Download CHAPTER 6 ANSWERS TO "DO YOU UNDERSTAND?" TEXT

CHAPTER 6
ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
DO YOU UNDERSTAND?
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 much less 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:
(1  t R n ) n
1
t  n 1 f 1 
(1  t R n -1 ) n - 1
(1.12) 5
1.7623
1
 1  0.1609  16.09%
t  4 f1 
4
1.5181
(1.11)
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 bonds down 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 longterm 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.
DO YOU UNDERSTAND?
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: The most important factors are (1) the firm’s expected cash flow; (2) the amount of the firm’s
fixed contractual cash payments, such as interest and principal payments or lease payments; (3) the
length of time the firm has been profitable; and (4) the variability of the firm’s earnings.
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.
DO YOU UNDERSTAND?
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: If the stock price is held constant, when interest rates rise, the price of the firm’s bonds
will fall relative to the value of the stock. It may be advantageous to convert the bonds to stock
in such an environment.