Foundations of Financial Markets and Institutions, 4e
(Fabozzi/Modigliani/Jones)
Foundations of Financial Markets and Institutions, 4e
(Fabozzi/Modigliani/Jones)
Chapter 9 Properties and Pricing of Financial Assets
Multiple Choice Questions
1 Properties of Financial Assets
1) Which of the below is NOT one of the eleven properties of
financial assets?
A) moneyness
B) multiplicity and denomination
C) reversibility
D) cash flow
Answer: B
Comment: The eleven properties of financial assets are (1)
moneyness, (2) divisibility and denomination, (3) reversibility,
(4) cash flow, (5) term to maturity, (6) convertibility, (7)
currency, (8) liquidity, (9) return predictability, (10)
complexity, and (11) tax status.
Diff: 2
Topic: 9.1 Properties of Financial AssetsObjective: 9.1 the many
key properties of financial assets: moneyness; divisibility and
denomination; reversibility; cash flow and return; term to
maturity; convertibility; currency; liquidity; return
predictability or risk; complexity; and tax status
2) Which of the below is NOT one of the eleven properties of
financial assets?
A) convertibility
B) currency
C) liquidity predictability
D) tax status
Answer: C
Comment: The eleven properties of financial assets are (1)
moneyness, (2) divisibility and denomination, (3) reversibility,
(4) cash flow, (5) term to maturity, (6) convertibility, (7)
currency, (8) liquidity, (9) return predictability, (10)
complexity, and (11) tax status.
Diff: 2
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
3) Which of the below are THREE of the eleven properties of
financial assets?
A) return predictability, complexity, and tax status
B) convertibility, currency, liquidity
C) liquidity, reversibility, and cash flow
D) money, divisibility, and denomination
Answer: D
Comment: The 11 properties of financial assets are (1)
moneyness, (2) divisibility and denomination (these are only ONE
property and not TWO), (3) reversibility, (4) cash flow, (5) term
to maturity, (6) convertibility, (7) currency, (8) liquidity, (9)
return predictability, (10) complexity, and (11) tax status.
Diff: 2
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
4) Which of the below statements is TRUE?
A) "Near money" is a financial asset that is used as a medium of
exchange or in settlement of transactions.
B) In the United States, money consists of currency and a very
few forms of deposits that permit check writing.
C) "Near money" is very close to "money" in that it can be
transformed into money at little cost, delay, or risk.
D) "Faraway money", in the case of the United States, includes
(i) time and savings deposits and (ii) a security issued by the
U.S. government called a Treasury bill.
Answer: C
Comment: Money is a financial asset that is used as a medium of
exchange or in settlement of transactions. In the United States,
money consists of currency and all forms of deposits that permit
check writing. "Near money", in the case of the United States,
includes (i) time and savings deposits and (ii) a security issued
by the U.S. government called a Treasury bill.
Diff: 2
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
5) ________ relates to the minimum size in which a financial
asset can be liquidated and exchanged for money.
A) Reversibility
B) Denomination
C) Convertibility
D) Divisibility
Answer: D
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
6) Reversibility is referred to as ________.
A) the cost of investing in a financial asset and then getting
out of it but not back into cash again.
B) the cost of investing in a financial asset instead of
investing in cash.
C) one-way cost
D) turnaround cost
Answer: D
Comment: Reversibility refers to the cost of investing in a
financial asset and then getting out of it and back into cash
again. Consequently, reversibility is also referred to as
turnaround cost or round-trip cost.
Diff: 2
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
7) The ________, the greater the probability of the market maker
________ in excess of a stated bound between the time of buying and
reselling the financial asset.
A) greater the variability; incurring a loss
B) lesser the variability; incurring a loss
C) lesser the variability; incurring a large gain
D) greater the variability; incurring no loss or gain
Answer: A
Comment: The greater the variability, the greater the
probability of the market maker incurring a loss in excess of a
stated bound between the time of buying and reselling the financial
asset.
Diff: 2
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
8) The return that an investor will realize by holding a
financial asset depends on all the ________ that the financial
asset will pay its owners; this includes dividends on shares and
coupon payments on bonds.
A) stock distributions
B) cash distributions
C) cash convertibility
D) liquid inventories
Answer: B
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
9) Return ________ is a basic property of financial assets, in
that it is a major determinant of their value.
A) convertibility
B) divisibility
C) predictability
D) complexity
Answer: C
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
10) A ________ asset is one that provides options for the issuer
or the investor, or both, and so represents a combination of
simpler assets.
