Chapter 08 True / False Questions 1.

In the American financial system the most readily marketable securities are issued by the U.S. Treasury Department. 2. Marketability of a security is positively related to the size and reputation of the issuing institution. 3. Marketability is generally greater for securities issued in large blocks. 4. Marketability is primarily an advantage to the issuer of new securities. 5. There is positive relationship between a security's marketability and its yield. 6. Investors interested in maximizing profitability usually hold a large amount of liquid securities. 7. Nearly all corporate bonds and mortgages and some U.S. government bonds issued in U.S. financial markets carry a call privilege. 8. The size of the call penalty paid on a security that has been called generally varies with the level of interest rates in the open market. 9. For bonds the minimum call penalty required is usually one year's worth of coupon income. 10. Most callable corporate bonds carry call deferments of from 15 to 20 years. 11. While an investor in callable bonds does not know exactly when his or her bonds will be called (if ever), he or she does know that the reinvestment rate will be at time of call because this is specified in the bond's indenture. 12. Call privileges on bonds are a disadvantage to investors precisely because the price of the callable bonds may decline. 13. A callable security will be called in when flotation costs of a new security issue are less than savings from issuing a new security at a lower interest rate. 14. While call privileges are, in general, a disadvantage to the investor, they do have greater capital gains potential than non-callable securities. 15. Generally speaking, the market price of a callable security will not rise significantly above its call price. 16. Callable securities usually sell at lower prices and higher interest rates than non-callable securities. 17. There is a positive relationship between the length of the call deferment period on a callable security and the required rates of interest on that security. 18. The key factor determining the size of the call premium on callable bonds is the promised call price offered by the security's issuer. 19. The yield differential between callable and non-callable securities is normally smallest when interest rates are expected to rise. 20. The expectation in the financial marketplace of a significant decline in market interest rates should increase the differential between required rates of interest on new callable and non-callable bonds.

21. Yield spreads between bonds with long call deferments versus those with short call deferments normally decrease when interest rates are expected to fall. 22. Recent research evidence suggests that when interest rates are high, the call premium generally increases. 23. An expectation that interest rates will fall in the market generally leads to a narrowing in the spread between corporate and U.S. government bonds of the same maturity. 24. High-coupon bonds carry greater call risk than low-coupon bonds, other factors held equal. 25. In general, the issuer of high-coupon callable bonds must pay a greater call premium than the issuer of lowcoupon callable bonds relative to non-callable securities. 26. Junk bonds are rated Baa3 or better by Moody's. 27. Junk bonds have been used to finance mergers. 28. The yields on junk bonds tend to be insufficient to cover the default risk inherent in such issues. 29. The Tax Reform Act of 1986 eliminated the favorable tax treatment of capital gains. Such gains became taxed at ordinary income tax rates. 30. Capital losses can be carried forward into subsequent years, but not backward, until all of the loss has been accounted for. 31. The maximum possible amount of capital loss that can be deducted for tax purposes is $3,000. 32. The interest income from municipal bonds is exempt from federal income taxes. 33. The foundation of the structure of interest rates in the financial markets is the risk-free interest rate. 34. In recent years marginal tax rates in the 40 to 50 percent range have represented a break-even level for investors interested in municipal bonds. 35. If the current yield on tax-exempt bonds is 8 percent and comparable taxable bonds carry a 12 percent yield, the break-even marginal tax rate must be 33.3 percent. 36. The tax-exempt feature attached to municipal bonds actually limits, rather than expands, the market for these securities. 37. The tax-exempt feature of municipal bonds has reduced the tax burden carried by the average citizen. 38. Convertible bonds are examples of "hybrid securities," but convertible preferred stock is not. 39. Conversion of a convertible bond into common stock can be reversed; that is, the stock received by the investor can be turned back into convertible bonds according to the indenture provision accompanying most convertible bond issues. 40. Convertible bonds generally carry a higher yield than nonconvertible corporate bonds of comparable quality and maturity.

41. Fees for getting a credit rating on a security are usually paid by investors interested in buying the security. 42. The interest on convertible bonds is federal income tax deductible for the issuing corporation. 43. When a company's common stock rises in price, its convertible bonds also tend to rise in price. 44. The floor which, normally, is the lowest value to which a convertible bond can fall is known as the conversion value of that bond. 45. Each interest rate prevailing at any moment in the financial markets is really a summation of various premiums paid to lenders of funds to get those investors to hold a particular security. 46. Common stock is generally a more risky investment than convertible bonds issued by the same company. 47. The market yield on a risky security is equal to the risk-free interest rate plus the risk premium. The higher the degree of default risk, the lower the risk premium. 48. The concept of anticipated loss represents each investor's view of the appropriate risk premium on a security. If an investor faces the following situation, he or she would be inclined to buy the security: anticipated loss 6% risk-free rate 6% current yield to maturity 10% 49. Moody's Investor Service and Standard and Poor's Corporation are two of the most widely consulted investment rating companies in the U.S. 50. Among the factors influencing the risk premiums on corporate securities are: volatile earnings, length of time in operation and amount of leverage employed.

