LOS b, (Part 2): Describe the various coupon rate structures.

Q1. Which of the following statements regarding zero-coupon bonds and spot interest rates is most accurate?

A)   Price appreciation creates only some of the zero-coupon bond's return.

B)   Spot interest rates will never vary across time.

C)   A coupon bond can be viewed as a collection of zero-coupon bonds.

Q2. Which of the following statements regarding spot rates and zero-coupon bonds is least accurate?

A)   With zero coupon bonds, investors have no reinvestment risk.

B)   The yield to maturity on a zero coupon bond is called the spot interest rate.

C)   The graph of current corporate bond yields is called the spot yield curve.

Q3. Which of the following statements regarding zero-coupon bonds and spot interest rates is TRUE?

A)   Price appreciation creates all of the zero-coupon bond's return.

B)   If the yield to maturity on a 2-year zero coupon bond is 6%, then the 2-year spot rate is 3%.

C)   Spot interest rates will never vary across the term structure.

Q4. Which of the following statements regarding zero-coupon bonds is TRUE?

A)   Zero-coupon bonds have substantial amount of coupon reinvestment risk.

B)   An investor who holds a zero-coupon bond until maturity will receive a return equal to the bond's effective annual yield.

C)   An investor who holds a zero-coupon bond until maturity will receive an annuity of coupon payments plus recovery of principal at maturity.

Q5. A coupon bond:

A)   does not pay interest on a regular basis, but pays a lump sum at maturity.

B)   pays interest on a regular basis (typically semi-annually).

C)   always sells at par.

Q6. Which of the following statements about zero-coupon bonds is FALSE?

A)   A zero coupon bond may sell at a premium to par when interest rates decline.

B)   The lower the price, the greater the return for a given maturity.

C)   All interest is earned at maturity.

Q7. Which of the following statements concerning coupon rate structures is least accurate?

A)   Accrual bonds, like zero-coupon bonds, always sell at a discount to face value.

B)   Accrual bonds have only one cash inflow at maturity.

C)   Zero-coupon bonds have only one cash inflow at maturity.

LOS b, (Part 2): Describe the various coupon rate structures.fficeffice" />

Q1. Which of the following statements regarding zero-coupon bonds and spot interest rates is most accurate?

A)   Price appreciation creates only some of the zero-coupon bond's return.

B)   Spot interest rates will never vary across time.

C)   A coupon bond can be viewed as a collection of zero-coupon bonds.

Correct answer is C)

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. Any bond can be viewed as the sum of the present value of its individual cash flows where each of those cash flows are discounted at the appropriate zero-coupon bond spot rate.

Q2. Which of the following statements regarding spot rates and zero-coupon bonds is least accurate?

A)   With zero coupon bonds, investors have no reinvestment risk.

B)   The yield to maturity on a zero coupon bond is called the spot interest rate.

C)   The graph of current corporate bond yields is called the spot yield curve.

Correct answer is C)

The graph of yields on zero-coupon bonds (spot rates) is called the spot yield curve. Note that the return on zero-coupon bonds is based entirely on price appreciation. An investor in a default-free zero-coupon bond will not have to worry about reinvesting coupons to realize the yield to maturity.

Q3. Which of the following statements regarding zero-coupon bonds and spot interest rates is TRUE?

A)   Price appreciation creates all of the zero-coupon bond's return.

B)   If the yield to maturity on a 2-year zero coupon bond is 6%, then the 2-year spot rate is 3%.

C)   Spot interest rates will never vary across the term structure.

Correct answer is A)

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. Spot rates are defined as interest rates used to discount a single cash flow to be received in the future. If the yield to maturity on a 2-year zero is 6%, we can say that the 2-year spot rate is 6%.

Q4. Which of the following statements regarding zero-coupon bonds is TRUE?

A)   Zero-coupon bonds have substantial amount of coupon reinvestment risk.

B)   An investor who holds a zero-coupon bond until maturity will receive a return equal to the bond's effective annual yield.

C)   An investor who holds a zero-coupon bond until maturity will receive an annuity of coupon payments plus recovery of principal at maturity.

Correct answer is B)

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s return comes from price appreciation), investors have no uncertainty about the rate at which coupons will be invested. An investor who holds a zero-coupon bond until maturity will receive a return equal to the bond’s effective annual yield.

Q5. A coupon bond:

A)   does not pay interest on a regular basis, but pays a lump sum at maturity.

B)   pays interest on a regular basis (typically semi-annually).

C)   always sells at par.

Correct answer is B)

This choice accurately describes a coupon bond.

With an accrual bond, payments are deferred to maturity and then disbursed along with the par value at maturity. Unlike a normal zero-coupon bond, these issues are sold at (or near) their par values and then the interest accrues at a compound rate on top of that. So, they start at $1,000 and then appreciate from there.

Q6. Which of the following statements about zero-coupon bonds is FALSE?

A)   A zero coupon bond may sell at a premium to par when interest rates decline.

B)   The lower the price, the greater the return for a given maturity.

C)   All interest is earned at maturity.

Correct answer is A)

Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The amount of the discount may change as interest rates change, but a zero coupon bond will always be priced less than par.

Q7. Which of the following statements concerning coupon rate structures is least accurate?

A)   Accrual bonds, like zero-coupon bonds, always sell at a discount to face value.

B)   Accrual bonds have only one cash inflow at maturity.

C)   Zero-coupon bonds have only one cash inflow at maturity.

Correct answer is A)

Accrual bonds, unlike zero-coupon bonds, do not always sell at a discount to face value. The interest accrues forward and thus the bonds are likely to sell for more than face value.

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