of 100 euros, and
matures in five years. The bond pays annual interest payments. Calculate the price of the bond (in euros) if the
yield to maturity is 3.5 percent.
A. 100.00
B. 106.77
C. 106.33
D. 105.00
4. Generally, a bond can be valued as a package of
A. annuity and perpetuity only.

B. perpetuity and single payment only.
C. annuity and single payment only.
D. annuity, perpetuity, and single payment.

Difficulty: Basic
5. A government bond issued in Germany has a coupon rate of 5 percent, a face value of 100 euros, and
matures in five years. The bond pays annual interest payments. Calculate the yield to maturity of the bond (in
euros) if the price of the bond is 106 euros.
A. 5.00 percent
B. 3.80 percent
C. 3.66 percent
D. 6.00 percent

6. You buy a 12-year 10 percent annual coupon bond at par value, $1,000. You sell the bond three years later for
$1,100. What is your rate of return over this three-year period?
A. 40 percent
B. 10 percent
C. 20 percent
D. 30 percent
7. If a bond pays interest semiannually, then it pays interest
A. once per year.

B. every six months.
C. every three months.
D. every two years.

Difficulty: Basic
8. A three-year bond with 10 percent coupon rate and $1,000 face value yields 8 percent. Assuming annual coupon
payments, calculate the price of the bond.
A. $857.96
B. $951.96
C. $1,000.00
D. $1,051.54

9. A five-year treasury bond with a coupon rate of 8 percent has a face value of $1,000. What is the semiannual
interest payment?
A. $80
B. $40
C. $100
D. $50

Difficulty: Basic
10. A three-year bond has an 8 percent coupon rate and a $1,000 face value. If the yield to maturity on the bond is 10
percent, calculate the price of the bond assuming that the bond makes semiannual coupon payments.
A. $857.96
B. $949.24
C. $1,057.54
D. $1,000.00
Difficulty: Challenge
11. A four-year bond has an 8 percent coupon rate and a face value of $1,000. If the current price of the bond is
$878.31, calculate the yield to maturity of the bond (assuming annual interest payments).
A. 8 percent
B. 10 percent
C. 12 percent
D. 6 percent
12. A five-year bond with a 10 percent coupon rate and $1,000 face value is selling for $1,123. Calculate the yield to
maturity on the bond assuming annual interest payments.
A. 10.0 percent
B. 8.9 percent
C. 7.0 percent
D. 5.0 percent
13. Which of the following statements about the relationship between interest rates and bond prices is true?
A. There is an inverse relationship between bond prices and interest rates, and the price of long-term bonds
fluctuates more than the price of short-term bonds for a given change in interest rates (assuming that the
coupon rate is the same for both).
B. There is an inverse relationship between bond prices and interest rates, and the price of short-term bonds
fluctuates more than the price of long-term bonds for a given change in interest rates (assuming that the coupon
rate is the same for both).
C. There is a direct relationship between bond prices and interest rates, and the price of short-term bonds
fluctuates more than the price of long-term bonds for a given change in interest rates (assuming that the coupon
rate is the same for both).
D. There is a direct relationship between bond prices and interest rates, and the price of long-term bonds
fluctuates more than the price of short-term bonds for a given change in interest rates (assuming that the
coupon rate is the same for both).
14. Consider a bond with a face value of $1,000, an annual coupon rate of 6 percent, a yield to maturity of 8 percent,
and 10 years to maturity. This bond's duration is
A. 8.7 years.
B. 7.6 years.
C. 10.0 years.
D. 6.5 years.

15. A bond has a face value of $1,000, an annual coupon rate of 7 percent, yield to maturity of 10 percent, and 20
years to maturity. The bond's duration is
A. 10.0 years.
B. 7.4 years.
C. 20.0 years.
D. 12.6 years.
16. A bond has a face value of $1,000, a coupon rate of 0 percent, yield to maturity of 9 percent, and 10 years to
maturity. This bond's duration is
A. 6.7 years.
B. 7.5 years.
C. 9.6 years.
D. 10.0 years.

17. A bond with duration of 10 years has a yield to maturity of 10 percent. This bond's volatility (modified duration) is
A. 9.09 percent.
B. 6.8 percent.
C. 14.6 percent.
D. 10.0 percent.

18. A bond with duration of 5.7 years has a yield to maturity of 9 percent. The bond's volatility (modified duration) is
A. 1.9 percent.
B. 5.2 percent.
C. 5.7 percent.
D. 9.0 percent.

19. If a bond's volatility is 10.00 percent and the interest rate goes down by 0.75 percent (points), then the price of the
bond
A. decreases by 10.00 percent.

B. decreases by 7.50 percent.
C. increases by 7.50 percent.
D. increases by 0.75 percent.
20. If a bond's volatility is 5.0 percent and its yield to maturity changes by 0.5 percent (points), then the price of the
bond
A. changes by 5.0 percent.

B. changes by 2.5 percent.
C. changes by 7.5 percent.
D. will not change.
21. The volatility of a bond is given by
A. duration/(1 + yield) only.

