ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
CHAPTER 6
1. If you know interest rates are going to rise in the future, would you rather own a long- or a short-term bond? Explain.
Answer: If rates are rising, bond prices will fall.For any given change in interest rates, long-term bonds exhibit more price volatility than short-term bonds. Thus, it is better to hold short-term bonds when rates are rising because their prices will fall more slowly than those of long-term bonds.
2. Suppose the spot rate on four-year bonds is 11 percent and the spot rate on five-year bonds is 12 percent. What forward rate is implied on a one-year bond delivered four years from now?
Solution:
3. What bond portfolio adjustments would investors make if interest rates are expected to decline in the future? How do these adjustments cause the yield curve to change?
Answer: Profit-maximizing investors will shift their holdings from short-term to long-term bonds. Selling pressure drives the prices of short-term bondsdown and the yields up. Buying pressure drives the prices of long-term bonds up and the yields down. If short-term rates are increasing while long-term rates are decreasing, we would see the yield curve flatten or perhaps become downward-sloping.
4. How does the existence of a liquidity premium affect the shape of the yield curve?
Answer: The liquidity premium puts an upward bias in the slope of the yield curve that causes yield curves to tend toward an upward slope.
5. Under the market segmentation theory, why do investors not shift their holdings into the securities with the highest returns? Under the preferred-habitat theory, what is necessary for investors to shift their holdings away from their preferred maturities?
Answer: Financial institutions that face regulatory capital requirements may desire to hold only those securities whose durations match their holding periods. Such a strategy minimizes their interest rate risk and protects their capital position. Therefore, these participants may restrict themselves to a particular maturity segment. Under the preferred habitat theory, investors will consider leaving their preferred maturity segments if other maturities offer a sufficient premium in the form of higher yields.
1. Suppose the yield on a 30-year corporate bond rated Aaa is 8.86 percent and the yield on a 30-year Treasury bond is 8.27 percent. What is the default risk premium? Would you expect a higher or lower default risk premium on an A-rated bond?
Solution: Use: DRP = i - irf = 8.86% - 8.27% = 0.59% or 59 basis points.
The default risk premium is expected to be higher for A-rated bonds because these bonds have more default risk than Aaa-rated bonds.
2. How does the yield spread between Treasury bonds and risky corporate bonds vary over the business cycle? Can you provide a logical explanation for the cyclical behavior of the spread?
Answer: The spread contracts when the economy expands and widens when the economy slows down. Probability of default is increasing during recessions when most businesses tend to have lower cash flows. Because investors are risk-averse, they may sell their corporate bonds and substitute them with Treasury securities during recessions. The selling pressure drives down the prices of corporate bonds and drives up their yields. At the same time, buying pressure on Treasury bonds drives their prices up and yields down. Thus, the spread widens during recessions. As the economy improves, investors may be more willing to hold the more risky (corporate) bonds. They buy more corporate bonds and less Treasury bonds, causing the spread to narrow in expansions.
3. What factors do rating agencies consider when assigning bond ratings?
Answer: Themostimportantfactorsare(1)thefirm’sexpectedcashflow;(2)theamountofthefirm’sfixedcontractualcashpayments,suchasinterestandprincipalpaymentsorleasepayments;(3)thelengthoftimethefirmhasbeenprofitable;and(4)thevariabilityofthefirm’searnings.
4. At what marginal tax rate would you be indifferent between an A-rated, ten-year corporate bond offering a yield of 10 percent and an A-rated, ten-year municipal bond offering a yield of 6 percent? Why does the municipal bond offer a lower rate if it has the same bond rating and maturity as the corporate bond?
Solution: The market indifference tax rate is 1 - (Muni rate/Corp rate) or 1 –(0.06/0.10) = 40%.
The municipal bond can offer a lower rate than the corporate bond of the same rating and maturity because interest income on municipal bonds is not taxable at the federal level. This means that the municipal bond still offers a competitive after-tax return compared to the corporate bond.
1. Which securities tend to have higher yields, those that are more marketable or those that are less marketable? Why?
Answer: Less marketable securities have higher yields because of the additional premium associated with infrequently traded securities.
2. At what stage of the business cycle would you expect issuers to call in bonds? At what stage of the business cycle would you expect the call interest premium to be the highest? Explain.
Answer: Issuers find it profitable to call bonds and refund with new bonds when interest rates are low. This tends to happen during economic recession. A callable bond issued at the top of the business cycle tends to carry a higher call interest premium. This is when interest rates tend to be at a cyclical peak. Investors, therefore, rationally anticipate the falling interest rates to come and the increased likelihood of issuers calling bonds. To compensate for the increased call risk, investors require a higher call interest premium.
3. Why do you think investors are willing to accept lower yields on putable bonds? Explain.
Answer: The put option, giving the investors the right to sell the bond back to the issuer, protects investors from unanticipated events that increase the bond’s risk. Thus, putable bonds are less risky and therefore tend to carry lower yields.
4. Holding the price of the firm’s stock constant, would you be more likely to convert bonds into stock when interest rates are rising or falling? Explain.