Chapter 09 True / False Questions 1. Interest rates tend to rise during a period of economic expansion. 2. Long-term security prices tend to be more volatile than the prices of short-term securities. 3. Short-term interest rates tend to be more volatile than long-term interest rates. 4. Long-term securities as a rule carry more principal risk than short-term securities. 5. Long-term securities carry greater income risk to the investor than short-term securities. 6. According to your text there is no research evidence to support the notion that interest rates display seasonal patterns of highs and lows. 7. Short- term interest rates tend to rise during the summer and fall months and to fall over the winter and spring months. 8. Long-term interest rates typically rise in the late spring through mid-summer (June or July) and fall during the winter months. 9. While modest, seasonal patterns in interest rates tend to be stable over time. 10. If projected money-supply growth is less than projected GNP growth interest rates are likely to fall, other factors held constant. 11. According to the Fisher effect, if the rate of expected inflation decreases, the real rate must fall and the nominal rate also declines. 12. If the Flow-of-Funds approach to forecasting interest rates projects that credit demand will be less than credit supply at current interest rates, this would be a forecast that interest rates will decrease in the future. 13. An increase in the volume of security offerings shown on the forward calendar would, other things held equal, lead financial analysts to forecast lower interest rates as security dealers attempt to lighten their inventories of unsold securities. 14. Indications that the U.S. Treasury will need to increase its level of borrowing in the open market should result in higher market interest rates. 15. According to the expectations hypothesis, an upward-sloping yield curve implies that investors in the financial markets expect interest rates to rise above their current levels in the future. 16. Consensus forecasts rely upon the simultaneous use of several different forecasting methods. 17. The result of an interest-rate swap is usually a lower interest rate for both swap partners and a better balance between cash inflows and outflows for both parties to the swap. 18. The notional amount of a swap never changes hands. 19. Interest-rate swaps necessarily reduce credit risk. 20. Interest-rate swaps are not subject to interest-rate risk.

21. The forecasting of interest rates has become a very precise science, reducing the uncertainty faced by financial managers. 22. According to the money-supply income effect, if the money supply grows more slowly than planned spending, interest rates will rise. 23. An index amortizing rate swap allows the parties to the swap to change interest rates over the life of the swap but the notional principal does not change. 24. A call option grants the buyer the right to purchase a specific number of securities on or before an expiration date at a specified price. 25. Swaps are used to reduce default risk. 26. An IAR swap eliminates all interest-rate risk. 27. If an IAR swap uses LIBOR (the London InterBank Offer Rate) as an interest-rate index, then changes in LIBOR will affect the notional principal involved in the swap. 28. All IAR swaps experience a change in notional principal from the first day the swap is in force. 29. The process of economic expansion and contraction is called the Wall Street Effect. 30. Even interest rate protection products like swaps are subject to interest rate risk. 31. The concept of futures trading is a relatively new idea. 32. Futures trading is designed to protect an investor against price fluctuations. 33. The advantage of hedging is that it significantly reduces risk. 34. Trading in financial futures by financial institutions (such as commercial banks) is relatively free of restrictions. 35. The principal reason for the existence of a futures market is hedging. 36. There is a relatively stable relationship between spot and futures prices. 37. A rise in the market price of a security may be fully offset by a loss in the futures market. 38. Hedging reduces risk, according to the textbook. 39. An option contract gives the buyer the right to sell a commodity or security at a set price on or before expiration of the contract. 40. Most terms of trade for futures contracts are completely controlled by the various exchanges. 41. The basic trading unit for Treasury notes is a $1 million face value on an 8-percent coupon rate. 42. T-bills were declared eligible for trading in the U.S. financial futures market in January 1976. 43. One of the major options involving money market instruments is the Eurodollar deposit futures option. 44. The Eurodollar futures option contract is unusual because settlement is in Eurodollar deposits. 45. The Treasury bond futures option contract is traded in units of $100,000.

