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Exam 3: Interest Rates and Security Valuation

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Question 1

Multiple Choice

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For large interest rate increases,duration ________ the fall in security prices,and for large interest rate decreases,duration ________ the rise in security prices.

A) overpredicts; overpredicts
B) overpredicts; underpredicts
C) underpredicts; overpredicts
D) underpredicts; underpredicts
E) None of these choices are correct.

F) A) and E)
G) B) and E)

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Question 2

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The higher a bond's coupon,the lower the bond's price volatility.

A) True
B) False

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Question 3

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Is the realized rate of return related to the expected return? the required return? Explain.

All else equal,the holder of a fairly priced premium bond must expect a capital loss over the holding period.

If a security's realized return is negative,it must have been true that the expected return was greater than the required return.

Convexity arises because

The lower the level of interest rates,the greater a bond's price sensitivity to interest rate changes.

The greater a security's coupon,the lower the security's price sensitivity to an interest rate change,ceteris paribus.

A common stock paid a dividend at the end of last year of $3.50. Dividends have grown at a constant rate of 6 percent per year over the last 20 years,and this constant growth rate is expected to continue into the future. The stock is currently selling at a price of $35 per share. What is the expected rate of return on this stock?

A 10-year maturity zero coupon bond will have lower price volatility than a 10-year bond with a 10 percent coupon.

Which would have a longer duration: (a)a five-year fully amortized installment loan with semiannual payments or (b)a five-year semiannual payment bond,ceteris paribus. Why?

Any security that returns a greater percentage of the price sooner is less price-volatile.

An annual payment bond has a 9 percent required return. Interest rates are projected to fall 25 basis points. The bond's duration is 12 years. What is the predicted price change?

For a given interest rate change,a 20-year bond's price change will be twice that of a 10-year bond's price change.

Suppose you owned stock in a company for the last three years. You originally bought the stock three years ago for $30 and just sold it for $56. The stock paid an annual dividend of $1.35 on the last day of each of the past three years. What is your realized return on this investment?

You are considering the purchase of a certain stock. You expect to own the stock for the next four years. The current market price of the stock is $24.50 and you expect to sell it for $55 in four years. You also expect the stock to pay an annual dividend of $1.25 at the end of year 1,$1.35 at the end of year 2,$1.45 at the end of year 3 and $1.55 at the end of year 4. What is your expected return from this investment?

Explain the effects of coupon and maturity on volatility.

A four-year maturity 0 percent coupon corporate bond with a required rate of return of 12 percent has an annual duration of ________ years.

What is convexity? How does convexity affect duration-based predicted price changes for interest rates changes?

A nine-year maturity AAA-rated corporate bond has a 6 percent coupon rate. The bond's promised yield is currently 5.75 percent and the bond sells for its FPV. The bond pays interest semiannually and has an annual duration of 7.1023 years. A) What is the bond's convexity? B) If promised yields decrease to 5.45 percent,what is the bond's predicted new price,including convexity? C) Based on your result in b,would you prefer to have a bond with more or less convexity? Explain.