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CHAPTER 7
INTEREST RATES AND BOND
VALUATION
Answers to Concepts Review and Critical Thinking Questions
1. No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury
securities have substantial interest rate risk.
2. All else the same, the Treasury security will have lower coupons because of its lower default risk, so
it will have greater interest rate risk.
3. No. If the bid price were higher than the ask price, the implication would be that a dealer was willing
to sell a bond and immediately buy it back at a higher price. How many such transactions would you
like to do?
4. Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must
be higher.
5. There are two benefits. First, the company can take advantage of interest rate declines by calling in
an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a
6. Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are
used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond
7. Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their
8. Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many
large investors are prohibited from investing in unrated issues.
9. Treasury bonds have no credit risk since it is backed by the U.S. government, so a rating is not
CHAPTER 7 B-119
10. The term structure is based on pure discount bonds. The yield curve is based on coupon-bearing
issues.
11. Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among
credit agencies.
12. As a general constitutional principle, the federal government cannot tax the states without their
consent if doing so would interfere with state government functions. At one time, this principle was
13. Lack of transparency means that a buyer or seller can’t see recent transactions, so it is much harder
to determine what the best bid and ask prices are at any point in time.
14. Companies charge that bond rating agencies are pressuring them to pay for bond ratings. When a
company pays for a rating, it has the opportunity to make its case for a particular rating. With an
unsolicited rating, the company has no input.
15. A 100-year bond looks like a share of preferred stock. In particular, it is a loan with a life that almost
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. The yield to maturity is the required rate of return on a bond expressed as a nominal annual interest
rate. For noncallable bonds, the yield to maturity and required rate of return are interchangeable
2. Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This
is because the fixed coupon payments determined by the fixed coupon rate are not as valuable when
interest rates rise—hence, the price of the bond decreases.
