CHAPTER 8

TRUE/FALSE QUESTIONS

(T) 1. Capital market securities are typically used to finance real capital investments.

(F) 2. Capital market securities are more liquid than money market securities.

(T) 3. Money market securities are all debt securities, while capital market securities are either
debt or equity securities.

(T) 4. Capital market interest rates tend to be higher than money market rates for a given issuer.

(T) 5. Life insurance companies are likely to invest more in corporate capital market
securities as a percentage of investments than commercial banks.

(T) 6. Investors may invest in capital market securities either directly or indirectly.

(F) 7. Both governments and businesses issue both debt and equity capital market securities.

(F) 8. Households in aggregate owe more financially than they own.

(F) 9. The market where firms and institutions warehouse funds until needed in the near future
is called the capital market.

(T) 10. In 2015 the volume of mortgages outstanding exceeds the volume of corporate bonds in
the U.S.

(F) 11. Yields on U.S. Treasury "ask" prices are higher than yields quoted on "bid" prices.

(T) 12. A U.S. Treasury STRIP is a zero-coupon bond.

(F) 13. Most state and local government bonds are sold to investors in low tax brackets.

(T) 14. A serial bond issue matures over a period of years.

(T) 15. In 2015 households were the major investor in municipal bonds.

(F) 16. TIPS are designed to primarily protect investors from default risk.

(T) 17. A state turnpike authority is more likely to issue revenue bonds than a city that issues
bonds to finance a school expansion.

(F) 18. Lower marginal tax rates increase the demand for municipal securities.

(T) 19. The money market provides liquidity for deficit units; the capital market finances
economic growth.

(F) 20. Bonds rated Ba or BB are investment grade bonds.

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(F) 21. Secondary trading of privately issued securities was authorized by Regulation Q.

(F) 22. Commercial banks purchase more tax-exempt securities in periods when loan losses are
high.

(F) 23. Financial guarantees generate interest income for banks and insurers.

(T) 24. Revenue bonds are generally considered more risky than general obligation bonds.

(F) 25. The after-tax return on a 9 percent municipal bond held by a commercial bank in the 34
percent tax bracket is 5.94 percent.

(F) 26. Callable bonds are the bonds that can be redeemed at par at the option of their holders.

(T) 27. A bond’s promised yield is inversely related to its default rating, all else equal.

(F) 28. Bondholders may profitably convert their convertible bonds into shares of stock when the
conversion price is greater than the market price of the stock.

(F) 29. The conversion feature of a bond is designed to give the issuer the opportunity to
repurchase bonds at a stated price prior to maturity.

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 MULTIPLE-CHOICE QUESTIONS

(c) 1. Which of the following is not an example of capital market securities?

a. common stocks
b. convertible bonds
c. commercial paper
d. mortgages

(d) 2. The secondary markets for capital market securities have facilitated economic growth in
the U.S. because
a. they help provide marketability for capital market claims.
b. they have increased people's willingness to buy capital market claims.
c. they make people more willing to invest because they can more easily diversify
their risk.
d. all of the above

(d) 3. The biggest supplier of funds in the capital markets are

a. financial institutions
b. state and local governments
c. federal government
d. households and non-profit organizations

(a) 4. A capital market issue is most likely to finance

a. new plant and equipment.
b. seasonal inventory needs.
c. a quarterly dividend payment.
d. the sale of common stock.

(a) 5. Between 1990 and 2015 the fastest growing debt sector in the U. S. is
a. Treasury debt
b. common stock
c. mortgage debt
d. corporate debt

(b) 6. TIPS have less _____ risk than “regular” Treasury securities of the same maturity.
a. default
b. inflation
c. liquidity
d. foreign exchange

(a) 7. You purchase a Treasury inflation-protected note with an original principal amount of
$1,000,000 and a 2.8 percent annual coupon (paid semiannually). What will the
first coupon payment be if the semiannual inflation over the first six months is 1.2%?
a. $14,168
b. $14,000
c. $28,336
d. $28,000
e. $12,336

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(e) 8. The yield on a three-year Treasury note is 4.5% and the yield on a three-year TIPS is
2.4%. What is the market’s estimate of the annual inflation rate over the next
three years?
a. 1.1%
b. 1.6%
c. 4.5%
d. 2.4%
e. 2.1%

(c) 9. Investors in U.S. Treasury STRIPs are primarily interested in eliminating which of the
following bond investor risks?
a. default risk
b. price risk
c. reinvestment risk
d. foreign exchange risk

(d) 10. Which of the following statements about STRIPs is true?

a. STRIPs are sold directly to the final investors by the Treasury Department
b. When a STRIP is created, all interest payments become one security and the
principal payment becomes the other.
c. Many small investors prefer STRIPs because stripped interest is tax exempt.
d. Treasury securities dealers create STRIPs to help investors limit default risk.
e. None of the above statements is true.