A) complex
B) taxable
C) predictable and divisible
D) liquid
Answer: A
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
2 Principles of Pricing of Financial Assets
1) The fundamental principle of finance is that the true or
correct price of an asset equals the ________ of all cash flows
that the owner of the asset expects to receive during its life.
A) present value
B) future value
C) projected value
D) asset value
Answer: A
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.7 the principles that reveal how the properties of
an asset affect its value, either through the discount rate or
through its expected cash flow
2) The correct price for a financial asset can be expressed as
follows:
P = +++ where ________.
A) P = the price of the cash flow
B) CFt = the financial asset in year t (t = 1, ,N)
C) N = the maturity of the financial asset
D) r = the appropriate cash rate
Answer: C
Comment: The correct price for a financial asset can be
expressed as follows:
P = +++ where
P = the prince of the financial asset; CFt = the cash flow in
year t (t = 1, ,N); N = the maturity of the financial asset; and, r
= the appropriate discount rate.
Diff: 2
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.5 the principles of valuing complex financial
assets
3) The appropriate discount rate, r, is the return that the
market or the consensus of investors requires on the asset. A
convenient (but approximate) expression for the appropriate
discount rate is this: r = RR + IP + DP + MP + LP + EPP where
________.
A) IP= the real rate of interest, which is the reward for not
consuming and for lending to other users.
B) MP = the maturity risk premium, which is the reward for
taking on the risk of default in the case of a loan or bond or the
risk of loss of principal for other assets.
C) LP = the liquidity premium, which is the reward for not
consuming and for lending to other users.
D) EP= the exchange-rate risk premium, which is the reward for
investing in an asset that is not denominated in the investor's
home currency.
Answer: D
Comment: The appropriate discount rate, r, is the return that
the market or the consensus of investors requires on the asset. A
convenient (but approximate) expression for the appropriate
discount rate is this: r = RR + IP + DP + MP + LP + EP where
RR = the real rate of interest, which is the reward for not
consuming and for lending to other users;
IP = the inflation premium, which is the compensation for the
expected decline in the purchasing power of the money lent to
borrowers;
DP = the default risk premium, which is the reward for taking on
the risk of default in the case of a loan or bond or the risk of
loss of principal for other assets;
MP = the maturity premium, which is the compensation for lending
money for long periods of time;
LP = the liquidity premium, which is the reward for investing in
an asset that may not be readily converted to cash at a fair market
value; and,
EP= the exchange-rate risk premium, which is the reward for
investing in an asset that is not denominated in the investors home
currency.
Diff: 2
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.2 the components of an asset's discount rate or
required rate of return
4) DP is the default risk premium, which is the ________.
A) reward for investing in an asset that may not be readily
converted to cash at a fair market value.
B) reward for taking on the risk of default in the case of a
loan or bond or the risk of loss of principal for other assets.
C) compensation for lending money for long periods of time.
D) reward for investing in an asset that is not denominated in
the investor's home currency.
Answer: B
Comment: DP is the default risk premium, which is the reward for
taking on the risk of default in the case of a loan or bond or the
risk of loss of principal for other assets.
MP is the maturity premium, which is the compensation for
lending money for long periods of time.
LP is the liquidity premium, which is the reward for investing
in an asset that may not be readily converted to cash at a fair
market value.
EP is the exchange-rate risk premium, which is the reward for
investing in an asset that is not denominated in the investors home
currency.
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.4 how the discount rate is structured to encompass
the components of an asset's risk
5) Assume that the market thinks the real rate is 2.00%, the
inflation premium is 2.70%, the bond's default risk justifies a
premium of 2.10%, the maturity premium is 0.50%, and the liquidity
premium is 1.10%. Since the cash flows are denominated in euros,
the foreign-exchange rate premium is 1.50%. What is the discount
rate?
A) 8.90%
B) 9.70%
C) 9.90%
D) None of these
Answer: C
Comment: We have: RR = 2.00%, IP = 2.70%, DP = 2.01%, MP =
0.50%, LP = 1.01%, EP = 1.50%. Thus, we have this value for the
discount rate: r = 2.0% + 2.7% + 2.1% + 0.5% + 1.1% + 1.5% = 9.90%
or 0.0990.
