91. A high yield bond fund states that through active management, the fund s return has outperformed an index of Treasury securities by 4% on average over the past five years. As a performance benchmark for this fund, the index chosen is: A. appropriate. B. inappropriate, because the index return does not reflect active management. C. inappropriate, because the index does not reflect the actual bonds in which the fund invests. 9. The change in the intrinsic value of a firm s common stock resulting from an increase in ROE most likely: A. increases the stock s intrinsic value. B. decreases the stock s intrinsic value. C. depends on the reason for the increase in ROE. 93. Which of the following statements about short selling is least accurate? A. A short seller is required to set up a margin account. B. A short sale involves securities the investor does not own. C. A short seller loses if the price of the stock sold short decreases. 94. Compared to an index of 100 U.S. exchange-traded stocks, an index of 100 U.S. government and corporate bonds will most likely: A. reflect equally timely price data. B. be more difficult to build and maintain. C. have less turnover among the securities in the index. 95. Beth Knight, CFA, and David Royal, CFA, are independently analyzing the value of Bishop, Inc. stock. Bishop paid a dividend of $1 last year. Knight expects the dividend to grow by 10% in each of the next three years, after which it will grow at a constant rate of 4% per year. Royal also expects a temporary growth rate of 10% followed by a constant growth rate of 4%, but he expects the supernormal growth to last for only two years. Knight estimates that the required return on Bishop stock is 9%, but Royal believes the required return is 10%. Royal s valuation of Bishop stock is approximately: A. equal to Knight s valuation. B. $5 less than Knight s valuation. C. $5 greater than Knight s valuation. 96. An industry in the growth phase of the industry life cycle is most likely to experience: A. increasing prices. B. increasing profitability. C. intense competition among competitors. Page 8 01 Kaplan, Inc.
Questions 97 through 110 relate to Fixed Income. (1 minutes) 97. Consider the following Treasury spot rates expressed as bond equivalent yields: Maturity Spot Rate 6 months 3.0% 1 year 3.5% 1.5 years 4.0% years 4.5% If a Treasury note with two years remaining to maturity has a 5% semiannual coupon and is priced at $1,008, the note is: A. overpriced. B. underpriced. C. correctly priced. 98. Which of the following is an advantage of a callable bond (compared to an identical option-free bond) to an investor? A. Less reinvestment risk. B. Higher yield. C. More convexity. 99. An investor is considering the purchase of Security X, which matures in ten years and has a par value of $1,000. During the first five years, X has a 6% coupon with quarterly payments. During the remaining five years, X has an 8% coupon with quarterly payments. The face value is paid at maturity. A second 10-year security, Security Z, has a 6% semiannual coupon and is selling at par. Assuming that X has the same bond equivalent yield as Z, the price of Security X is closest to: A. $943. B. $1,036. C. $1,067. 100. The yield spreads between corporate bonds and Treasuries are most likely to decrease if: A. liquidity decreases in the market for the bonds. B. a credit rating downgrade on the bonds becomes more likely. C. investors increase their estimates of the recovery rate on the bonds. 101. The full price of a bond: A. includes accrued interest. B. includes commissions and taxes. C. is also known as the clean price. 01 Kaplan, Inc. Page 9
10. Which of the following statements regarding sinking funds is most accurate? A. The specific bonds that will be redeemed on each scheduled date are identified in the indenture. B. Sinking fund redemptions can be accomplished by making cash payment to the trustee who will then retire the required proportion of the bonds. C. If yields have declined since the bond was issued, companies are likely to choose to retire the required portion of the debt by delivering securities to the trustee. 103. A debt covenant designates one of a holding company s subsidiaries as restricted. Which of the following credit-related considerations does this covenant address? A. Credit migration risk. B. Structural subordination. C. Payments to equity holders. 104. Consider a 5-year, $1,000 par semiannual-pay bond with a 7.5% coupon and a 9.5% YTM. Based on a yield change of 50 basis points, the effective duration of the bond is closest to: A. 8.73. B. 10.03. C. 1.50. 105. For a bond currently priced at $1,018 with an effective duration of 7.48, if the market yield moved down 75 basis points, the new price would be approximately: A. $961. B. $1,075. C. $1,094. 106. Which of the following statements about Treasury Inflation Protected Securities (TIPS) is most accurate? A. Inflation adjustments are made annually. B. Yields on TIPS are effectively real rates of interest. C. The coupon rate adjusts upward for inflation. 107. Consider a $1,000-face value, 1-year, 8%, semiannual coupon bond with a YTM of 10.45%. The change in value for a decrease in yield of 38 basis points is: A. $1.18. B. $.76. C. $3.06. Page 30 01 Kaplan, Inc.
