TRAINING

Part 2.1 What Do Interest Rates Mean and What Is Their Role in Valuation?

Multiple Choice Questions

1) A bond's future payments are called its

A) cash flows.
B) maturity values.
C) discounted present values.
D) yields to maturity.

2) Which of the following are true of coupon bonds?

A) The owner of a coupon bond receives a fixed interest payment every year until the maturity
date, when the face or par value is repaid.
B) U.S. Treasury bonds and notes are examples of coupon bonds.
C) Corporate bonds are examples of coupon bonds.
D) All of the above.
E) Only A and B of the above.

3) If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year
is
A) $650.
B) $1,300.
C) $130.
D) $13.
E) None of the above.

4) Dollars received in the future are worth ________ than dollars received today. The process of
calculating what dollars received in the future are worth today is called ________.
A) more; discounting
B) less; discounting
C) more; inflating
D) less; inflating

5) With an interest rate of 10 percent, the present value of a security that pays $1,100 next year
and $1,460 four years from now is approximately
A) $1,000.
B) $2,000.
C) $2,560.
D) $3,000.

1
6) The interest rate that equates the present value of the cash flow received from a debt
instrument with its market price today is the
A) simple interest rate.
B) discount rate.
C) yield to maturity.
D) real interest rate.

7) For a simple loan, the simple interest rate equals the

A) real interest rate.
B) nominal interest rate.
C) current yield.
D) yield to maturity.

8) The yield to maturity of a one-year, simple loan of $400 that requires an interest payment of
$50 is
A) 5 percent.
B) 8 percent.
C) 12 percent.
D) 12.5 percent.

9) Which of the following $1,000 face value securities has the highest yield to maturity?
A) A 5 percent coupon bond selling for $1,000
B) A 10 percent coupon bond selling for $1,000
C) A 12 percent coupon bond selling for $1,000
D) A 12 percent coupon bond selling for $1,100

10) Which of the following are true for a coupon bond?

A) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
B) The price of a coupon bond and the yield to maturity are negatively related.
C) The yield to maturity is greater than the coupon rate when the bond price is below the par
value.
D) All of the above are true.
E) Only A and B of the above are true.

11) A consol bond is a bond that

A) pays interest annually and its face value at maturity.
B) pays interest in perpetuity and never matures.
C) pays no interest but pays its face value at maturity.
D) rises in value as its yield to maturity rises.

12) A frequently used approximation for the yield to maturity on a long-term bond is the
A) coupon rate.
B) current yield.
C) cash flow interest rate.
D) real interest rate.

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13) The yield to maturity for a one-year discount bond equals
A) the increase in price over the year, divided by the initial price.
B) the increase in price over the year, divided by the face value.
C) the increase in price over the year, divided by the interest rate.
D) none of the above.

14) If a $10,000 face value discount bond maturing in one year is selling for $5,000, then its
yield to maturity is
A) 5 percent.
B) 10 percent.
C) 50 percent.
D) 100 percent.

15) A discount bond

A) is also called a coupon bond.
B) is also called a zero-coupon bond.
C) is also called a fixed-payment bond.
D) is also called a corporate bond.

16) An ex post real interest rate is adjusted for ________ changes in the price level.
A) actual
B) expected
C) nominal
D) real

17) If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to
maturity of 7 percent, then the real interest rate on this bond is
A) 7 percent.
B) 22 percent.
C) -15 percent.
D) -8 percent.
E) none of the above.

18) Based on Figure 3.1 in the text, the difference between the nominal rate and the estimated
real rate was largest around
A) 1960.
B) 1970.
C) 1980.
D) 1990.

19) In which of the following situations would you prefer to be making a loan?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.

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20) What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for
$900 one year later?
A) 5 percent
B) 10 percent
C) -5 percent
D) -10 percent
E) None of the above

21) Which of the following are generally true of all bonds?

A) The only bond whose return equals the initial yield to maturity is one whose time to maturity
is the same as the holding period.
B) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on
bonds whose term to maturities are longer than the holding period.
C) The longer a bond's maturity, the greater is the price change associated with a given interest
rate change.
D) All of the above are true.
E) Only A and B of the above are true.

22) Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to
maturity of 15 percent. If the interest rate on one-year bonds rises from 15 percent to 20 percent
over the course of the year, what is the yearly return on the bond you are holding?
A) 5 percent
B) 10 percent
C) 15 percent
D) 20 percent

23) The riskiness of an asset's return that results from interest rate changes is called
A) interest-rate risk.
B) coupon-rate risk.
C) reinvestment risk.
D) yield-to-maturity risk.

24) (I) The average lifetime of a debt security's stream of payments is called duration.
(II) The duration of a portfolio is the weighted average of the durations of the individual
securities, with the weights reflecting the proportion of the portfolio invested in each.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.

25) The return on a bond is equal to the yield to maturity when

A) the holding period is longer than the maturity of the bond.
B) the maturity of the bond is longer than the holding period.
C) the holding period and the maturity of the bond are identical.
D) none of the above.

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26) What is the approximate duration of a 5-year zero-coupon bond?
A) 2 years
B) 3 years
C) 4 years
D) 5 years

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True/False

1) The current yield is the best measure of an investor's return from holding a bond.

2) The current yield goes up as the price of a bond falls.

3) The real interest rate is equal to the nominal rate minus inflation.

4) Prices for long-term bonds are more volatile than for shorter-term bonds.

5) When the real interest rate is high, there are greater incentives to borrow and fewer incentives
to lend.

6) Increasing duration implies that interest-rate risk has increased.

7) Interest-rate risk is the uncertainty that an investor faces because the interest rate at which a
bond's future coupon payments can be invested is unknown.

8) Bonds with a maturity that is longer than the holding period have no interest-rate risk.

6
Open Questions

What is the yield to maturity? Why it is considered as a good measure of interest rates?

7
Quantitative Exercices

1. Consider a bond with an 8% annual coupon and a face value of $1,000. Complete the
following table:

Years to Discount Rate Current

Maturity Price
4 6
5 8
7 9
10 11
11 12

2. Calculate the yield to maturity on the bond that has a price of $1,000 and pays $50 dividend
for the life of the bond. What will happen if the dividend is $25 instead of $50?

3. Anna bought a bond with a par value of $10,000 and a coupon rate of 8% at par. After a year,
she was able to sell her bond for $11,000. Calculate the rate of return on Anna’s investment.
What is the current yield and capital gain on her investment?

4. Calculate the duration of a five-year bond with a face value of $1,000 and a coupon rate of
8%. Assume that the current interest rates are 10%. What will your answer be if the current
interest rates fall to 7%? Show all your calculations.

5. Using the data provided in the previous problem, calculate the price difference using the
duration formula.

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TRAINING - Correction

Part 2.1 What Do Interest Rates Mean and What Is Their Role in Valuation?

Multiple Choice Questions

1) A bond's future payments are called its

A) cash flows.
B) maturity values.
C) discounted present values.
D) yields to maturity.
Answer: A

2) Which of the following are true of coupon bonds?

A) The owner of a coupon bond receives a fixed interest payment every year until the maturity
date, when the face or par value is repaid.
B) U.S. Treasury bonds and notes are examples of coupon bonds.
C) Corporate bonds are examples of coupon bonds.
D) All of the above.
E) Only A and B of the above.
Answer: D

3) If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year
is
A) $650.
B) $1,300.
C) $130.
D) $13.
E) None of the above.
Answer: A

4) Dollars received in the future are worth ________ than dollars received today. The process of
calculating what dollars received in the future are worth today is called ________.
A) more; discounting
B) less; discounting
C) more; inflating
D) less; inflating
Answer: B

5) With an interest rate of 10 percent, the present value of a security that pays $1,100 next year
and $1,460 four years from now is approximately
A) $1,000.
B) $2,000.
C) $2,560.
D) $3,000.
Answer: B
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6) The interest rate that equates the present value of the cash flow received from a debt
instrument with its market price today is the
A) simple interest rate.
B) discount rate.
C) yield to maturity.
D) real interest rate.
Answer: C

7) For a simple loan, the simple interest rate equals the

A) real interest rate.
B) nominal interest rate.
C) current yield.
D) yield to maturity.
Answer: D

8) The yield to maturity of a one-year, simple loan of $400 that requires an interest payment of
$50 is
A) 5 percent.
B) 8 percent.
C) 12 percent.
D) 12.5 percent.
Answer: D

9) Which of the following $1,000 face value securities has the highest yield to maturity?
A) A 5 percent coupon bond selling for $1,000
B) A 10 percent coupon bond selling for $1,000
C) A 12 percent coupon bond selling for $1,000
D) A 12 percent coupon bond selling for $1,100
Answer: C

10) Which of the following are true for a coupon bond?

A) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
B) The price of a coupon bond and the yield to maturity are negatively related.
C) The yield to maturity is greater than the coupon rate when the bond price is below the par
value.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: D

11) A consol bond is a bond that

A) pays interest annually and its face value at maturity.
B) pays interest in perpetuity and never matures.
C) pays no interest but pays its face value at maturity.
D) rises in value as its yield to maturity rises.
Answer: B

12) A frequently used approximation for the yield to maturity on a long-term bond is the
10
A) coupon rate.
B) current yield.
C) cash flow interest rate.
D) real interest rate.
Answer: B

13) The yield to maturity for a one-year discount bond equals

A) the increase in price over the year, divided by the initial price.
B) the increase in price over the year, divided by the face value.
C) the increase in price over the year, divided by the interest rate.
D) none of the above.
Answer: A

14) If a $10,000 face value discount bond maturing in one year is selling for $5,000, then its
yield to maturity is
A) 5 percent.
B) 10 percent.
C) 50 percent.
D) 100 percent.
Answer: D

15) A discount bond

A) is also called a coupon bond.
B) is also called a zero-coupon bond.
C) is also called a fixed-payment bond.
D) is also called a corporate bond.
Answer: B

16) An ex post real interest rate is adjusted for ________ changes in the price level.
A) actual
B) expected
C) nominal
D) real
Answer: A

17) If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to
maturity of 7 percent, then the real interest rate on this bond is
A) 7 percent.
B) 22 percent.
C) -15 percent.
D) -8 percent.
E) none of the above.
Answer: D

18) Based on Figure 3.1 in the text, the difference between the nominal rate and the estimated
real rate was largest around
A) 1960.
B) 1970.
11
C) 1980.
D) 1990.
Answer: C

19) In which of the following situations would you prefer to be making a loan?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.
Answer: B

20) What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for
$900 one year later?
A) 5 percent
B) 10 percent
C) -5 percent
D) -10 percent
E) None of the above
Answer: C

21) Which of the following are generally true of all bonds?

A) The only bond whose return equals the initial yield to maturity is one whose time to maturity
is the same as the holding period.
B) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on
bonds whose term to maturities are longer than the holding period.
C) The longer a bond's maturity, the greater is the price change associated with a given interest
rate change.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: D

22) Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to
maturity of 15 percent. If the interest rate on one-year bonds rises from 15 percent to 20 percent
over the course of the year, what is the yearly return on the bond you are holding?
A) 5 percent
B) 10 percent
C) 15 percent
D) 20 percent
Answer: C

23) The riskiness of an asset's return that results from interest rate changes is called
A) interest-rate risk.
B) coupon-rate risk.
C) reinvestment risk.
D) yield-to-maturity risk.
Answer: A

24) (I) The average lifetime of a debt security's stream of payments is called duration.
12
(II) The duration of a portfolio is the weighted average of the durations of the individual
securities, with the weights reflecting the proportion of the portfolio invested in each.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

25) The return on a bond is equal to the yield to maturity when

A) the holding period is longer than the maturity of the bond.
B) the maturity of the bond is longer than the holding period.
C) the holding period and the maturity of the bond are identical.
D) none of the above.
Answer: C

26) What is the approximate duration of a 5-year zero-coupon bond?

A) 2 years
B) 3 years
C) 4 years
D) 5 years
Answer: D
Topic: Chapter 3.3 Distinction Between Interest Rates and Returns
Question Status: New Question

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True/False

1) The current yield is the best measure of an investor's return from holding a bond.
Answer: FALSE

2) The current yield goes up as the price of a bond falls.