B. slope of the curve relating the bond price to the interest rate only.
C. yield to maturity only.
D. duration/(1 + yield) and slope of the curve relating the bond price to the interest rate only.

22. One can best describe the term structure of interest rates as the relationship between
A. spot interest rates and bond prices.

B. spot interest rates and stock prices.
C. spot interest rates and time.
D. yields of coupon bonds and their maturity.

23. The interest rate represented by "r2" is the
A. spot rate on a one-year investment.

B. spot rate on a two-year investment.
C. expected spot rate two years from today.
D. expected spot rate one year from today.

Difficulty: Basic
24. If the nominal interest rate per year is 10 percent and the inflation rate is 4 percent, what is the real rate of
interest?
A. 10.0 percent
B. 4.1 percent
C. 5.8 percent
D. 14.0 percent
Difficulty: Basic
25. Mr. X invests $1,000 at a 10 percent nominal rate for one year. If the inflation rate is 4 percent, what is the
real value of the investment at the end of one year?
A. $1,100
B. $1,000
C. $1,058
D. $1,040
26. Which bond is more sensitive to an interest rate change of 0.75 percent?
Bond A: YTM = 4.00%, maturity = 8 years, coupon = 6% or $60, par value = $1,000. Bond B:
YTM = 3.50%, maturity = 5 years, coupon = 7% or $70, par value = $1,000.
A. Bond A
B. Bond B
C. Both are equally sensitive.
D. Cannot be determined
27. As CFO of your corporation, you would prefer (all else equal) to see the price of your corporation's bonds
A. increase, indicating that bond investors view your firm as less risky.
B. decrease, indicating that bond investors view your firm as less risky.
C. increase, indicating that bond investors view your firm as more willing to take risks.
D. decrease, indicating that bond investors view your firm as more willing to take risks.

28. Which of the following bonds has the longest duration?
A. 5-year coupon bond

B. 5-year, zero-coupon bond
C. 10-year coupon bond
D. 10-year, zero-coupon bond
Difficulty: Basic
29. Which of the following bonds has the greatest volatility?
A. 5-year coupon bond

B. 5-year, zero-coupon bond
C. 10-year coupon bond
D. 10-year, zero-coupon bond

30. The yield to maturity on a bond is really its internal rate of return.
TRUE
Difficulty: Basic
31. In the United States, most bonds make coupon payments annually.
FALSE

Difficulty: Basic
32. The duration of any bond is the same as its maturity.
FALSE

33. The duration of a zero-coupon bond is the same as its maturity.
TRUE

34. The longer a bond's duration, the greater its volatility.
TRUE
35. The term structure of interest rates determines the relationship between yield to maturity and maturity.
TRUE

36. If the term structure of interest rates is flat, then the 9-year spot interest rate equals the 10-year spot interest rate.
TRUE
37. Short-term and long-term interest rates always move in parallel.
FALSE
38. The expectations theory implies that the only reason for a declining term structure is that investors expect
spot interest rates to fall.
TRUE

39. (1 + rnominal) = (1 + rreal)(1 + inflation rate).
TRUE
40. U.S. Treasury bonds have almost zero default risk but are subject to inflation risk.
TRUE

41. Inflation-indexed bonds were almost unknown in the United States before 1997.
TRUE

42. The U.S. Treasury issues inflation-indexed bonds known as TIPs.
TRUE

43. Long-term spot rates are usually higher than short-term spot rates.
TRUE

44. Once a bond defaults, bondholders can no longer receive any residual payment from the bond.
FALSE

45. Corporate bond yields are generally higher than government bond yields for bonds having the same coupon
rate and maturity.
TRUE

Difficulty: Basic
46. The spread of junk bond yields, over that of U.S. Treasuries, is generally lower than the spread of
investment-grade bonds.
FALSE

Difficulty: Basic
47. Consider the impact of inflation risk on the term structure of interest rates. If investors become more wary of
inflation, one would expect to observe a steeper, more upwards sloping, term structure of interest rates.
TRUE
48. For many years, real rates of interest tended to fluctuate more wildly than nominal rates of interest.
FALSE

