Assignment 2

Multiple Choices (50 marks, 5 marks for each)

1. Bert owns a bond that will pay him $75 each year in interest plus a $1,000 principal payment at
maturity. What is the $1,000 called?
A. coupon
B. face value
C. discount
D. yield
E. dirty price
Answer: B

2. The current yield is defined as the annual interest on a bond divided by which one of the following?
A. coupon
B. face value
C. market price
D. call price
E. dirty price
Answer: C

3. The Fisher effect is defined as the relationship between which of the following variables?
A. default risk premium, inflation risk premium, and real rates
B. nominal rates, real rates, and interest rate risk premium
C. interest rate risk premium, real rates, and default risk premium
D. real rates, inflation rates, and nominal rates
E. real rates, interest rate risk premium, and nominal rates
Answer: D

4. Home Canning Products common stock sells for $44.96 a share and has a market rate of return of 12.8
percent. The company just paid an annual dividend of $1.04 per share. What is the dividend growth rate? 
A. 8.29 percent
B. 8.45 percent
C. 9.23 percent
D. 9.67 percent
E. 10.25 percent
Answer: E
5. Which of the following relationships apply to a par value bond?
I. coupon rate < yield-to-maturity
II. coupon rate = yield-to-maturity
III. market price = call price
IV. market price = face value 
A. I and II only
B. I and III only
C. II and IV only
D. I, II, and III only
E. II, III, and IV only
Answer: C

6. Real rates are defined as nominal rates that have been adjusted for which of the following?
A. inflation
B. default risk
C. accrued interest
D. interest rate risk
E. both inflation and interest rate risk
Answer: A

7. A bond has a market price that exceeds its face value. Which of the following features currently apply
to this bond?
I. discounted price
II. premium price
III. yield-to-maturity that exceeds the coupon rate
IV. yield-to-maturity that is less than the coupon rate
A. III only
B. I and III only
C. I and IV only
D. II and III only
E. II and IV only
Answer: E

8. The Walthers Company has a semi-annual coupon bond outstanding. An increase in the market rate of
interest will have which one of the following effects on this bond?
A. increase the coupon rate
B. decrease the coupon rate
C. increase the market price
D. decrease the market price
E. increase the time period
Answer: D

9. Jen's Fashions is growing quickly. Dividends are expected to grow at a 22 percent rate for the next 3
years, with the growth rate falling off to a constant 8 percent thereafter. The required return is 12 percent
and the company just paid a $3.80 annual dividend. What is the current share price? 
A. $128.96
B. $131.11
C. $146.17
D. $148.87
E. $152.20
Answer: C

10. Last year, T-bills returned 2 percent while your investment in large-company stocks earned an
average of 5 percent. Which one of the following terms refers to the difference between these two rates
of return? 
A. risk premium
B. geometric return
C. arithmetic
D. standard deviation
E. variance
Answer: A

Short Answer Questions (10 marks):

1. A stock had the following prices and dividends. What is the geometric average return on this stock?
    

Return for year 2 = ($16.62 - $16.40 + $0.50)/$16.40 = 4.3902 percent

Return for year 3 = ($15.48 - $16.62 + $0.50)/$16.62 = -3.8508 percent
Return for year 4 = ($9.15 - $15.48 + $0.25)/$15.48 = -39.2765 percent
Geometric return = (1.043902  0.961492  0.607235)1/3 - 1 = -15.21 percent
ANSWER: B

2. Explain the difference between systematic and unsystematic risk. Also explain why one of these types
of risks is rewarded with a risk premium while the other type is not. 

Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by
investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded
since it can be eliminated by investors. Systematic risk is risk which affects most, or all, securities and
cannot be diversified away. Since systematic risk must be accepted by investors it is rewarded with a risk
premium and is measured by beta.

Long-Answer Questions (40 marks)

1. Dexter Mills issued 10-year bonds a year ago at a coupon rate of 13.2 percent. The bonds make
semiannual payments. The yield-to-maturity on these bonds is 9.6 percent. Assume the par value
is 1,000 USD. (15 marks in total)
a. What is the current bond price? 
Answer:
1
1− (10−1)×2
0.096
(1+ )
0.132 ×1000 2 1000
P= × + =1213.74
2 0.096 0.096 (10−1)×2
(1+ )
2 2
1000
Enter 9*2 9.6/2 132/2
 N I/Y PV PMT FV
Solve for −1213.74

b. If the current bond price is 1,050 USD. Should you buy the bond? What would be the price
pattern for the bond?
Answer: I will buy the bond because the current price is lower than the value of the bond. As
investors realize the price is lower than the value of the bond, they will buy the bond, pushing up
the price of the bond, in the end the price will be the same as the bond value.

2. Bond S is a 6 percent coupon bond. Bond T is a 10 percent coupon bond. Both bonds have 15
years to maturity, make semiannual payments, and have a yield-to-maturity of 8 percent. If
interest rates suddenly rise by 1 percent. (15 marks)
a. What will the percentage change in the price of Bond S and T be? 

Answer:
Price of Bond S:
N: 30; I/Y: 4; PMT: 30; FV:1000; PV=-827.08
Price of Bond T:
N: 30; I/Y: 4; PMT: 50; FV:1000; PV=-1172.92

If interest rate increase to 9% a year

Price of Bond S (new)
N: 30; I/Y: 4.5; PMT: 30; FV:1000; PV=-755.67
Price of Bond T (new)
N: 30; I/Y: 4.5; PMT: 50; FV:1000; PV=-1081.44

So the price change in S is (755.67-827.08)/827.08= -8.63%

The price change in T is (1081.44-1172.92)/ 1172.92=-7.80%
b. Based on the results in part a, explain why the percentage change in price in one bond is
larger than the other.
Answer: Bond S is more sensitive to interest rate change compared with bond T. The reason is
bond S has a lower coupon rate. When we calculate the price of the bond, a lower coupon
indicates the relative weight of discount rate is larger. Therefore, the price risk for Bond S is
larger, indicating a higher sensitivity to the interest rate increase.

3. If you actually sell the bond before it matures, your realized return is known as the holding period
yield. Suppose that today, you buy a 13 percent annual coupon bond for $1,000. The bond has 15 years to
maturity. Two years from now, the yield-to-maturity has declined by 2 percent and you decide to sell.
What is your holding period yield? 
(10 marks)
 Answer:
The yield-to-maturity at the time of purchase must be 13 percent, which is the coupon rate,
because the bond was purchased at par value.
Yield-to-maturity in 2 years = 13 percent - 2 percent = 11 percent

1
1− (15−2)
(1+0.11) 1000
P=(0.13 ×1000)× + (15−2)
=1135
0.11 (1+0.11)

Enter 15-2 11 130 1000

N I/Y PV PMT FV
Solve for −1135

1
1−
( 1+r )2 1135
1000= ( 0.13× 1000 ) × + ; r =19.16 %
r ( 1+r )
2

Enter 2 -1000 130 1135

N I/Y PV PMT FV
Solve for 19.16

This cannot be solved directly, so it's easiest to just use the calculator method to get an answer. You can
then use the calculator answer as the rate in the formula just to verify that your answer is correct.