Diff: 2
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.4 how the discount rate is structured to encompass
the components of an asset's risk
6) Suppose the cash flows for a bond's coupon payment for years
1 through 4 are $100. That is, CFt = $100 for t (t = 1, ... ,4).
Further assume the the discount rate is 9.00% and at the end of
year the bond will pay back the bond's par value of $1,000. To the
nearest dollar, what is the correct price for this bond?
A) $866
B) $932
C) $1,012
D) $1,032
Answer: D
Comment: The correct price for the bond can be expressed as
follows:
P = + ... + where P = the prince of thebond; CFt = the cash flow
in year t (t = 1, , N); N = the maturity of the bond; and, r = the
appropriate discount rate. Inserting our given values, where CF1 =
CF2 = CF3 = $100, CFN = CF4 = $1,000 + $100 = $1,100 and r = 9.00%
or 0.09, we have:
P = + + + = $91.7431 + 84.168 + $77.21835 + $779.2677 =
$1,032.40.
Diff: 3
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.7 the principles that reveal how the properties of
an asset affect its value, either through the discount rate or
through its expected cash flow
7) Suppose the cash flows for a financial asset's payment for
years 1 through 4 are $100. That is, CFt = $100 for t (t = 1, ...
,4). Further assume the the discount rate is 8.00% and at the end
of four years that the financial asset will pay $1,000 in addition
to the $100. Finally, assume a broker's commission of $30 is
imposed by brokers to buy or sell the bond. To the nearest dollar,
what is the correct price for this financial asset?
A) $1,014
B) $1,000
C) $994
D) None of these
Answer: A
Comment: The correct price for a financial asset can be
expressed as follows:
P = +++ where P = the prince of the financial asset; CFt = the
cash flow in year t (t = 1, ,4); 4 years is the maturity of the
financial asset; and, r = the appropriate discount rate. For this
case we must subtract $30 at the beginning (t = 0) and subtract out
$30 at t = 4. Inserting our given values, where CF1 = CF2 = CF3 =
$100, CF4 = $1,000 + $100 - $30 = $1,070, and r = 8.00% or 0.08, we
have:
P = -$30 + +++= -$30+ $92.59259 + $85.73388 + $79.38322 +
$786.4819 = $1,014.19.
Diff: 3
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.7 the principles that reveal how the properties of
an asset affect its value, either through the discount rate or
through its expected cash flow
8) Suppose the cash flows for a financial asset's payment for
years 1 through 5 are $80. That is, CFt = $80 for t (t = 1, ...
,5). Further assume the the discount rate is 8.00% and at the end
of the five years that the financial asset will pay back $1,000 in
addition to the $80. Finally, assume a broker's commission of $30
is imposed by brokers to buy or sell the financial asset and that a
government entity imposes a transfer tax of $20 on each
transaction. To the nearest dollar, what is the correct price for
this financial asset?
A) $912
B) $914
C) $916
D) $918
Answer: C
Comment: The correct price for a financial asset can be
expressed as follows:
P = ++++ where P = the prince of the financial asset; CFt is the
cash flow in year t (t = 1, ,5); 5 years is the maturity of the
financial asset; and, r is the appropriate discount rate. For this
case we must subtract $30 and $20 at the beginning (t = 0) and also
subtract out $30 and $20 at t = 5. Inserting our given values,
where CF1 = CF2 = CF3 = CF4 =$80, CF5 = $1,000 +$80 - $30 - $20 =
$1,030, and r = 8.00% or 0.08, we have:
P = -$30 -$20 + ++++ = -$30 -$20 + $74.0741 + $68.5871 +
$63.5066 + $58.8024 + $701.0007 = $915.97.
Diff: 3
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.7 the principles that reveal how the properties of
an asset affect its value, either through the discount rate or
through its expected cash flow
9) Suppose the cash flows for a financial asset's payment for
years 1 through 5 are $90. That is, CFt = $90 for t (t = 1, ...
,5). Further assume the the discount rate is 7.00% and at the end
of the five years that the financial asset will pay back $1,000 in
addition to the $90. Finally, assume a broker's commission of $40
is imposed by brokers to buy or sell the financial asset and that a
government entity imposes a transfer tax of $25 on each
transaction. To the nearest dollar, what is the correct price for
this financial asset?