49. Two bonds have the same maturity, risk rating, and face value, but have different coupon rates. The bond
with a lower coupon rate will have a longer duration.
TRUE
50. A U.S. Treasury "strip" is a zero-coupon bond.
TRUE
Difficulty: Basic
51. The law of one price states that the same commodity must sell at the same price in a well-functioning
market.
TRUE
Difficulty: Basic
52. From the investor's perspective, briefly describe the cash flows associated with a bond.
Bonds generally provide two types of cash flows: interest payments and the principal payment. Interest
payments occur each period, usually annually or semiannually. Periodic interest payments are also called
coupon payments. Thus, interest payments form an annuity. Principal payment occurs at the time of maturity of
the bond and is a lump-sum payment.
Difficulty: Basic
53. Briefly explain the term yield to maturity.
The yield to maturity is the single discount rate that implies the present value of the cash flows received from
buying a bond is equal to its current price. It can be used for calculating the bond’s price. Conceptually, it is the
same as the internal rate of return (IRR).
54. What is the relationship between interest rates and bond prices?
Interest rates and bond prices are inversely related. Higher interest rates cause bond prices to fall and vice
versa. For a given change in interest rates, prices of long-term bonds fluctuate more than those of short-term
bonds. Similarly, for a given change in interest rates, low-coupon bond prices fluctuate more than those of high-
coupon bonds.
55. Discuss the concept of duration.
Duration is the weighted average time of the present values of a bond's cash flows. The weights are determined by the
present value factors. Duration is expressed in units of time. Duration is an important concept for two reasons. First, the
volatility of a bond is directly related to its duration. Second, one way to hedge interest rate risk is through a strategy of
duration matching (discussed later in the textbook).
56. Briefly discuss the concept of volatility.

Volatility is calculated as duration/(1 + yield). Bonds with longer duration also have greater volatility. A bond's
volatility is directly related to its duration. Volatility is also the absolute value of the slope of the curve relating the
bond price to the interest rate.
57. Briefly explain what is meant by the term structure of interest rates.
The term structure of interest rates is the plot of spot interest rates on the y-axis and time on the x-axis. It is
closely related to the yield curve. It shows how interest rates and maturity are related. Economists have
developed several theories to explain the shape of the yield curve.
58. Briefly explain the expectations theory.
The expectations theory states that, in equilibrium, a series of investments in short-term bonds must offer the
same expected return as an equivalent investment in single long-maturity bonds.
59. What is the relationship between real and nominal rates of interest?
The exact relationship is given by

(1 + nominal rate ) = (1 + real rate) × (1 + expected inflation rate). It can also be written as Nominal rate = real
rate + inflation rate + (real rate) × (inflation rate). In approximate form, the nominal rate is approximately equal to
the real rate plus the inflation rate when both the real rate and the inflation rate are small.
Difficulty: Basic
60. Define the term real interest rate.
The real interest rate is the nominal interest rate adjusted for inflation. We do not observe it directly (except for
the case of U.S. Treasury TIPS). The relationship between the two is given by
1 + rnominal = (1 + rreal rate)(1 + inflation rate). (An approximate formula that works for small
values is: rnominal = rreal rate + inflation rate.)
61. What are TIPs? Briefly explain.
TIPs (Treasury inflation-protected securities) are issued by the U.S. Treasury. The U.S. Treasury began issuing
TIPs in 1997. These are also known as inflation-indexed bonds. The real cash flows on TIPs are fixed, but the
nominal cash flows, which include interest and principal, increase as the Consumer Price Index (CPI) increases.
Thus, the buying power of the borrower is protected.
62. Discuss why a dollar tomorrow cannot be worth less than a dollar the day after tomorrow.
If a dollar tomorrow were worth less than a dollar a day after tomorrow, it would be possible to earn a very large
amount of money through a “money-machine” effect. This is only possible if someone else is losing a very large
amount of money. These conditions can only exist for a short period and cannot exist in equilibrium as the
source of money is quickly exhausted. Thus, a dollar tomorrow cannot be worth less than a dollar the day after
tomorrow.
Chapter 03 Test Bank - Static Summary

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Difficulty: Basic 15
Difficulty: Challenge 23
Difficulty: Intermediate 24

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Chapter 03 Test Bank - Static KEY

1. The following entities issue bonds to engage in long-term borrowing except

A. the federal government.

Accessibility: Keyboard Navigation

4. Generally, a bond can be valued as a package of

A. annuity and perpetuity only.

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Accessibility: Keyboard Navigation

7. If a bond pays interest semiannually, then it pays interest

A. once per year.

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A. decreases by 10.00 percent.

A. changes by 5.0 percent.

21. The volatility of a bond is given by

A. duration/(1 + yield) only.

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A. spot interest rates and bond prices.

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23. The interest rate represented by "r2" is the

A. spot rate on a one-year investment.

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28. Which of the following bonds has the longest duration?

A. 5-year coupon bond

29. Which of the following bonds has the greatest volatility?

A. 5-year coupon bond

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32. The duration of any bond is the same as its maturity.

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33. The duration of a zero-coupon bond is the same as its maturity.

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34. The longer a bond's duration, the greater its volatility.

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37. Short-term and long-term interest rates always move in parallel.

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39. (1 + rnominal) = (1 + rreal)(1 + inflation rate).

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42. The U.S. Treasury issues inflation-indexed bonds known as TIPs.

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50. A U.S. Treasury "strip" is a zero-coupon bond.

53. Briefly explain the term yield to maturity.

55. Discuss the concept of duration.

56. Briefly discuss the concept of volatility.

58. Briefly explain the expectations theory.

The exact relationship is given by

60. Define the term real interest rate.

61. What are TIPs? Briefly explain.

Chapter 03 Test Bank - Static Summary

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