File: ch02, Chapter 2: INVESTMENT ALTERNATIVES

Type: Multiple Choice

1. Which of the following is not an investing choice available to households?

a. Hold the liabilities of traditional intermediaries, such as banks

b. Hold securities directly, such as common stock
c. Hold securities indirectly, such as mutual funds
d. Hold currency in a drawer or under a mattress

Ans: d
Difficulty: Easy
Response: While holding currency may be considered saving (= not spending), it is not
considered investing. This chapter explores choices which are probably better for nearly all
households.
Ref: Organizing Financial Assets

2. Which investment alternative has increased greatly in popularity over time?

a. Traditional intermediaries, such as banks

b. Direct securities, such as stocks and bonds
c. Indirect securities, such as mutual funds
d. All choices have remained about equally popular since World War II

Ans: c
Difficulty: Easy
Response: Indirect investing has become increasingly more popular over time, particularly
through the purchase of mutual funds.
Ref: Organizing Financial Assets

3. Which of the following is an example of “indirect investing”?

a. Common stocks
b. Mutual funds
c. Checking accounts
d. Index options

Ans: b
Difficulty: Easy
Response: Investors buy and sell “direct investments” themselves, and directly control these
investments. In a mutual fund, the fund managers buy and sell securities on behalf of the fund’s
investors.
Ref: Organizing Financial Assets
4. Why might investing in Coca-Cola be considered an international investment?

a. Coca-Cola has its headquarters in Europe

b. Coca-Cola derives most of its sales and profits from other countries
c. Coca-Cola’s stock price is quoted in euros
d. Coca-Cola’s stock price is most heavily dependent on foreign currency changes

Ans: b
Difficulty: Medium
Response: Coca-Cola is truly a global company, with a significant percentage of its operations in
countries around the world. As such, much of the stock’s performance will be tied to events
happening overseas.
Ref: Organizing Financial Assets

5. Which of the following is the best explanation for why most individuals have at least
some of their funds invested in nonmarketable financial assets?

a. Nonmarketable financial assets are generally more liquid than marketable assets.
b. Many nonmarketable financial assets are very safe.
c. All nonmarketable financial assets protect the investor against inflation.
d. Nonmarketable financial assets are bought and sold based on standardized contracts
traded on organized exchanges.

Ans: b
Difficulty: Easy
Response: Nonmarketable financial assets include accounts guaranteed by, and instruments
issued by, the U.S. government, and are, therefore, considered to be of the highest safety
available.
Ref: Nonmarketable Financial Assets

6. Which of the following is not considered a money market security?

a. Government bonds
b. Treasury bills
c. Negotiable certificates of deposit (CDs)
d. Commercial paper

Ans: a
Difficulty: Easy
Response: Treasury and agency bonds have maturities from 10 to 30 years, far more than the one
year limit defining the money markets.
Ref: Money Market Securities
7. Which of the following is not an example of capital market securities?

a. Treasury bills
b. Treasury bonds
c. Corporate bonds
d. Corporate stocks

Ans: a
Difficulty: Easy
Response: Treasury bills are short-term, money market instruments.
Ref: Capital Market Securities

8. What is the coupon payment on a $1,000 par 5.75% coupon Treasury note that matures in
8 years and is currently priced at 99 5/32?

a. $28.75
b. $49.57
c. $57.50
d. $99.15

Ans: a
Difficulty: Medium
Response: Treasury notes are bonds with a maturity of 1-10 years that pay interest semi-annually.
The coupon payment is par x coupon rate/2. Price does not affect coupon payment.
Ref: Fixed-Income Securities

9. Which of the following bonds is most risky for investors to purchase?

a. Treasury bonds
b. Investment-grade corporate bonds
c. Investment-grade municipal bonds
d. Junk, or high yield bonds

Ans: d
Difficulty: Medium
Response: The credit rating indicates the level of default risk, and junk bonds have lower credit
ratings than Treasuries and investment-grade corporate and municipal bonds.
Ref: Fixed-Income Securities
10. Which of the following bonds should have the lowest promised return?

a. 10-year Treasury bond

b. 10-year corporate bond rated BB
c. 10-year corporate bond rated AA
d. 30-year corporate bond rated BB

Ans: a
Difficulty: Difficult
Response: The higher the credit rating of a bond, and the lower the maturity of a bond, the lower
the coupon interest payment should be. U.S. Treasury bonds have the highest ratings, AAA,
from the 3 major bond rating agencies, and are, therefore, seen as the safest and lowest yielding
bonds for any given maturity.
Ref: Fixed-Income Securities

11. Which of the following types of bonds are not issued by government entities?

a. Federal government bonds

b. Government agency bonds
c. Municipal bonds
d. Corporate bonds

Ans: d
Difficulty: Medium
Response: Federal bonds, notes, and bills are issued by the U.S. Treasury, as are federal agency
bonds, such as those issued by SLMA. Municipal bonds are issued by state or local
governments, or local authorities such as school districts.
Ref: Fixed-Income Securities

12. Why does the invoice price of a bond include accrued interest?

a. The seller wants to keep the interest earned since the last payment date.
b. The buyer wants to receive the interest earned since the last payment date.
c. The seller wants to obtain the interest earned between the time of sale and the next
payment date.
d. The buyer wants to keep the interest earned since the last payment date.

Ans: a
Difficulty: Medium
Response: Accrued interest is interest earned since the last semi-annual payment date.
Ref: Fixed-Income Securities
13. What happens if the price quoted for a bond goes above its face value?

a. It is considered a premium bond.

b. It is considered a discount bond.
c. The buyer can pay the lower of face or market price.
d. The seller receives only the face value.