(c) 11. General obligation bonds are sold through

a. rights offerings.
b. negotiated bids.
c. competitive bids.
d. private placement.

(d) 12. Which of the following would be least likely to purchase a tax-exempt municipal bond?
a. commercial bank
b. casualty insurance company
c. mutual fund
d. pension fund

(a) 13. Which of the following terms is not commonly associated with municipal bonds?
a. inflation-protected bonds
b. serial bonds
c. general obligation bonds
d. revenue bonds

(c) 14. An investor in the 34 percent federal tax bracket would select which of the following to
maximize their expected after tax return ignoring risk?
a. 7% general obligation bond
b. 10% corporate bond
c. 11% mortgage
d. 6.6% revenue bond

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(b) 15. If average corporate bond and tax-exempt municipal bond rates were 8.33% and 6.25%
respectively, at what marginal tax rate would an investor be indifferent between
the two?
a. 18%
b. 25%
c. 30%
d. 33%
e. 35%

(a) 16. If average corporate bond and tax-exempt municipal bond rates were 8.33% and 6.25%
respectively, an investor in the 34 percent marginal corporate tax bracket would purchase
a. the tax-exempt bond.
b. the corporate bond.
c. either security (i.e., the investor is indifferent)
d. the security with the higher pre-tax yield.

(c) 17. In 2015 the largest investor in municipal bonds were

a. property and casualty insurance companies
b. commercial banks
c. households
d. mutual funds
e. pension funds

(c) 18. Industrial development bonds (IDBs) are debt securities issued by:
a. the federal government
b. non profit organizations
c. state and local government agencies
d. nonfinancial businesses.

(a) 19. Everything else being equal, a bond will sell at a higher yield if it
a. has a call provision.
b. has low default risk.
c. can be converted to stock.
d. is listed on an exchange.

(c) 20. Privately placed securities

a. have to be registered with SEC.
b. never trade in the secondary market.
c. can only be sold to large, sophisticated investors (e.g., financial institutions).
d. cannot be originally sold to less than 35 investors.
e. both c and d.

(b) 21. Corporate bonds are less marketable than money market instruments and corporate
equities because
a. the former are for smaller denominations.
b. corporate bonds are long-term securities, which tend to be riskier and less
marketable.
c. corporate bonds are not tax exempt and money market securities are.
d. Corporate bonds are in fact not less marketable than money market instruments
and corporate equities.

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(d) 22. The existence of each of the following bond terms will result in a lower required yield
except
a. conversion feature.
b. collateral.
c. sinking fund.
d. call provision.

(a) 23. In the primary market, corporate bonds cannot be sold through
a. securities exchanges such as the NYSE
b. competitive sales
c. negotiated sales
d. private placement

(b) 24. In the 1980s, low credit quality businesses were able to first issue their new bond
securities in which market?
a. municipal bond market
b. junk bond market
c. investment-grade bond market
d. secondary market
e. subprime mortgage market

(d) 25. The first investment banker to make a major market in junk bonds was
a. Goldman Sachs
b. Credit Suisse
c. Salomon Brothers
d. Drexel-Burnham

(c) 26. Life insurance companies and pension funds buy corporate bonds for which two major
reasons?
a. tax sheltering and high yield
b. liquidity and after-tax returns
c. liability maturity matching and after-tax returns
d. low risk and liquidity

(b) 27. Credit-rating agency ratings are associated with which of the following investor risks?
a. interest rate risk
b. default risk
c. purchasing power risk
d. reinvestment risk
e. exchange rate risk

(c) 28. Which of the following is not a true statement about municipal bonds (munis) and
corporate bonds?
a. Interest paid on munis is tax-exempt, while interest paid on corporate bonds is
not.
b. Munis often have a range of maturities (are serial issues) but many corporate
bonds do not.
c. Unlike corporate bonds, munis are rated by bond-rating agencies such as
Moody’s.
d. All of the above are differences between munis and corporate bonds.

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(a) 29. The quality of a financial guarantee depends on the reputation and financial strength of
the
a. guarantor.
b. investor.
c. borrower.
d. the Federal government.

(a) 30. Letters of credit are mostly associated with

a. financial guarantees.
b. investment banking.
c. a bond indenture.
d. a commercial bank seasonal loan.

(d) 31 The incentive to securitize a portfolio of loans is

a. the profit from the loan revenue.
b. the profit from the interest on the asset-backed securities issued.
c. the profit from the fees paid for financial guarantees.
d. the profit from the difference between the loan revenue and the costs of
guarantees and return on the asset-backed securities.