108. The minimum data required to calculate the implied forward rate for three years beginning three years from now is: A. the 3-year and 6-year spot rates. B. the 4-year, 5-year, and 6-year spot rates. C. spot rates at 1-year intervals for the 6-year period. 109. Consider three bonds that are identical in all features except those shown in the following table: Bond Embedded Option Amount Outstanding A Call $0 million B Call $80 million C Put $0 million The bond most likely to have the largest spread to a comparable Treasury security is: A. Bond A. B. Bond B. C. Bond C. 110. A 3-year, 6% coupon, semiannual-pay note has a yield to maturity of 5.5%. If an investor holds this note to maturity and earns a 4.5% return on reinvested coupon income, his realized yield on the note is closest to: A. 5.46%. B. 5.57%. C. 5.68%. Questions 111 through 116 relate to Derivatives. (9 minutes) 111. Janet Powers writes a covered call on a stock she owns, Billings, Inc. The current price of the stock is $45, and Powers writes the call at a strike price of $50. The call option premium is $3.50. Which of the following statements regarding Powers s covered call strategy is most accurate? A. Powers is trading the stock s upside potential in exchange for current income. B. The price of the stock must rise to at least $48.50 before Powers will lose money. C. Powers is eliminating downside risk at the same time she is increasing her current income with the covered call strategy. 11. A portfolio manager holds a long position on a forward contract on $0 million face value 81-day T-bills priced at 1.85% on a discount basis. At settlement, 81-day T-bills are priced at 1.95% on a discount basis. If the contract settles in cash, at settlement the portfolio manager will: A. pay $4,500. B. receive $4,500. C. pay $0,000. 01 Kaplan, Inc. Page 31
Answers 93. C The short seller loses if the stock price increases. The other choices are accurate statements. (Study Session 13, LOS 46.e) 94. B Bond indexes are more difficult to build and maintain than stock indexes for several reasons. Bonds in an index have to be replaced as they mature, so turnover is likely to be greater in a bond index than in a stock index. Many bonds lack the continuous trade data that exists for exchange-traded equities. (Study Session 13, LOS 47.i) 95. B You can select the correct answer without calculating the share values. Royal is using a shorter period of supernormal growth and a higher required rate of return on the stock. Both of these factors will contribute to a lower value using the multistage DDM. Knight: $(. 1110 ) $(. 1110) $(. 1110) /( 009. 004. ) + + = $ 4. 43 109. 109. 1. 09 $(. 1110) $(. 1110) /( 010. 004. ) royal: + = $ 19. 33 110. 110. 3 royal s valuation is $5.10 less that Knight s valuation. (Study Session 14, LOS 51.e) 96. B An industry in the growth stage is usually characterized by increasing profitability, decreasing prices, and a low degree of competition among competitors. (Study Session 14, LOS 50.h) 97. B The market value of the Treasury note is the present value of the remaining coupons plus the present value of the principal, discounted at the semiannual rates available from dividing each annual spot rate in the table by two. value of T-note = $ 5 $ 5 $ 5 $, 1 05 + + + = $, 1 010. 05 3 4 (. 1 015) (. 1 0175) (. 10) (. 