A) $962
B) $971
C) $986
D) $1,002
Answer: B
Comment: The correct price for a financial asset can be
expressed as follows:
P = ++++ where P = the prince of the financial asset; CFt is the
cash flow in year t (t = 1, ,5); 5 years is the maturity of the
financial asset; and, r is the appropriate discount rate. For this
case we must subtract $40 and $25 at the beginning (t = 0) and also
subtract out $30 and $20 at t = 5. Inserting our given values,
where CF1 = CF2 = CF3 = CF4 =$90, CF5 = $1,000 +$90 - $40 - $25 =
$1,025, and r = 7.00% or 0.07, we have:
P = -$40 -$25 + + + + + = -$40 -$25 + $84.1121 + $78.6095 +
$73.4668 + $68.6606 + $730.8108 = $970.66.
Diff: 3
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.7 the principles that reveal how the properties of
an asset affect its value, either through the discount rate or
through its expected cash flow
10) Suppose that a bond is granted a favorable tax treatment
such that the interest and any capital gain from this bond would
not be taxed. Suppose that the marginal tax rate on otherwise
equivalent taxable bonds is 25% and the appropriate discount rate
is 7%. What is the after-tax discount rate?
A) 5.25%
B) 5.35%
C) 5.65%
D) 5.75%
Answer: A
Comment: The after-tax discount rate is: pretax discount rate *
(1 - marginal tax rate) = 0.09 * (1 - 0.25) = 0.052500 = 5.25%.
Diff: 2
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.2 the components of an asset's discount rate or
required rate of return
11) Although we use a single discount rate to discount each cash
flow, there are theoretical reasons that suggest this is
________.
A) not practical.
B) always correct but not practical.
C) suitable.
D) inappropriate.
Answer: D
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.4 how the discount rate is structured to encompass
the components of an asset's risk
12) The appropriate ________ can often be approximated as the
sum of rewards for the various risks an asset poses to its
buyer.
A) reward premium
B) discount rate
C) risk premium
D) coupon rate
Answer: B
Diff: 2
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.4 how the discount rate is structured to encompass
the components of an asset's risk
3 Price Volatility of Financial Assets
1) A fundamental principle is that a financial asset's price
changes in ________.
A) the same direction of the change in the required rate of
return.
B) the same direction of the change in the required yield.
C) unknown and unpredictable ways compared to the change in the
required yield.
D) the opposite direction of the change in the required rate of
return or the required yield.
Answer: D
Diff: 1
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.6 the inverse relationship between an asset's price
and its discount rate
2) The ________ of a financial asset to a change in the required
yield will not be the same for all assets.
A) price indifference
B) price insensitivity
C) price sensitivity
D) cash flow sensitivity
Answer: C
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.8 what factors affect the price sensitivity of a
financial asset to changes in interest rates
3) When we refer to changes in the required yield, it is
convenient to measure a change in yield in terms of what market
participants refer to as ________.
A) a basis modification rather than a yield modification.
B) a yield modification rather than in terms of a basis
modification.
C) a percentage change rather than a basis point.
D) a basis point rather than in terms of a percentage
change.
Answer: D
Comment: When we refer to changes in the required yield, it is
convenient to measure a change in yield in terms of what market
participants refer to as a basis point rather than in terms of a
percentage change.
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.3 what is meant by a basis point
4) Which of the below statements is TRUE?
A) Fifty basis points are equal to one-fifth percentage point,
and a yield change from 9% to 9.2% represents a 50 basis point
change in yield.
B) One basis point is defined as 0.0001, or equivalently,
0.01%.
C) A yield change from 7% to 7.5% is a 0.50 basis point
change.
D) A yield change from 6% to 8.35% is a 2,350 basis point change
in yield.
Answer: B
Comment: One basis point is defined as 0.0001, or equivalently,
0.01%. Therefore, 100 basis points are equal to one percentage
point, and a yield change from 9% to 10% represents a 100 basis
point change in yield. A yield change from 7% to 7.5% is a 50 basis
point change, and a yield change from 6% to 8.35% is a 235 basis
point change in yield.
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.3 what is meant by a basis point
5) For two bonds with the same maturity and with the same
required yield, the lower the coupon rate, the greater the price
responsiveness for a given change in the required yield. This is an
example of ________ affecting a bond's price sensitivity.
A) a bond's maturity
B) a bond's coupon rate
C) a bond's principal
D) a change in Fed policy
Answer: B
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.8 what factors affect the price sensitivity of a
financial asset to changes in interest rates
6) This measure of price sensitivity is popularly referred to as
________.
A) basis point sensitivity.
B) value sentiment.
C) duration.