(b) 32. Securitization of loan portfolios, such as credit card loans and mortgage loans, will occur
if
a. the financial market will pay more for the loan portfolio than the issued asset-
backed securities.
b. the financial market will pay more for the asset-backed securities issued than the
loan portfolio.
c. a financial guarantee is obtained from a commercial bank.
d. the borrowers permit their loan to be securitized.

(d) 33. Which of the following is NOT associated with credit enhancements for asset-backed
securities?
a. Cash-collateral accounts that are deposits set aside to cover losses
b. Financial guarantees from bond insurance companies
c. Standby letters of credit from major commercial banks
d. A guarantee to pay from the original borrowers

(e) 34. The most important government regulator in the U.S. capital markets is the
a. Federal Reserve System
b. Treasury Department
c. National Association of Security Dealers (NASD)
d. Federal Deposit Insurance Corporation
e. Securities and Exchange Commission

(c) 35. Bonds issued by foreign entities in the United States are called:
a. foreign bonds
b. American depository receipts
c. Yankee bonds
d. Samurai bonds

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(c) 36. The primary private (non-government) regulator of capital market activity is
a. the SEC
b. the CFTC
c. FINRA
d. NASDAQ

(d) 37. A putable bond gives the bondholders the right

a. to sell the bond back to the corporation at the original purchase price.
b. to sell the bond back to the corporation at a stated premium.
c. to sell the bond back to the corporation at the current market value.
d. to sell the bond back to the corporation at par.

(c) 38. A Treasury Bond with a $1000 par is quoted at 97:14 Bid, 97:15 Ask. The price
for you to buy this bond is
a. $974.38
b. $975.42
c. $974.69
d. $975.77

(b) 39. Which one of the following bonds is likely to have the highest required rate of return,
ceteris paribus?
a. AAA rated noncallable corporate bond with a sinking fund.
b. AA rated callable corporate bond without a sinking fund
c. AA rated callable corporate bond with a sinking fund
d. AAA rated callable corporate bond with a sinking fund

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 ESSAY QUESTIONS

1. Compare and contrast the characteristics of the securities of the money market with those of the
capital market.

Answer: Money market securities are short-term, usually less than nine months in maturity, but
certainly less than or equal to one year, while capital market securities are usually from over one
year to perpetuities. The money market is largely a “primary” market with some secondary
market activity. The capital market is a secondary market with some primary market additions.
Most money market securities are unsecured debt (with the exception of repos, which are
collateralized), while equities and debt, some collateralized, some not, make up the capital
market. Capital market securities are risker and involve a significant chance of loss of principal
investment. Money market securities are safe and liquid and one should not lose any principal on
this type investment. Promised yields on capital market securities are higher than for money
markets. Money markets provide liquidity; capital markets provide the opportunity for
significant growth of your investment.

2. What might determine whether an individual investor buys corporate or municipal bonds?
Provide a numerical example.

Answer: Everything else being the same, an individual investor would select the higher after-tax
return; so the relative yields and marginal tax rate of the investor will likely determine the choice
between corporate bonds and munis. For example, with a 7% yield available on a corporate
bond, an individual in the 28% marginal tax bracket would have to find a similar (in terms of
maturity and rating) 5.04% municipal or state bond. For individuals’ pension investment in a tax-
deferred program, one would invest in the taxable securities.

3. What types of risks are faced by bond investors?

Answer: Bond investors may face a variety of risk including default risk, price risk, and
reinvestment risk (for coupon bonds), foreign exchange risk and/or political risk for international
investments, and marketability risk.

4. Why are U.S. Treasury STRIPs are of interest to individuals with IRA's or $401k pension plans?

Answer: STRIPs are zero-coupon bonds. Such securities are of interest to individuals investing
with tax-deferred pension plans for several reasons. One, an individual buying a STRIP outside a
qualified pension plan will pay annual interest on the imputed interest rate on the zeros even
though cash is not received, but not if the investment is held in a qualified plan. Second, zeros
held to maturity earn the expected yield to maturity and are not subject to reinvestment risk. One
will immediately know the amount of cash expected in the plan at the bonds’ maturity absent
default.

5. What factors have contributed to the increased globalization of bond markets?

Answer: There have been a number of cumulative factors that, over time, have contributed to the
increased globalization of bond markets. The development of standardized legal remedies in the
event of default, the development of markets in more stable economies, and a growing amount of
quality government debt has attracted investors into financial investment. Exchange rate
stability, computerization, and information processing technology have also allowed for greater
international market development.

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6. You check the Wall Street Journal and find information regarding a principal STRIP that will
mature in 7 years. The price quote per hundred of par for this STRIP is 85.75%. Using
semiannual compounding, what is the promised yield to maturity on the STRIP?

Answer: The YTM is [(100 / 85.75) (1/(7x2)) – 1] x 2 = 2.208%

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