46. In order to hedge against rising interest rates a bank would buy a call option on Eurodollar futures. 47. Most options are held to expiration. 48. The purpose of a short hedge is to guarantee a desired yield in case interest rates decline before securities are actually purchased in the cash market. 49. Cross-hedging is characterized by using different types of securities in the spot and futures markets. 50. Under federal regulation in the U.S. commercial banks must limit their futures and options trading to hedging real risk-exposure situations. 51. Savings and loan associations use futures to hedge the market value of their mortgage-related securities. 52. One disadvantage of the financial futures market is that it may prohibit financial institutions from extending increased amounts of credit. 53. The futures and options markets tend to promote greater efficiency in the use of scarce financial resources. 54. A perfect hedge is rare. 55. Hedging may be compared to insurance in that it helps to protect against certain kinds of risk exposure. 56. Trading in Treasury note futures began at the Chicago Board of Trade in 1967. 57. One-year T-bill futures contracts carry denominations of $250,000. 58. Most options on financial instruments are traded on the New York Futures Exchange. 59. Selling futures contracts can help protect a firm against an expected decline in commodity prices. 60. Financial futures and options contracts are less beneficial to investors heavily leveraged with debt because their net earnings are particularly sensitive to changes in interest rates. 61. Some financial analysts feel that futures and options markets, rather than helping reduce risk and promoting the more efficient use of scarce resources, may in fact be aimed at wealthy investors, giving them a speculative outlet for their funds and, thus, the futures and options markets really increase risk. 62. Commercial bank participation in the futures markets has been limited. One reason for this is the accounting procedures used to recognize gains and losses from futures trading. These accounting procedures tend to show volatile fluctuations in income for those banks active in the futures markets. 63. Hedging may be compared to insurance in that it actually reduces risk. 64. A perfect hedge contracts away all risk and creates a situation where any change in the market price is exactly offset by a profit or loss on the futures contract. 65. Trading in the financial futures market allows an investor to sell futures contracts on selected securities to protect against the risk of a decline in the yield of the investment. 66. Cross hedging rests on the assumption that the prices of most financial instruments tend to move in the same direction by roughly the same proportion. 67. The spread between the cash or spot price of a commodity or security and its futures price is known as basis. 68. The risk of futures trading is the risk of changes in the basis.

69. According to your text, futures trading "works" because basis risk is less than price risk on a commodity or security. 70. Stock index futures make it possible to completely offset upward or downward movements in the DowJones Industrial Average, but not in the Standard & Poor's 500 Stock Index. 71. The seller of a stock index futures contract is betting on a bull (rising) stock market. 72. Futures contracts are daily "marked to market" which means each day the futures exchange clearinghouse sets the price at which they will be traded. 73. The writer of a call option gains when the market value of the futures contract or security named in the option rises above the strike price. 74. The writer of a put option benefits if the market value of the futures contract or security stays below the option's strike price. 75. For the purchaser of a put option, the option will normally be exercised for profit if the difference between the strike price and the value of the underlying futures contract or security exceeds the sum of the option premium, taxes and transactions costs. 76. For the purchaser of a call option the option will normally be exercised for profit if the market price of the underlying futures contract or security climbs above the sum of the strike price, option premium, taxes and transactions costs. 77. The volatility ratio is a measure of basis risk associated with a futures contract. 78. The principle of convergence suggests that option prices tend to approach the value of the underlying futures contract as the expiration date of the options approaches. 79. Stock index futures contracts are settled by the transfer of ownership of a diversified basket of stocks. 80. The International Monetary Market (IMM) was the first futures market to open in Europe. 81. Arbitrageurs hope to profit from price differences in markets around the world. 82. When an investor goes "long" in the futures market, he or she expects to profit from a decline in interest rates. 83. All futures contracts trade in the same quantities and have the same delivery dates. 84. In the international money market interest-rate risk associated with large commercial loans can be dealt with using the one-month LIBOR futures contract, according to the textbook. 85. The LIBOR futures contract trades in $3 million units at the Chicago Mercantile Exchange. 86. Barings Brothers collapsed in 1995 due to massive losses from trading derivatives instruments. 87. Normally arbitrage trading based upon price difference between two different securities markets is highly risky due to the simultaneous holding of both long and short positions. 88. The Federal funds futures contract traded on the Chicago Board of Trade's exchange covers 90 days. 89. Most financial futures trading centers on U.S.T-bill contracts. 90. As the global financial system becomes "smaller" through technological advances, alliances and mergers among the world's leading securities exchanges are likely to continue.

91. When interest rates rise, asset prices normally fall and this is particularly true of fixed income securities. 92. Interest rates are notoriously difficult to predict, however they do tend to follow the business cycle. 93. Implied market forecasts are predictions that are based on the interest rate expectations of the market. 94. Research has increasingly pointed towards time patterns in market interest rates that come close to a random walk, that is, it can be predicted on a consistent basis. 95. Derivatives continue to gain popularity, with the outstanding value in 2006 at more than $280 trillion. 96. Investors interested in hedging may buy a futures contract in order to lock in a price on a specific asset at a future date. 97. Hedging in the futures market reduces the overall risk in the market. 98. Hedging is a low-cost method of transferring the risk of unanticipated changes in asset prices or interest rates from one investor or institution to another. 99. A key feature of the futures market that allows the hedging process to transfer risk effectively is the fact that prices in the spot market are generally correlated with prices in the futures market. 100. Hedging essentially involves adopting equal and opposite positions in the spot and futures markets for the same assets.