FINA441, Chapter 3 Assignment
Answer the following questions (note: answers for the first few questions may not be in the textbook,
but the instructor notes may be helpful).
Debt vs. Equity Securities
1.
Refer to the instructor notes for this chapter. For each of the following, determine if a debt or
equity security has been created, or both:
(A) You open a savings account at Baker Boyer Bank.
(B) You purchase a share of Baker Boyer Bank common stock.
(C) You open a savings (share) account at Blue Mtn. Credit Union.
(D) You purchase a Ford Motor corporate bond.
(E) You become a partner in a small business.
2.
Which is generally more risky to invest in: a debt or equity security? Why?
3.
Which type of security usually has a higher rate of return over long-periods of time, a debt or
equity security? Why?
Treasury Securities
4.
Why does the U.S. government sell Treasury Securities?
5.
Go to http://research.stlouisfed.org/fred2/series/FYGFD and describe the growth in gross
federal debt before and after the turn of the century.
6.
Go to http://www.treasurydirect.gov/NP/BPDLogin?application=np
(A) Record the latest Total Public Debt Outstanding (to the penny!).
(B) Total Public Debt Outstanding was $5.73T when George W. Bush took office in Jan/2001
and $10.63T when Barrack Obama took office in Jan/2009. In light of this information, what
is your reaction to the following quotes?
"No pecuniary consideration is more urgent than the regular redemption and discharge of the public
debt; on none can delay be more injurious, or an economy of time more valuable." – George
Washington
“Then I say the earth belongs to each of these generations during its course, fully, and in their own
right. The 2nd generation receives it clear of the debts and encumbrances of the 1st, the 3rd of the 2nd
and so on. For if the 1st could charge it with a debt, then the earth would belong to the dead and not the
living generation. Then no generation can contract debts greater than may be paid during the course of
its own existence.” – Thomas Jefferson
“My plan reduces the national debt, and fast. So fast, in fact, that economists worry that we’re going to
run out of debt to retire.” – George W. Bush, 2001
“The problem is that the way Bush has done it over the last eight years is to take out a credit card from
the Bank of China in the name of our children, driving up our national debt from $5 trillion for the first
42 Presidents --- #43 added $4 trillion by his lonesome -- so that we now have over $9 trillion of debt
that we are going to have to pay back --- $30,000 for every man, woman, and child. That’s
irresponsible. It’s unpatriotic. I found this national debt, doubled, wrapped in a big bow waiting for me
as I stepped in the Oval Office.” - Barak Obama
(C) Where are you in the picture below and how does this relate to the national debt?
(D) Refer to the Market Indicators statistics that we reviewed in class, specifically the U.S.
gross debt to GDP ratio. Evaluate the effect of our debt level in light of a study by Carmen
Reinhart and Kenneth Rogoff who found that economic growth began to suffer when a
country’s debt-to-GDP ratio exceeded 90%. (Note: this study was later found to have some
minor inaccuracies, but its conclusions still remains strong.)
(E) From the same Treasury Direct website (letter A above), on the left click on Full MSPD
(Monthly Statement of Public Debt). A sub-menu entitled “Balancing Sheet (PDF)” should
appear. Download the Balancing Sheet for the latest month. Complete the following table
using the last column entitled Outstanding-Total. The first line has been done for you.
Type
MARKETABLE
Treasury Bills
Treasury Notes
Treasury Bonds
Treasury Inflation-Protected Securities
Floating Rate Notes
Federal Financing Bank
TOTAL MARKETABLE
TOTAL NONMARKETABLE
TOTAL TREASURY SECURITIES O/S
Outstanding-Total
Percent of Total
$ 1.506 trillion
?
?
?
?
?
$ 13.123 trillion
$ 5.705 trillion
$ 18.827 trillion
8%
%
%
%
%
%
70%
30%
100%
7.
(A) Explain the difference between Treasury Bills, Notes and Bonds (see instructor notes).
(B) Why do you think TIPS are popular (Treasury inflation-protected securities)r?
8.
What investment do you think is considered to be the most risk-free investment in the world?
What risks does it not have and why does it not have those risks?
Read Chapter 3 in your text and answer the following questions.
9.
What are the four main characteristics that can cause the yields of debt securities to vary?
Credit Risk (or Default Risk)
10.
What is credit or default risk?
11.
Which investment is considered to have no credit (default) risk?
12.