Answer: TRUE

3) The real interest rate is equal to the nominal rate minus inflation.
Answer: TRUE

4) Prices for long-term bonds are more volatile than for shorter-term bonds.
Answer: TRUE

5) When the real interest rate is high, there are greater incentives to borrow and fewer incentives
to lend.
Answer: FALSE

6) Increasing duration implies that interest-rate risk has increased.

Answer: TRUE

7) Interest-rate risk is the uncertainty that an investor faces because the interest rate at which a
bond's future coupon payments can be invested is unknown.
Answer: FALSE

8) Bonds with a maturity that is longer than the holding period have no interest-rate risk.
Answer: FALSE

14
Open Questions

What is the yield to maturity? Why it is considered as a good measure of interest rates?

The yield to maturity is the interest rate that equates the present value of cash flows received
from a debt instrument with its value today. Because the concept behind the calculation of the
yield to maturity makes good economic sense, it is considered a good measure of interest rates.

15
Quantitative Exercices

1. Consider a bond with an 8% annual coupon and a face value of $1,000. Complete the
following table:

Years to Discount Rate Current

Maturity Price
4 6
5 8
7 9
10 11
11 12

Solution:

Years to Yield to Current

Maturity Maturity Price
4 6 $1,069.30
5 8 $1,000.00
7 9 $949.67
10 11 $823.32
11 12 $762.49

2. Calculate the yield to maturity on the bond that has a price of $1,000 and pays $50 dividend
for the life of the bond. What will happen if the dividend is $25 instead of $50?

Solution: Since the bond pays dividends forever, I = C/P, where I is the yield to maturity, C is
the yearly payment of $50 in this case, and P is the price of a bond, which is $1,000 in this case;
I = 50/1000 = 0.05 or 5%;
If the payment is $25, I = 25/1000 = 0.025 or 2.5%.

3. Anna bought a bond with a par value of $10,000 and a coupon rate of 8% at par. After a year,
she was able to sell her bond for $11,000. Calculate the rate of return on Anna’s investment.
What is the current yield and capital gain on her investment?

Solution: Return on investment = (coupon payment + price in the following year - the current
price)/current price;
Return on investment = (800 + 11,000 – 10,000)/10,000 = 0.18 or 18%;
The current yield will be 800/10,000 = which is 8%, and the capital gain will be (11,000 -
10,000)/10,000 = 0.1 or 10%.

4. Calculate the duration of a five-year bond with a face value of $1,000 and a coupon rate of
8%. Assume that the current interest rates are 10%. What will your answer be if the current
interest rates fall to 7%? Show all your calculations.
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Solution: Coupon payments for bond are 1,000 x 8% = 80.00. First of all, we need to calculate
the PV of payments, then weights of PV (which is PV/PV of total cash payments multiplied by
1000, and then weighted maturity):

PV of Cash
Year Cash payments Weights of PV Weighted Maturity
Payments
1 80.00 72.73 7.87 0.08
2 80.00 66.12 7.15 0.14
3 80.00 60.11 6.50 0.20
4 80.00 54.64 5.91 0.24
5 80.00 49.67 5.37 0.27
5 1,000.00 620.92 67.19 3.36
TOTAL 924.18 100.00 4.28

So, the duration of bond is 4.28 years; we can do the same calculations for the interest rate of 7%
as follows:

PV of Cash
Year Cash payments Weights of PV Weighted Maturity
Payments
1 80.00 74.77 7.18 0.07
2 80.00 69.88 6.71 0.13
3 80.00 65.30 6.27 0.19
4 80.00 61.03 5.86 0.23
5 80.00 57.04 5.48 0.27
5 1,000.00 712.99 68.49 3.42
TOTAL 1,041.00 100.00 4.33

Now, the duration is 4.33 instead of 4.28 due to the fall in interest rates. So, interest rates and the
duration of bonds change in opposite directions.

5. Using the data provided in the previous problem, calculate the price difference using the
duration formula.

Solution:
Change in price = –current duration  (change in interest rates)/(1 + current interest rate)
= –4.280  (–0.03/(1 + 0.1)) = 0.1164 or + 11.64%

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