LOS c, (Part 1): Explain the importance of reinvestment income in generating the yield computed at the time of purchase, and calculate the amount of income required to generate that yield.

Q1. An investor purchases a 4-year, 6%, semiannual-pay Treasury note for $9,485. The security has a par value of $10,000. To realize a total dollar return equal to 7.515% (its yield to maturity), the investor must have which of the following reinvestment assumptions?

A)   All payments must be reinvested at 7.515%.

B)   All payments must be reinvested at more than 7.515%.

C)   All payments must be reinvested at less than 7.515%.

Q2. If the promised yield is equal to the realized yield then:

A)   nominal yield is smaller than the promised yield.

B)   current yield is lesser than the yield to maturity.

C)   the coupon payments are reinvested at the promised yield during the life of the issue.

Q3. Which of the following is an incorrect statement when zero-coupon bonds are compared to coupon-paying bonds with the same maturity? Zero-coupon bonds:

A)   are less sensitive to interest rate changes.

B)   have a higher duration.

C)   are sold at a lower price.

LOS c, (Part 1): Explain the importance of reinvestment income in generating the yield computed at the time of purchase, and calculate the amount of income required to generate that yield.fficeffice" />

Q1. An investor purchases a 4-year, 6%, semiannual-pay Treasury note for $9,485. The security has a par value of $10,000. To realize a total dollar return equal to 7.515% (its yield to maturity), the investor must have which of the following reinvestment assumptions?

A)   All payments must be reinvested at 7.515%.

B)   All payments must be reinvested at more than 7.515%.

C)   All payments must be reinvested at less than 7.515%.

Correct answer is A)

The reinvestment assumption that is embedded in any present value-based yield measure implies that all coupons and principal payments must be reinvested at the specific rate of return, in this case, the yield to maturity. Thus, to obtain a 7.515% total dollar return, the investor must reinvest all the coupons at a 7.515% rate of return. Total dollar return is made up of three sources, coupons, principal, and reinvestment income.

Q2. If the promised yield is equal to the realized yield then:

A)   nominal yield is smaller than the promised yield.

B)   current yield is lesser than the yield to maturity.

C)   the coupon payments are reinvested at the promised yield during the life of the issue.

Correct answer is C)

The promised yield is the YTM and the realized yield is the actual return earned during a specific horizon.  In order for the realized yield to equal the promised yield, reinvestments must occur at the promised yield.  When the realized yield is equal to the promised yield there are no conclusions that can be made about whether the bond is selling at par, a discount, or a premium.

Q3. Which of the following is an incorrect statement when zero-coupon bonds are compared to coupon-paying bonds with the same maturity? Zero-coupon bonds:

A)   are less sensitive to interest rate changes.

B)   have a higher duration.

C)   are sold at a lower price.

Correct answer is A)

Since zero-coupon bonds have a higher duration than coupon-paying bonds of the same maturity, they are more sensitive to interest rate changes.

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