D) saturation.
Answer: C
Diff: 1
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
7) Approximate percentage change in a financial asset's price
equals what?
A) It equals -Duration x (Yield change in decimal forms) x
100.
B) It equals [-Duration / (Yield change in decimal forms)] x
100.
C) It equals -Duration x [(Yield change in decimal forms) /
100].
D) It equals +Duration x (Yield change in decimal forms) x
100.
Answer: A
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
8) Suppose that the required yield on a 6% coupon, 12-year bond
increases from 10% to 11% (0.01 in decimal form). If this bond's
duration is 8.96, what is the approximate percentage change in
price?
A) -4.48%
B) +7.48%
C) -8.96%
D) +9.86%
Answer: C
Comment: The approximate percentage change in a financial assets
price = -Duration * (Yield change in decimal forms) * 100.
Inserting in our values, we get: approximate percentage change in
price =-8.96 x (0.01) x 100 =-8.96%.
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
9) Assume the price of a coupon bond is $650. Further assume
that if the yield is increased by 50 basis points, then the price
would be $620 and if the yield is decreased by 50 basis points,
then the price would be $700. What is the duration?
A) about 12.3
B) about 12.8
C) about 13.3
D) about 13.6
Answer: A
Comment: We have these values: y = 0.005, P0 = $650, P_ = $700,
and P+= $620. The duration (or approximate percentage price change
for a 100 basis point change in yield) is . Inserting in our
values, we get: = 12.31.
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
10) Which of the below statements is FALSE?
A) The importance of being able to measure the sensitivity of an
individual asset, a portfolio of assets, and a liability cannot be
overemphasized.
B) To control interest rate risk, it is necessary to be able to
measure it.
C) An investor with a portfolio of assets wants to be able to
measure her exposure to interest rate changes in order to assess
whether or not the exposure is acceptable. If it is not, she can
alter the exposure.
D) When a duration is calculated under the assumption that the
cash flows do not change when interest rates change, the resulting
duration is called effective duration.
Answer: D
Comment: When a duration is calculated under the assumption that
the cash flows do not change when interest rates change, the
resulting duration is called modified duration. In contrast, a
duration calculated assuming that the cash flow changes when
interest rates change is called effective duration. The difference
between modified duration and effective duration for some assets
can be quite dramatic.
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
True/False Questions
1 Properties of Financial Assets
1) A useful way to think of liquidity and illiquidity, proposed
by Professor James Tobin, is in terms of how much sellers stand to
lose if they wish to sell immediately as against engaging in a
costly and time-consuming search.
Answer: TRUE
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
2) Tax rates are constant from year to year, from country to
country, and even among municipal units within a country (as with
state and local taxes in the United States).
Answer: FALSE
Comment: Tax rates differ from year to year, from country to
country, and even among municipal units within a country (as with
state and local taxes in the United States).
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
3) A financial asset has many properties, and each affects the
asset's value in a similar and important way.
Answer: FALSE
Comment: A financial asset has many properties, and each affects
the assets value in a distinctive and important way.
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
4) Some properties are intrinsic to the asset, such as its
maturity or promised cash flow.
Answer: TRUE
Diff: 1
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
2 Principles of Pricing of Financial Assets
1) The price of a complex asset is the sum of the prices of its
component parts.
Answer: TRUE
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.5 the principles of valuing complex financial
assets
2) The price of an asset moves in the same direction of a change
in its discount rate.
Answer: FALSE
Comment: The price of an asset moves in the opposite direction
of a change in its discount rate.
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.6 the inverse relationship between an asset's price
and its discount rate
3) An asset's price is the present value of its expected cash
flows, discounted at an appropriate rate.
Answer: TRUE
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.5 the principles of valuing complex financial
assets
4) The conversion privilege of a convertible bond is not valued
by the market.
Answer: FALSE
Comment: The conversion privilege of a convertible bond is
valued by the market .
Diff: 1
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
3 Price Volatility of Financial Assets
1) The term duration was first used in 1938 by Frederick
Macaulay as a measure of the weighted average time to maturity of a
bond.
Answer: TRUE
Diff: 1
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
2) It is important to be able to measure the price sensitivity
of an asset or liability to interest rate changes and the
appropriate measure is the modified duration.
Answer: FALSE
Comment: It is important to be able to measure the price
sensitivity of an asset or liability to interest rate changes and
the appropriate measure is the effective duration.
