Financial Markets and Institutions, 6e (Mishkin/Eakins)
Chapter 10 The Bond Market
10.1 Multiple Choice
1) Compared to money market securities, capital market securities have
A) more liquidity.
B) longer maturities.
C) lower yields.
D) less risk.
2) (I) Securities that have an original maturity greater than one year are traded in capital
markets. (II) The best known capital market securities are stocks and bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
3) (I) Securities that have an original maturity greater than one year are traded in money
markets. (II) The best known money market securities are stocks and bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
4) (I) Firms and individuals use the capital markets for long–term investments. (II) The capital
markets provide an alternative to investment in assets such as real estate and gold.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
5) The primary reason that individuals and firms choose to borrow long–term is to reduce the
risk that interest rates will _________ before they pay off their debt.
A) rise
B) fall
C) become more volatile
D) become more stable
6) A firm that chooses to finance a new plant by issuing money market securities
A) must incur the cost of issuing new securities to roll over its debt.
B) runs the risk of having to pay higher interest rates when it rolls over its debt.
C) incurs both the cost of reissuing securities and the risk of having to pay higher interest
rates on the new debt.
D) is more likely to profit if interest rates rise while the plant is being constructed.
7) The primary reason that individuals and firms choose to borrow long–term is to
A) reduce the risk that interest rates will fall before they pay off their debt.
B) reduce the risk that interest rates will rise before they pay off their debt.
C) reduce monthly interest payments, as interest rates tend to be higher on short–term
than long–term debt instruments.
D) reduce total interest payments over the life of the debt.
8) A firm will borrow long–term
A) if the extra interest cost of borrowing long–term is less than the expected cost of rising
interest rates before it retires its debt.
B) if the extra interest cost of borrowing short–term due to rising interest rates does not
exceed the expected premium that is paid for borrowing long term.
C) if short–term interest rates are expected to decline during the term of the debt.
D) if long–term interest rates are expected to decline during the term of the debt.
9) The primary issuers of capital market securities include
A) the federal and local governments.
B) the federal and local governments, and corporations.
C) the federal and local governments, corporations, and financial institutions.
D) local governments and corporations.
10) Governments never issue stock because
A) they cannot sell ownership claims.
B) the Constitution expressly forbids it.
C) both A and B of the above.
D) neither (a) nor (b) of the above.
11) (I) The primary issuers of capital market securities are federal and local governments, and
corporations. (II) Governments never issue stock because they cannot sell ownership claims.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
12) (I) The primary issuers of capital market securities are financial institutions.
(II) The largest purchasers of capital market securities are corporations.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
13) The distribution of a firm’s capital between debt and equity is its
A) current ratio.
B) liability structure.
C) acid ratio.
D) capital structure.
14) The largest purchasers of capital market securities are
A) households.
B) corporations.
C) governments.
D) central banks.
15) Individuals and households frequently purchase capital market securities through financial
institutions such as
A) mutual funds.
B) pension funds.
C) money market mutual funds.
D) all of the above.
E) only A and B of the above.
16) (I) There are two types of exchanges in the secondary market for capital securities: organized
exchanges and over–the–counter exchanges. (II) When firms sell securities for the very first
time, the issue is an initial public offering.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
17) (I) Capital market securities fall into two categories: bonds and stocks. (II) Long–term bonds
include government bonds and long–term notes, municipal bonds, and corporate bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
18) The _________ value of a bond is the amount that the issuer must pay at maturity.
A) market
B) present
C) discounted
D) face
19) The _________ rate is the rate of interest that the issuer must pay.
A) market
B) coupon
C) discount
D) funds
20) (I) The coupon rate is the rate of interest that the issuer of the bond must pay.
(II) The coupon rate is usually fixed for the duration of the bond and does not fluctuate with
market interest rates.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
21) (I) The coupon rate is the rate of interest that the issuer of the bond must pay. (II) The
coupon rate on old bonds fluctuates with market interest rates so they will remain attractive
to investors.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
22) Treasury bonds are subject to _________ risk but are free of _________ risk.
