cityboy

11. An investor whose marginal tax rate is 35% is analyzing a tax-exempt bond offering a yield of 5.40%. The tax-equivalent yield of the bond is closest to: A. 8.31%. B. 3.51%. C. 6.94%.

Ans: A; C is correct because Tax-equivalent yield = Tax-exempt yield/(1 – Marginal tax rate) = 5.40%/(1 – 0.35) = 8.31%

cityboy

12. A U.S. investor has purchased a tax-exempt 10-year municipal bond at a yield of 3.75% which is 100 basis points less than the yield on a 10-year option-free U.S. Treasury. If the investor’s marginal tax rate is 33.5%, then taxable equivalent yield and the yield ratio is closest to: Taxable equivalent yield Yield ratio A. 7.14 0.79 B. 5.64 0.79. C. 5.64 1.19.

Ans: B; Taxable equivalent yield =3.75%/ (1-33.5%) =5.64 Yield ratio = (yield on tax-exempt bond) / (yield of US Treasury) =3.75% / (3.75%+ 1%) = 3.75 / 4.75 =0.79

cityboy

12. A U.S. investor has purchased a tax-exempt 10-year municipal bond at a yield of 3.75% which is 100 basis points less than the yield on a 10-year option-free U.S. Treasury. If the investor’s marginal tax rate is 33.5%, then taxable equivalent yield and the yield ratio is closest to: Taxable equivalent yield Yield ratio A. 7.14 0.79 B. 5.64 0.79. C. 5.64 1.19.

Ans: B; Taxable equivalent yield =3.75%/ (1-33.5%) =5.64 Yield ratio = (yield on tax-exempt bond) / (yield of US Treasury) =3.75% / (3.75%+ 1%) = 3.75 / 4.75 =0.79

cityboy

14. Recent economic trend suggests that the economy is increasingly likely to enter a recession stage. What is the most likely impact on the yields of lower-quality corporate bonds and on credit spreads of lower-quality versus higher-quality corporate bonds? A. One will increase and one will decrease. B. Both will increase. C. Both will decrease.

Ans: B; Yields of lower quality increases: During economic contractions, the probability of default increases for lower- quality issues and their yields increase. Credit spreads increases: when an economic contraction is likely, investors tend to sell low-quality issues and buy high-quality issues, causing credit spreads of lower quality versus higher quality bonds to widen.

cityboy

15. Larger size debt issues normally have: A. greater yield spread. B. the same yield spread with smaller size debt issues. C. lower yield spread.

Ans: C; C is correct because larger issues normally have greater liquidity because they are more actively traded in the secondary market and therefore have lower yield spreads when compared with smaller issues.

cityboy

16. The yield on a U.S. Treasury STRIPS security is also known as the Treasury: A. spot rate. B. forward rate. C. yield spread.

Ans: A; Spot rates are the appropriate discount rates for cash flows that come at different points in time; while yield to maturity is the single discount rate that makes the present value of a bond’s promised cash flows equal to its market price. Therefore, yield to maturity is flat while spot rate is not flat because the discount rate for a payment that comes one year from now is not necessarily the same discount rate that should be applied to a payment that comes five years from now. Conceptually, spot rates are the discount rates for zero-coupon bonds, securities that have only a single cash flow at a future date. A is correct because a STRIPS security is a zero-coupon bond with no default risk and therefore represents the appropriate discount rate for a cash flow certain to be received at the maturity date for the STRIPS.