Answer: Ifthestockpriceisheldconstant,wheninterestratesrise,thepriceofthefirm’sbondswillfallrelativetothevalueofthestock.Obviously,itisadvantageoustoconvertthebondstostockinsuchanenvironment.
CHAPTER 7
1. Given the economic role of the money market, explain the importance of the typical characteristics of money market securities.
Answer: Money market securities are liquid, short-term, high quality debt securities issued by high quality borrowers and are used to store liquidity by investors around the world. All of these characteristics are important to money market investors because they have very low risk tolerance due to the temporary nature of their cash surplices.
2. Using the median yield figure from Exhibit 7.4, calculate the price of a 13-week T-bill and express it as a percentage of face value.
Solution: At the median yield of 5.02%, the price(% of face value) of a 13-weekT-bill on a discount basis is: (See eq. 7.3)
3. Refer to Exhibit 7.6. On February 21, 2007, what is the price of the T-bill maturing on August 2, 2007? Calculate the price two ways, using both the asked yield and the bid yield. Assume a face value of $10,000.
Solution: The price of the T-bill, discount basis is:
The ask price is:
The bid price is:
4. Assuming a face value of $10,000, what is the price of a T-bill with 161 days to maturity if its bond equivalent yield is 1.99 percent?
Solution: The price of the T-bill, discount basis is:
5. Why is the bond equivalent yield of a T-bill higher than the yield calculated on a discount basis?
Answer: First, the bond equivalent yield uses a 365-day year versus a 360-day year. Any periodic yield multiplied by a smaller fraction, 161/365 versus 161/360, will have a higher yield. Second, the bond equivalent yield is based on the purchasing price of a security, which in the case of discount securities is always lower than their face value, on which the discount yield is based.
1. Why do issues of securities by U.S. government agencies tend to have higher interest rates than similar issues of debt by the U.S. Treasury?
Answer: The U.S. government agencies have the explicitguarantee of the government but lower marketability (and thus liquidity) than U.S. Treasury securities of equivalent term. Government-sponsoredagencies do not have the explicit guarantee of the government, nor the liquidity/marketability of U.S. Treasury issues. See Federal Reserve Bulletin, Table A30.
2. Why would you never observe a U.S. Treasury bill paying the same quoted rate of interest as a negotiable CD of the same maturity?
Answer: First, the negotiable CD has a some default risk – as even an insured CD is guaranteed only up to $100,000 by the Federal Deposit Insurance Corporation, and many negotiable CDs are much larger than that. Second, because of the mathematics involved in computing discount interest rates, the T-bill discount rate understates the true rate of return paid by the T-bill, while the CD does not have the same problem.
3. Why is a repo like a secured loan?
Answer: The borrower of the money sells a government security to the lender along with an agreement to repurchase it at a future time at a predetermined higher price that is based on the repo rate. Thus the lender of the money owns the security until the money is paid back with interest, so the security serves as collateral for the loan.
4. How and why do banker’s acceptances frequently arise in international trade transactions?
Answer: Exporters of goods and services often trust the guarantee of an international bank more than they trust an importer’s agreement to pay them in the future. Thus, exporters often ask importers to obtain a letter of credit from a well-known bank that will agree to pay the importer’s obligation. When the exporter complies with all terms of the transaction, the bank “accepts” the obligation to make payment to complete the transaction if the importer does not. Because the bank’s credit is good, the banker’s acceptance can be sold easily in the money markets before maturity.
CHAPTER 8
1. Why do businesses use the capital markets?
Answer: Businesses use the capital markets to finance long-term investments and to provide a "market value" evaluation of company performance. The use of long-term securities allows issuers to be certain of the cost of funds for the life of the investment and reduces refinancing problems.
2. What is the difference among a T-bill, a T-note, and a T-bond?
Answer: There are two major factors that differentiate T-bill, T-notes, and T-bonds: term and interest payments. T-bills are offered in maturities of four, 13, and 26 weeks and are zero-coupon securities selling at a discount relative to the face value. T-notes are intermediate-term coupon-paying securities with original maturities of two, five, and ten years. T-bonds have maturities greater than 10 years and, similar to T-notes, pay interest regularly.
3. What is a STRIP? Explain how they are created.
Answer: A Separate Trading of Registered Interest and Principal (STRIPS) is a Treasury security that has been separated into its component parts: each interest payment and the principal payment become a separate zero-coupon securities. Treasury securities dealers buy Treasury securities whole at auction and then create STRIP components to meet customer demands. Each newly created zero-coupon security is registered with the Treasury upon the dealer’s request.
4. Explain how STRIPs can be used to immunize portfolios against interest rate risk.
Answer: STRIPS are zero-coupon bonds and a portfolio of STRIPS will have its duration equal to its maturity. If a bond is held to its duration, the realized YTM equals the expected YTM, eliminating reinvestment and price risk.
1. Explain why sinking funds on corporate bond issues play the same role as the serial structure found on municipal bond issues.