A) default; interest–rate
B) default; underwriting
C) interest–rate; default
D) interest–rate; underwriting
23) The prices of Treasury notes, bonds, and bills are quoted
A) as a percentage of the coupon rate.
B) as a percentage of the previous day’s closing value.
C) as a percentage of $100 face value.
D) as a multiple of the annual interest paid.
24) The security with the longest maturity is a Treasury
A) note.
B) bond.
C) acceptance.
D) bill.
25) (I) To sell an old bond when interest rates have risen, the holder will have to discount the
bond until the yield to the buyer is the same as the market rate. (II) The risk that the value of
a bond will fall when market interest rates rise is called interest–rate risk.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
26) To sell an old bond when interest rates have _________, the holder will have to _________
the price of the bond until the yield to the buyer is the same as the market rate.
A) risen; lower
B) risen; raise
C) fallen; lower
D) risen; inflate
27) Most of the time, the interest rate on Treasury notes and bonds is _________ that on money
market securities because of _________ risk.
A) above; interest–rate
B) above; default
C) below; interest–rate
D) below; default
28) (I) In most years the rate of return on short–term Treasury bills is below that on the 20–year
Treasury bond. (II) Interest rates on Treasury bills are more volatile than rates on long–term
Treasury securities.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
29) (I) Because interest rates on Treasury bills are more volatile than rates on long–term
securities, the return on short–term Treasury securities is usually above that on longer–term
Treasury securities.
(II) A Treasury STRIP separates the periodic interest payments from the final principal
repayment.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
30) Which of the following statements about Treasury inflation–indexed bonds is not true?
A) The principal amount used to compute the interest payment varies with the consumer
price index.
B) The interest payment rises when inflation occurs.
C) The interest rate rises when inflation occurs.
D) At maturity the securities pay the greater of face–value or inflation–adjusted principal.
31) The interest rates on government agency bonds are
A) almost identical to those available on Treasury securities since it is unlikely that the
federal government would permit its agencies to default on their obligations.
B) significantly higher than those available on Treasury securities due to their low
liquidity.
C) significantly lower than those available on Treasury securities because agency interest
payments are tax exempt.
D) significantly lower than those available on Treasury securities because the interest–rate
risk on agency securities is lower than that on Treasury securities.
32) (I) Municipal bonds that are issued to pay for essential public projects are exempt from
federal taxation. (II) General obligation bonds do not have specific assets pledged as security
or a specific source of revenue allocated for their repayment.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
33) (I) Most corporate bonds have a face value of $1000, pay interest semi–annually, and can be
redeemed anytime the issuer wishes. (II) Registered bonds have now been largely replaced
by bearer bonds, which do not have coupons.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
34) The bond contract that states the lender’s rights and privileges and the borrower’s
obligations is called the
A) bond syndicate.
B) restrictive covenant.
C) bond covenant.
D) bond indenture.
35) Policies that limit the discretion of managers as a way of protecting bondholders’ interests
are called
A) restrictive covenants.
B) debentures.
C) sinking funds.
D) bond indentures.
36) Typically, the interest rate on corporate bonds will be _________ the more restrictions are
placed on management through restrictive covenants, because _________.
A) higher; corporate earnings will be limited by the restrictions
B) higher; the bonds will be considered safer by bondholders
C) lower; the bonds will be considered safer by buyers
D) lower; corporate earnings will be higher with more restrictions in place
37) Restrictive covenants can
A) limit the amount of dividends the firm can pay.
B) limit the ability of the firm to issue additional debt.
C) restrict the ability of the firm to enter into a merger agreement.
D) do all of the above.
E) do only A and B of the above.
38) (I) Restrictive covenants often limit the amount of dividends that firms can pay the
stockholders.
(II) Most corporate indentures include a call provision, which states that the issuer has the
right to force the holder to sell the bond back.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
39) Call provisions will be exercised when interest rates _________ and bond values _________.
