LOS b, (Part 2): Explain the limitations and assumptions for traditional yield measures.

Q1. When computing the yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the:

A)   yield to maturity at the time of the investment.

B)   prevailing yield to maturity at the time interest payments are received.

C)   coupon rate.

Q2. The yield to maturity (YTM) is:

A)   the discount rate that will set the present value of the payments equal to the bond price.

B)   neither of these answers are correct.

C)   below the coupon rate when the bond sells at a discount, and about the coupon rate when the bond sells at a premium.

Q3. Which of the following is a limitation of the cash flow yield measure? The cash flow yield measure:

A)   assumes that the projected cash flows are reinvested at the cash flow yield.

B)   assumes that interest rates do not change over the life of the security.

C)   assumes a flat yield curve.

Q4. Regarding the computation of the cash flow yield for an agency security, which of the following is the best reason why the assumption that the projected cash flows are actually realized is very restrictive?

A)   Prepayments.

B)   Interest rate risk.

C)   Default risk.

Q5. In which of the following cases is the bond selling at a discount? The coupon rate is:

A)   greater than current yield and current yield is greater than yield-to-maturity.

B)   smaller than current yield and current yield is smaller than yield-to-maturity.

C)   smaller than current yield and current yield is greater than yield-to-maturity.

Q6. In which of the following conditions is the bond selling at a premium? The coupon rate:

A)   current rate and yield-to-maturity are all the same.

B)   is greater than current yield, which is greater than yield-to-maturity.

C)   is less than current yield, which is less than yield-to-maturity.

Q7. A bond will sell at a discount when the coupon rate is:

A)   greater than the current yield and the current yield is greater than the yield to maturity.

B)   less than the current yield and the current yield is greater than the yield to maturity.

C)   less than the current yield and the current yield is less than the yield to maturity.

Q8. Which of the following statements concerning the yield-to-maturity on a bond is CORRECT? Yield to maturity (YTM) is:

A)   based on the assumption that any payments received are reinvested at the current yield.

B)   below the current yield minus capital gain when the bond sells at a discount, and above the current yield plus capital loss when the bond sells at a premium.

C)   the discount rate that will set the present value of the payments equal to the bond price.

LOS b, (Part 2): Explain the limitations and assumptions for traditional yield measures.fficeffice" />

Q1. When computing the yield to maturity, the implicit reinvestment assumption is that the interest payments are reinvested at the:

A)   yield to maturity at the time of the investment.

B)   prevailing yield to maturity at the time interest payments are received.

C)   coupon rate.

Correct answer is A)

The reinvestment assumption states that reinvestment must occur at the YTM in order for an investor to earn the YTM.  The assumption also states that payments are received in a prompt and timely fashion resulting in immediate reinvestment of those funds.  

Q2. The yield to maturity (YTM) is:

A)   the discount rate that will set the present value of the payments equal to the bond price.

B)   neither of these answers are correct.

C)   below the coupon rate when the bond sells at a discount, and about the coupon rate when the bond sells at a premium.

Correct answer is A)

The YTM is a measure that will take into account present value, future value, periodic payments, and periods until maturity to find the rate of return that is being earned.  If the YTM is given, the result will be finding the present value of the future value and periodic cash flows. 

Q3. Which of the following is a limitation of the cash flow yield measure? The cash flow yield measure:

A)   assumes that the projected cash flows are reinvested at the cash flow yield.

B)   assumes that interest rates do not change over the life of the security.

C)   assumes a flat yield curve.

Correct answer is A)

Cash flow yield has two major deficiencies: (i) it is implicitly assumed that the cash flows will be reinvested at the cash flow yield prevailing when the MBS or ABS is priced, and (ii) it is assumed that the MBS or ABS will be held until maturity.

Q4. Regarding the computation of the cash flow yield for an agency security, which of the following is the best reason why the assumption that the projected cash flows are actually realized is very restrictive?

A)   Prepayments.

B)   Interest rate risk.

C)   Default risk.

Correct answer is A)

Prepayments instill uncertainty into the assumed cash flows used to compute cash flow yield.

Q5. In which of the following cases is the bond selling at a discount? The coupon rate is:

A)   greater than current yield and current yield is greater than yield-to-maturity.

B)   smaller than current yield and current yield is smaller than yield-to-maturity.

C)   smaller than current yield and current yield is greater than yield-to-maturity.

Correct answer is B)

When a bond is selling at a discount the nominal yield, coupon payment divided by face value, will be less than current yield and current yield will be less than YTM. 

Q6. In which of the following conditions is the bond selling at a premium? The coupon rate:

A)   current rate and yield-to-maturity are all the same.

B)   is greater than current yield, which is greater than yield-to-maturity.

C)   is less than current yield, which is less than yield-to-maturity.

Correct answer is B)

When a bond is selling at a premium the nominal yield, coupon payment divided by face value, will be greater than current yield and current yield will be greater than YTM.

Q7. A bond will sell at a discount when the coupon rate is:

A)   greater than the current yield and the current yield is greater than the yield to maturity.

B)   less than the current yield and the current yield is greater than the yield to maturity.

C)   less than the current yield and the current yield is less than the yield to maturity.

Correct answer is C)         l

When a bond sells at a discount the nominal yield, coupon yield divided by the face value, will be less than current yield and current yield will be less than YTM. 

Q8. Which of the following statements concerning the yield-to-maturity on a bond is CORRECT? Yield to maturity (YTM) is:

A)   based on the assumption that any payments received are reinvested at the current yield.

B)   below the current yield minus capital gain when the bond sells at a discount, and above the current yield plus capital loss when the bond sells at a premium.

C)   the discount rate that will set the present value of the payments equal to the bond price.

Correct answer is C)         l

Reinvestments occur at the YTM. The YTM will find the present value of a future value and associated payments.

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