1215

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

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

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

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

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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.

1215

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

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

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

C) Spot interest rates will never vary across time.

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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.

1215

Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company’s investment banker, suggests a non-interest rate index floater. This type of bond will provide all the following advantages EXCEPT:

A) the bond agreement allows Allcans to set coupon payments based on business results.

B) the bond's coupon rate is linked to the price of aluminum.

C) the payment structure helps protect Allcan's credit rating.

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The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally. Non-interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices.

Both of the other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non-interest index floater allows Allcans to protect its credit rating during adverse circumstances.

1215

Sometimes floating rate issues have caps and/or floors, which limit the maximum or minimum coupon rate that the issue will pay. Which of the following statements is CORRECT with regard to floating rate issues that have caps and floors?

A) A floor is a disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the bondholder.

B) A cap is an advantage to the bondholder while a floor is an advantage to the issuer.

C) A cap is a disadvantage to the bondholder while a floor is a disadvantage to the issuer.

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A cap limits the upside potential of the coupon rate paid on the floating rate bond and is therefore a disadvantage to the bondholder. A floor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer.

1215

Consider a floating rate issue that has a coupon rate that is reset on January 1 of each year. The coupon rate is defined as one-year London Interbank Offered Rate (LIBOR) + 125 basis points and the coupons are paid semi-annually. If the one-year LIBOR is 6.5% on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year?

A) 3.250%.

B) 7.750%.

C) 3.875%.

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This value is computed as follows:

Semi-annual coupon = (LIBOR + 125 basis points) / 2 = 3.875%

luqian55

thanks a lot