A) rise; rise
B) fall; rise
C) rise; fall
D) fall; fall
40) A requirement in the bond indenture that the firm pay off a portion of the bond issue each
year is called
A) a sinking fund.
B) a call provision.
C) a restrictive covenant.
D) a shelf registration.
41) (I) Callable bonds usually have a higher yield than comparable noncallable bonds. (II)
Convertible bonds are attractive to bondholders and sell for a higher price than comparable
nonconvertible bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
42) Long–term unsecured bonds that are backed only by the general creditworthiness of the
issuer are called
A) junk bonds.
B) callable bonds.
C) convertible bonds.
D) debentures.
43) A secured bond is backed by
A) the general creditworthiness of the borrower.
B) an insurance company’s financial guarantee.
C) the expected future earnings of the borrower.
D) specific collateral.
44) Financial guarantees
A) are insurance policies to back bond issues.
B) are purchased by financially weaker security issuers.
C) lower the risk of the bonds covered by the guarantee.
D) do all of the above.
E) do only A and B of the above.
45) Corporate bonds are less risky if they are _________ bonds and municipal bonds are less
risky if they are _________ bonds.
A) secured; revenue
B) secured; general obligation
C) unsecured; revenue
D) unsecured; general obligation
46) Which of the following are true for the current yield?
A) The current yield is defined as the yearly coupon payment divided by the price of the
security.
B) The formula for the current yield is identical to the formula describing the yield to
maturity for a discount bond.
C) The current yield is always a poor approximation for the yield to maturity.
D) All of the above are true.
E) Only A and B of the above are true.
47) The nearer a bond’s price is to its par value and the longer the maturity of the bond the more
closely _________ approximates _________
A) current yield; yield to maturity.
B) current yield; coupon rate.
C) yield to maturity; current yield.
D) yield to maturity; coupon rate.
48) Which of the following are true for the current yield?
A) The current yield is defined as the yearly coupon payment divided by the price of the
security.
B) The current yield and the yield to maturity always move together.
C) The formula for the current yield is identical to the formula describing the yield to
maturity for a discount bond.
D) All of the above are true.
E) Only A and B of the above are true.
49) The current yield is a less accurate approximation of the yield to maturity the _________ the
time to maturity of the bond and the _________ the price is from/to the par value.
A) shorter; closer
B) shorter; farther
C) longer; closer
D) longer; farther
50) The current yield on a $6,000, 10 percent coupon bond selling for $5,000 is
A) 5%.
B) 10%.
C) 12%.
D) 15%.
51) The current yield on a $5,000, 8 percent coupon bond selling for $4,000 is
A) 5%.
B) 8%.
C) 10%.
D) 20%.
E) none of the above.
52) For a consol, the current yield is an _________ of the yield to maturity.
A) underestimate
B) overestimate
C) approximate measure
D) exact measure
53) Which of the following are true of the yield on a discount basis as a measure of the interest
rate?
A) It uses the percentage gain on the face value of the security, rather than the percentage
gain on the purchase price of the security.
B) It puts the yield on the annual basis of a 360–day year.
C) It ignores the time to maturity.
D) All of the above are true.
E) Only A and B of the above are true.
54) The formula for the measure of the interest rate called the yield on a discount basis is
peculiar because
A) it puts the yield on the annual basis of a 360–day year.
B) it uses the percentage gain on the purchase price of the bill.
C) it ignores the time to maturity.
D) both A and B of the above.
E) both A and C of the above.
55) The yield on a discount basis of a 180–day $1,000 Treasury bill selling for $950 is
A) 10%.
B) 20%.
C) 25%.
D) 40%.
56) The yield on a discount basis of a 90–day $1,000 Treasury bill selling for $950 is
A) 5%.
B) 10%.
C) 15%.
D) 20%.
E) none of the above.
57) The yield on a discount basis of a 90–day $1,000 Treasury bill selling for $900 is
A) 10%.