1 05) At $1,008, the T-note is priced below the present value of its cash flows ($1,010) and is therefore underpriced. (Study Session 16, LOS 56.f) 98. B An issuer of a callable bond must compensate the bondholder when the issue is sold by offering a higher coupon rate or accepting a lower price than if the call feature was not included. Convexity will typically be much less than for an option-free bond, and reinvestment risk is greater for callable bonds. (Study Session 15, LOS 53.h) 99. C The bond equivalent yield rate on the par bond (Z) is 6% or a 3% semiannual rate. The equivalent quarterly rate, 1.03 1/ 1 = 0.014889. Security X makes 0 quarterly payments of $15 and 0 quarterly payments of $0. We need to use the cash flow function as follows: CF 0 = 0; CF 1 = 15; F 1 = 0; CF = 0; F = 19; CF 3 = 1,00; F 3 = 1; I = 1.4889; CPT NPV = $1,067.7. Note that CF 3 contains the final quarterly payment of $0 along with the $1,000 face value payment. (Study Session 16, LOS 56.c) 100. C Yield spreads reflect the credit quality of bond issuers and the liquidity of the market for their bonds. Narrowing (decreasing) yield spreads reflect improving credit quality or more liquidity. Widening (increasing) yield spreads reflect deteriorating credit quality or less liquidity. Increased estimates of the recovery rate in the event of default represent an improvement in investors assessment of the issuer s credit quality and are likely to narrow yield spreads on the issuer s bonds. (Study Session 16, LOS 59.a) 01 Kaplan, Inc. Page 195
Answers 101. A The full price is clean price plus accrued interest. (Study Session 15, LOS 5.c) 10. B The issuer may deliver either cash or bonds to the trustee. Specific bonds to be redeemed are not typically identified in advance. Companies would retire through the delivery of securities if yields have increased. (Study Session 15, LOS 5.d,e) 103. B Restricted subsidiaries are those whose cash flows and assets are designated to service the debt of their holding company. Classifying a subsidiary as restricted alleviates structural subordination by making holding company debt rank pari passu with the subsidiary s debt. (Study Session 16, LOS 59.j) 104. B Calculate the new bond prices at the 50 basis point change in rates both up or down and then plug into the effective duration equation: current price: N = 50; FV = 1,000; PMT = (0.075/)1,000 = 37.50; I/Y = 4.65; CPT PV = $830.54 +50 basis pts: N = 50; FV = 1,000; PMT = (0.075/)1,000 = 37.50; I/Y = 4.875; CPT PV = $790.59 50 basis pts: N = 50; FV = 1,000; PMT = (0.075/)1,000 = 37.50; I/Y = 4.375; CPT PV = $873.93. D effective = v v+ $ 873. 93 $ 790. 59 = v0 y 830. 54 0. 005 (Study Session 16, LOS 58.d) ( )( ) = 10.3 0 105. B [1 + 7.48 (0.0075)] 1,018 = $1,075 (Study Session 15, LOS 53.f) 106. B Inflation adjustments to principal are made semiannually. The coupon rate is fixed. Inflation adjustments make the yields on TIPS good estimates of their real returns. (Study Session 15, LOS 54.b) 107. C With YTM = 10.45% (I/Y = 5.5), PMT = 40, N = 4, FV = 1,000, PV = $834.61. With YTM = 10.07% (I/Y = 5.035), PV = $857.67, an increase of $3.06. (Study Session 15, LOS 53.f) 108. A If we want the 3-year forward rate in three years, the appropriate formula is: 6 6 13 1 z 3f3 = + / ( ) 1 1+ z3 3 ( ) z 6 = 6-year spot rate and z 3 = 3-year spot rate. (Study Session 16, LOS 57.g) 109. A The call benefits the issuer, so a bondholder will require a higher yield on a callable bond, while the put option has value to the bondholder. Therefore a callable bond will have a higher yield spread to Treasuries than an otherwise identical putable bond. Other things equal, a bond with less liquidity will have a higher spread to Treasuries than a bond with more liquidity. Smaller issue size is associated with less liquidity. (Study Session 15, LOS 55.g, h) 110. A This question does not require calculations. Because the return on reinvested coupon interest is less than the note s yield to maturity, the investor s realized yield on the note must be less than the YTM. Only Choice A can be correct. (Study Session 16, LOS 57.c) Page 196 01 Kaplan, Inc.