Ans: a
Difficulty: Medium
Response: The market price is determined by potential buyers and sellers, and can be either
higher than face value (premium) or lower (discount), depending on market conditions.
Ref: Fixed-Income Securities

14. Why would investors buy a zero-coupon bond, if they receive no coupon interest?

a. The price of the bond may go up if the company has significant profits.
b. The price of the bond is significantly below the face value payable at maturity.
c. These zero coupon bonds are not registered, so the investor need not pay taxes.
d. Zero coupon bonds are, by definition, worthless.

Ans: b
Difficulty: Medium
Response: The investors profit from the increase in price as the bond moves toward maturity.
Ref: Fixed-Income Securities

15. Which of the following is an advantage of Treasury Inflation Protected Securities?

a. The interest is exempt from Federal income tax.

b. The interest payments are constant throughout the life of the bond.
c. TIPS can be bought in denominations as low as $100.
d. The principal or face amount is adjusted upward every six months, based on CPI.

Ans: d
Difficulty: Easy
Response: TIPS protect investors from losses resulting from inflation.
Ref: Fixed-Income Securities

16. An investor in the 35% marginal tax bracket invests in a 4 percent coupon rate municipal
bond. What yield would a taxable, but otherwise identical corporate, bond have to pay
for the investor to be indifferent between the two bonds?

a. 2.0%
b. 3.0769%
c. 4.0%
d. 6.1538%
Ans: d
Difficulty: Medium
Response: Municipal bond interest is tax exempt, whereas corporate bond interest is taxable.
Taxable equivalent yield is tax exempt yield divided by (1 minus the marginal tax rate).
Ref: Fixed-Income Securities

17. Which of the following is not an advantage of investing in municipal bonds?

a. General obligation bonds are backed by the “full faith and credit” and taxing authority of
the issuer.
b. The investor in municipal bonds does not have to pay federal income taxes on interest
earned from these bonds.
c. The investor in revenue bonds has the proceeds of the project to back the interest
payments.
d. Municipal bonds pay higher interest than similarly-rated corporate bonds.

Ans: d
Difficulty: Difficult
Response: Municipal bonds usually pay a lower stated rate of interest because they are not
subject to federal taxes.
Ref: Fixed-Income Securities

18. High yield debt, also known as “junk bonds,” is typically rated by S&P (Moody’s) as:

a. AA (Aa) or lower.
b. BB (Ba) or lower.
c. A (A) or lower.
d. BBB (Baa) or lower.

Ans: b
Difficulty: Medium
Ref: Fixed-Income Securities

19. Which of the following is not an advantage of investing in “junk bonds”?

a. These bonds are more speculative than “investment grade” bonds, meaning higher
potential returns if they pay off.
b. These bonds have higher interest payments than “investment grade” bonds.
c. These bonds are exempt from federal taxes.
d. These bonds are more likely to default than “investment grade” bonds.

Ans: c
Difficulty: Medium
Response: Municipal bonds, not junk bonds, are exempt from federal taxes.
Ref: Fixed-Income Securities
20. ABC’s stock currently trades at $50 per share. Earnings this year are expected to be $5
per share, and dividends will be $3 per share. What are ABC’s payout ratio and dividend
yield?

a. 6% and 60%
b. 60% and 6%
c. 10% and 6%
d. 6% and 10%

Ans: b
Difficulty: Medium
Response: Dividend yield is dividends per share in a time period (1 year) divided by stock price
per share. Payout ratio is dividends per share divided by earnings per share.
Ref: Equity Securities

21. What kind of derivative gives an investor the right, but not the obligation to buy a pre-
determined quantity of an asset?

a. Futures contract
b. Put option
c. Call option
d. Collar

Ans.: c
Difficulty: Medium
Response: A call option gives the buyer the right, not the obligation to buy a pre-arranged
quantity of an asset underlying the option at a pre-agreed exercise price. Options can be
exercised before or at maturity (if “American options”) or at maturity (if “European options”).
Ref: Derivatives

Type: True/False

1. The investment choices available to individual investors continue to change rapidly.

Ans: True
Ref: Investment Alternatives

2. Direct investing allows investors to buy and sell securities themselves.

Ans: True
Ref: Organizing Financial Assets
3. Debt traded in the money market is short-term, highly marketable, and has a low default
probability.

Ans: True
Ref: Money Market Securities

4. Individual investors often invest directly in money market instruments.

Ans: False
Ref: Money Market Securities

5. The discount yield of a T-bill is always less than the investment yield on the same bill.

Ans: True
Response: The only difference between them is that the discount yield uses 360 days in a year,
whereas the investment yield uses 365 (or 366 for leap years).
Ref: Money Market Securities

6. The price of T-bonds is quoted in pennies, such as 101.38.

Ans: False
Response: The price of T-bonds is quoted in 32nds of a point.
Ref: Fixed-Income Securities

7. Senior securities are those which have been outstanding the longest.

Ans: False
Response: Senior securities, including secured debt, will be paid off before subordinated or
junior securities.
Ref: Fixed-Income Securities

8. Preferred stocks are like bonds in that the annual payments are guaranteed by the issuer.

Ans: False
Response: Preferred stock dividends are not legally binding.
Ref: Equity Securities

9. A “closely held” company is owned by a few shareholders and is not traded on any stock
market.

Ans: True
Ref: Equity Securities
10. The Price/Earnings ratio (P/E) is the current market price per share, divided by the
company’s earnings per share.

Ans: True
Ref: Equity Securities