Fixed Income【Reading 50】Sample relevant, relative, following, 2012

spartan1

The following are the yields on various bonds. The relevant benchmark is that of Treasury securities.

Treasury Bond Yield	4.00%
Bond Sector Yield	4.50%
Comparable Bond Yield	6.00%
ABC Bond Yield	6.50%

Is the ABC bond undervalued or overvalued and why? Using relative value analysis, the ABC bond is:

A) undervalued because its yield is greater than that of Treasuries.

B) undervalued because its spread is greater than that of comparable bonds.

C) overvalued because its spread is greater than that of comparable bonds.

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The purpose of relative value analysis is to determine whether a bond is fairly valued. The bond’s spread over some benchmark is compared to that of a required spread to determine whether the bond is fairly valued. The required spread will be that available on comparable securities. In this example, the relevant benchmark was Treasury securities. The spread for ABC bonds over Treasuries was 2.5%. The spread for comparable bonds over Treasuries was 2.0%. The higher spread for ABC bonds means that they are relatively undervalued (their price is low because their yield is higher).

ShooterMcCFA

How do the risk-return characteristics of a newly issued convertible bond compare with the risk-return characteristics of ownership of the underlying common stock? The convertible bond has:

A) lower risk and higher return potential.

B) higher risk and higher return potential.

C) lower risk and lower return potential.

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Buying convertible bonds in lieu of direct stock investing limits downside risk due to the price floor set by the straight bond value. The cost of the risk protection is the reduced upside potential due to the conversion premium.

ShooterMcCFA

Suppose that the stock price of a common stock increases by 10%. Which of the following is most accurate for the price of the recently issued convertible bond? The value of the convertible bond will:

A) increase by 10%.

B) increase by less than 10%.

C) remain unchanged.

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When the underlying stock price rises, the convertible bond will underperform because of the conversion premium.

ShooterMcCFA

The primary benefit of owning a convertible bond over owning the common stock of a corporation is the:

A) bond has lower downside risk.

B) bond has more upside potential.

C) conversion premium.

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The straight value of the bond forms a floor for the convertible bond’s price. This lowers the downside risk. The conversion premium is a disadvantage of owning the convertible bond, and it is the reason the bond has lower upside potential when compared to the stock.

ShooterMcCFA

Which of the following scenarios will lead to a convertible bond underperforming the underlying stock? The:

A) stock price is stable.

B) stock price falls.

C) stock price rises.

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A convertible bond underperforms the underlying common stock when that stock increases in value. This is because of the conversion premium which means that the bond will increase less than the increase in stock price. If the stock price falls, the convertible bond should outperform the stock because of the floor created by the straight-value. If the stock is stable, the bond is likely to outperform the stock because of the higher current yield of the bond. If the bond is upgraded, the bond should increase in value. There is no reason that upgrading the bond should lead to the bond underperforming the stock.

ShooterMcCFA

Which of the following correctly describes one of the basic features of a convertible bond? A convertible bond is a security that can be converted into:

A) common stock at the option of the issuer.

B) common stock at the option of the investor.

C) another bond at the option of the issuer.

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The owner of a convertible bond can exchange the bond for the common shares of the issuer.

ShooterMcCFA

Which of the following statements is most accurate concerning a convertible bond? A convertible bond's value depends:

A) only on interest rate changes.

B) on both interest rate changes and changes in the market price of the stock.

C) only on changes in the market price of the stock.

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The value of convertible bond includes the value of a straight bond plus an option giving the bondholder the right to buy the common stock of the issuer. Hence, interest rates affect the bond value and the underlying stock price affects the option value.

ShooterMcCFA

Suppose the market price of a convertible security is $1,050 and the conversion ratio is 26.64. What is the market conversion price?

A) $1,050.00.

B) $26.64.

C) $39.41.

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The market conversion price is computed as follows:
Market conversion price = market price of convertible security/conversion ratio = $1,050/26.64 = $39.41

ShooterMcCFA

What is the market conversion price of a convertible security?

A) The value of the security if it is converted immediately.

B) The price that an investor pays for the common stock if the convertible bond is purchased and then converted into the stock.

C) The price that an investor pays for the common stock in the market.

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The market conversion price, or conversion parity price, is the price that the convertible bondholder would effectively pay for the stock if she bought the bond and immediately converted it.
market conversion price = market price of convertible bond ÷ conversion ratio.

ShooterMcCFA

For a convertible bond with a call provision, with respect to the bond's convertibility feature and the call feature, the Black-Scholes option model can apply to:

A) only one feature.

B) both features.

C) neither features.

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The Black-Scholes model applies to the convertibility feature just as it does to the common stock. The Black-Scholes model is not appropriate for the call feature because the volatility of the bond cannot be assumed constant.