(A) Would a corporate bond rated Baa by Moody’s have more or less credit risk than a
corporate bond rated Aaa?
(B) Would bonds rated A or B likely offer the highest return? Why?
(C) Do you trust the rating agencies ability to correctly gage default risk? Why or why not?
13.
Find/record a company/country that had its bond rating downgraded in the last year.
14.
Are the following bonds considered junk bonds (yes or no)?
(A) a bond rated “Ba” by Moody’s
(B) a bond rated “BBB” by S&P
(C) a bond rated “Baa” by Moody’s.
15.
Go to http://screen.yahoo.com/bonds.html and search for a corporate bond that is a junk bond,
according to Fitch’s rating. Record the issue name, the coupon%, the rating, and whether the
bond is callable or not.
Liquidity Risk
16.
What is liquidity risk?
17.
Should a 4-year certificate of deposit (CD) offer a higher or lower interest rate than a 6-month
CD? Why? Look up the best rate for these two CDs at the link below and record these rates.
https://finance.yahoo.com/rates/deposit/1-year-cd/ (choose the correct maturity).
Tax Status
18.
All other things being equal, would a taxable bond offer a lower or higher rate of interest than a
tax-exempt bond? Why?
19.
T or F: A tax-exempt municipal bond with a yield of 7.2% would be a better investment than a
taxable corporate bond with a return of 9.5%, if the marginal tax rate is 28%.
Term to Maturity
20.
Usually (but not always), fixed-income securities with long-term maturities will offer higher
interest rates than those with shorter terms. Go to http://finance.yahoo.com/bonds and
determine if this currently true. What do you think causes this?
Special Provisions
There are two special provisions that can affect interest rates: call and convertibility features.
21.
Do you think that bonds with call features would usually have higher or lower interest rates, all
other things being equal? Why?
22.
Why do you think that the former Chair of the Federal Reserve, Alan Greenspan, said that it
would be very expensive to pay off the Federal debt early even if it had the funds to do so (i.e.
before Treasury securities mature)? Take a guess.
23.
Do you think that convertible bonds would usually have a higher or lower interest rate than
non-convertible bonds, all other things being equal? Why?
Explaining Actual Yield Differentials
24.
T or F: If an interest rate changes from 2.0% to 2.4%, the rate has changed by 4 basis points.
25.
T or F: Market forces usually cause the yields of all securities to move in the same direction.
Estimating the Appropriate Yield
26.
T or F: the yield on any given day for a short-term debt security is equal to the sum of the risk-
27.
free rate plus the default premium plus the liquidity premium plus/minus the tax adjustment.
T or F: For a long-term security, the yield on any given day must account for interest rate risk
and inflation risk premiums in addition to the other factors listed in the previous question.
A Closer Look at the Term Structure
28.
(A) Go to http://finance.yahoo.com/bonds and record the most recent yield for each of the
following: 3-month T-Bill and 30-year T-Note.
(B) Why should longer maturities usually offer higher rates?
29.
Draw the shapes of a normal, inverted and flat yield curve. You can draw in Word by clicking
on Insert, Shapes and Scribble icon.
30.
Identify three theories for why long-term bonds typically offer higher interest rates than shortterm bonds.
31.
Assume there is a sudden expectation of lower interest rates in the future. What would be the
effect on the shape of the yield curve? Why? What theory are you relying on to answer this
question?
32.
Briefly explain the liquidity premium theory.
33.
T or F: All three theories regarding the term structure of interest rates have some validity.
34.
What are four important uses for the term structure of interest rates?
35.
Go to the Living Yield Curve at https://www.youtube.com/watch?v=yph8TRldW6k. What is the
shape of the yield curve before recessions? (e.g., what was the shape of the curve during the fall
of 2006 before the recession started in 2007?)
Risk and Return (not thoroughly covered in your text, so give your best guess)
36.
For each item A-F, match of or more of the following factors that affect the return
IR - inflation risk
DR – default or credit risk
IRR – interest rate or maturity risk
LR - liquidity risk
TR - taxability adjustment risk
(A) Risks that T-bonds have more of than T-bills do.
(B) Risks that corporate bonds have more of than T-bonds do.
(C) Risks that common stocks have more of than T-bonds do.
(D) Risks that real estate investments have that large company stocks would not have.
(E) Risks that penny stocks have that large company stocks would not have.
(F) Risks that a T-bond have that a municipal bond would not have.