B) 20%.
C) 25%.
D) 40%.
58) The yield on a discount basis of a 180–day $1,000 Treasury bill selling for $900 is
A) 10%.
B) 20%.
C) 25%.
D) 40%.
59) When an old bond’s market value is above its par value the bond is selling at a _________.
This occurs because the old bond’s coupon rate is _________ the coupon rates of new bonds
with similar risk.
A) premium; below
B) premium; above
C) discount; below
D) discount; above
60) Corporations may enter the capital markets because
A) they do not have sufficient capital to fund their investment opportunities.
B) they want to preserve their capital to protect against expected needs.
C) it is required by the Securities and Exchange Commission (SEC).
D) none of the above.
61) Capital market trading occurs in
A) the primary market.
B) the secondary market.
C) both A and B
D) none of the above.
62) Bonds
A) are securities that represent a debt owed by the issuer to the investor.
B) obligate the issuer to pay a specified amount at a given date, generally without
periodic interest payments.
C) both A & B.
D) none of the above.
63) STRIPS (Separate Trading of Registered Interest and Principal Securities) are also called
A) interest–based securities.
B) zero–coupon securities.
C) leveraged securities.
D) covenant securities.
64) The risk on agency bond is
A) high.
B) zero.
C) moderate.
D) low.
65) The first step in finding the value of the bond is to
A) discount back the cash flows using an interest rate that represents the yield available
on other bonds of like risk and maturity.
B) identify the cash flows the holder of the bond will receive.
C) contact holder of the bond.
D) none of the above.
66) A change in the current yield ______ signals a change in the same direction of the yield to
maturity.
A) never
B) rarely
C) always
D) often
10.2 True/False
1) The primary issuers of capital market securities are local governments and corporations.
2) Capital market securities are less liquid and have longer maturities than money market
securities.
3) Governments never issue stock because they cannot sell ownership claims.
4) To sell an old bond when rates have risen, the holder will have to discount the bond until the
yield to the buyer is the same as the market rate.
5) Most of the time, the interest rate on Treasury notes is below that on money market
securities because of their low default risk.
6) Municipal bonds that are issued to pay for essential public projects are exempt from federal
taxation.
7) Most municipal bonds are revenue bonds rather than general obligation bonds.
8) Most corporate bonds have a face value of $1000, are sold at a discount, and can only be
redeemed at the maturity date.
9) Registered bonds have now been largely replaced by bearer bonds, which do not have
coupons.
10) A sinking fund is a requirement in the bond indenture that the firm pay off a portion of the
bond issue each year.
11) Debentures are long–term unsecured bonds that are backed only by the general
creditworthiness of the issuer.
12) In a leveraged buy out, a firm greatly increases its debt level by issuing junk bonds to
finance the purchase of another firm’s stock.
13) A financial guarantee ensures that the lender (bond purchaser) will be paid both principal
and interest in the event the issuer defaults.
14) The current yield on a bond is a good approximation of the bond’s yield to maturity when
the bond matures in five years or less and its price differs from its par value by a large
amount.
15) The secondary market is where new issues of stocks and bonds are introduced.
16) General obligation bonds have specific assets pledged as security or specific sources of
revenue allocated for their repayment.
10.3 Essay
1) What is the purpose of the capital market? How do cpaital market securities differ from
money market securities in their general characteristics?
2) What is a bond indenture?
3) What role do restrictive covenants play in bond markets?
4) What is the difference between a general obligation and a revenue bond?
5) What are Treasury STRIPS?
6) What is a convertible bond? How does the convertibility feature affect the bond’s price and
interest rate?
7) What is a bond’s current yield? How does current yield differ from yield to maturity and
what determines how close the two values are?
8) Distinguish between general obligation and revenue municipal bonds.
9) What is a callable bond? How does the callability feature affect the bond’s price and interest
rate?
10) What types of risks should bondholders be aware of and how do these affect bond prices
and yields?
11) Explain the different types of corporate bonds.