CHAPTER 7INTEREST RATES AND BONDVALUATIONAnswers to Concepts Review and Critical Thinking Questions1.No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasurysecurities have substantial interest rate risk.2.All else the same, the Treasury security will have lower coupons because of its lower default risk, soit will have greater interest rate risk.3.No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell abond and immediately buy it back at a higher price. How many such transactions would you like todo?4.Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield mustbe higher.5.There are two benefits. First, the company can take advantage of interest rate declines by calling inan issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate acovenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. Aput provision is desirable from an investor’s standpoint, so it helps the company by reducing thecoupon rate on the bond. The cost to the company is that it may have to buy back the bond at anunattractive price.6.Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds areused to establish the coupon rate necessary for a particular issue to initially sell for par value. Bondissuers also simply ask potential purchasers what coupon rate would be necessary to attract them.The coupon rate is fixed and simply determines what the bond’s coupon payments will be. Therequired return is what investors actually demand on the issue, and it will fluctuate through time. Thecoupon rate and required return are equal only if the bond sells for exactly at par.7.Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Theirprimary concern is that an investment provide the needed nominal dollar amounts. Pension funds, forexample, often must plan for pension payments many years in the future. If those payments are fixedin dollar terms, then it is the nominal return on an investment that is important.8.Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; manylarge investors are prohibited from investing in unrated issues.9.Treasury bonds have no credit risk since it is backed by the U.S. government, so a rating is notnecessary. Junk bonds often are not rated because there would be no point in an issuer paying arating agency to assign its bonds a low rating (it’s like paying someone to kick you!).
10.The term structure is based on pure discount bonds. The yield curve is based on coupon-bearingissues.