Answer: Sinking funds, an old term dating back to the days when companies accumulated funds to pay off bonds at maturity, today effectively pay off bonds periodically (called or purchased in the market). Serial bonds are bonds issued with varying maturities, so that part of the bond issue matures every year, beginning in a certain year.
2. When buying bonds, explain why investors should always make a tax-exempt and taxable comparison. What are the ground rules for making the comparison?
Answer: Everything else the same, the investor is seeking the higher after-tax return. To determine which bond offers the higher after-tax return, calculate the after-tax return of the corporate using the investor's marginal tax rate and compare it to the rate on the municipal bond.
3. Why are commercial banks large investors in municipal bonds and property and casualty insurance companies are not?
Answer: Until the Tax Reform Acts in the 1980's commercial banks were major investors in munis. Households are the major investor in munis today with mutual funds second and property/casualty insurance companies third. P/C companies have high tax exposure and seek tax sheltering via preferred stock and muni bonds. Life insurance companies, with considerable tax shelters coming from whole life policies, invest in taxable corporate bonds.
4. How do the secondary markets differ between municipal bonds and corporate bonds?
Answer: The secondary market for municipals is a dealer market and is quite thin, as are many corporate bond issues. There are more large-issues of corporate bonds, some listed on exchanges, which trade more frequently in dealer markets.
5. Explain how and why the junk bond market had an impact on commercial bank lending?
Answer: Prior to the development of the junk bond market, low credit quality firms depended on bank loans for their funds. Banks would only offer short-term or variable rate medium-term loans regardless of the borrowers’ need, thus passing on any interest rate risk to the borrower. These firms had no alternative until the junk bond market developed and allowed them to replace bank loans with marketable debt with longer maturities matching their cash flow needs.
1. Why are asset-backed securities becoming increasingly important in capital markets?
Answer: ManyABShavecharacteristicsthatmany capitalmarketinvestorsvaluehighly,suchasfinancialguarantees,predictablecashflows,orfloatingrates,andthusarewillingtopayapremiumfor them. This is especially true in the mortgage market where the credit enhancements reduce default risk to investors in mortgage-backed securities. Sincethesecharacteristicsarehighlydesirable,moreABSarebeingcreated.
2. Why are financial guarantees becoming increasingly important in financial markets both domestically and internationally?
Answer: Investors need only to ascertain the creditworthiness of the guarantor and not the creditworthiness of each underlying asset. Furthermore, the interest cost saving from the improved credit-enhanced credit rating exceeds the cost of the guarantee. Financial guarantees are increasingly important in international markets as the creditworthiness of the guarantor is often easier to assess than the creditworthiness of the borrower. Also, because collection activities across borders are problematic, it often will be easier to collect from a guarantor that has a financial reputation to protect than from a defaulting borrower in another country. Because of the reduction in default risk, guaranteed securities are more marketable than non-guaranteed securities and enable issuers to pay lower yields.
3. What types of credit enhancement can be obtained to make asset-backed securities more desirable?
Answer: Financial guarantees such as bond insurance, standby letters of credit, the use of cash collateral accounts, the use of subordinated tranches that enhance senior tranches by bearing the default risk, and setting aside profits and servicing fee accruals to protect buyers of tranches against future losses all make ABS more desirable.
4. Why are financial markets regulated, and who is the principal U.S. regulator?
Answer: Financial markets are regulated so people will retain confidence in them and continue to supply money to them. The Securities and Exchange Commission (SEC), established in 1933 after the Great Depression, is the principal regulator at the federal level. There are also regulators at the state level in every state who focus on consumer protection issues. In addition, there are self-regulatory bodies like the National Association of Securities Dealers (NASD) which were established to protect the integrity of the markets and the industries involved.
CHAPTER 9
1. If you had a 6 percent, $100,000, 15-year mortgage and you paid it as scheduled, how much interest would you pay in the first month of the sixth year on that mortgage? How much principal would you pay?
Solution: The total monthly required payment is $843.86 (on a financial calculator, enter 0.5% for the periodic rate (I), 180 for the number of payments (N), and 100,000 for the initial balance (PV), then solve for the payment (PMT)). The interest paid in the first month is 0.5% of the initial balance, or $500. The remainder of the payment, $343.86, is used to pay down the principal.
2. What would your principal and interest payments be if the mortgage were a 30-year mortgage at 6 percent?
Solution: The total monthly required payment is $599.55 (on a financial calculator, enter 0.5% for the periodic rate (I), 360 for the number of payments (N), and 100,000 for the initial balance (PV), then solve for the payment (PMT)). The interest paid in the first month is 0.5% of the initial balance, or $500. The remainder of the payment, $99.55, is used to pay down the principal.
3. If you had a mortgage with an initial rate of 2 percent that adjusted its rate once a year to equal the one-year Treasury bill rate plus 2.75 percent, with a cap on rate increases of 2 percent per year and 5 percent rate increase cap over the life of the mortgage, what rate would you pay in the second year of the mortgage if the one-year Treasury bill rate was 1.5 percent when the new rate was calculated?