Diff: 1
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
3) The larger an asset's coupon rate, the greater its price
sensitivity to a change in the discount rate, other things being
constant.
Answer: FALSE
Comment: The longer an assets maturity, the greater its price
sensitivity to a change in the discount rate, other things being
constant.
The larger an assets coupon rate, the lower its price
sensitivity to a change in the discount rate, if all else is the
same.
Diff: 2
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.8 what factors affect the price sensitivity of a
financial asset to changes in interest rates
4) Factors that influence an asset's price sensitivity include
its maturity, its coupon rate, and the initial level of the
required yield.
Answer: TRUE
Diff: 1
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.9 what duration means, and how it is related to the
price sensitivity of an asset to a change in interest rates
Essay Questions
1 Properties of Financial Assets
1) It should be understood that even a financial asset with a
stated maturity may terminate before its stated maturity. This may
occur for several reasons. Describe some of these reasons.
Answer: Reasons for the termination of a financial asset include
bankruptcy or reorganization. In addition, a financial asset (like
a bond) may have a call provisions entitling the debtor to repay in
advance, usually at some penalty and only after a number of years
from the time of issuance. Sometimes the investor may have the
privilege of asking for early repayment. This feature is called a
put option. Some assets have maturities that may be increased or
extended at the discretion of the issuer or the investor. For
example, the French government issues a six-year obligation
renouvelable du Trsor, which allows the investor, after the end of
the third year, to switch into a new six-year debt. Similar bonds
are issued by the British government.
Diff: 3
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
2) For financial assets traded with market makers, the most
relevant component of round-trip cost is the bid-ask spread. The
spread charged by a market maker varies sharply from one financial
asset to another, reflecting primarily the amount of risk the
market maker is assuming by "making" a market. This market-making
risk can be related to two main forces. Describe these two forces
or determinants of this risk.
Answer: One force is the variability of the price as measured,
say, by some measure of dispersion of the relative price over time.
The greater the variability, the greater the probability of the
market maker incurring a loss in excess of a stated bound between
the time of buying and reselling the financial asset. The
variability of prices differs widely across financial assets.
Treasury bills, for example, have a very stable price, while a
speculative stock will exhibit much larger short-run
variations.
The second determining factor of the bidask spread charged by a
market maker is what is commonly referred to as the thickness of
the market: by this is meant essentially the prevailing rate at
which buying and selling orders reach the market maker (that is,
the frequency of transactions). A thin market is one that has few
trades on a regular or continuing basis. Clearly, the greater the
frequency of order flows, the shorter the time that the security
will have to be held in the market maker's inventory, and hence the
smaller the probability of an unfavorable price movement while
held.
Diff: 3
Topic: 9.1 Properties of Financial Assets
Objective: 9.1 the many key properties of financial assets:
moneyness; divisibility and denomination; reversibility; cash flow
and return; term to maturity; convertibility; currency; liquidity;
return predictability or risk; complexity; and tax status
2 Principles of Pricing of Financial Assets
1) Suppose that you have a bond issued by a German firm and that
all payments are in euros for the maturity of the bond which is
four years. Why is the cash flow in U.S. dollars that you will
receive as a U.S. investor uncertain? In your answer illustrate the
uncertainty in terms of an exchange rate premium and the
appropriate discount rate.
Answer: The cash flow in U.S. dollars that a U.S. investor will
receive is uncertain because the dollar-euro exchange rate will
fluctuate over the four years. Suppose that the market assigns an
exchange premium of 3%. This means that the appropriate discount
rate increases from 9% to 12%. To continue with the effect of
currency risk, suppose that immediately after the purchase of this
bond the market expects that the exchange rate between the U.S.
dollar and the euro will become more volatile. The market will
adjust for this by increasing the foreign currency risk premium,
which, in turn, increases the appropriate discount rate and
decreases the price.
Diff: 3
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.2 the components of an asset's discount rate or
required rate of return
2) Define what we mean by "an appropriate discount rate".
Describe four of the six components that make up this rate.
Answer: The appropriate discount rate, r, is the return that the
market or the consensus of investors requires on the asset. A
convenient (but approximate) expression for the appropriate
discount rate can be expressed in terms of six components. This is
shown below:
r = RR + IP + DP + MP + LP + EP where
RR = the real rate of interest, which is the reward for not
consuming and for lending to other users
IP = the inflation premium, which is the compensation for the
expected decline in the purchasing power of the money lent to
borrowers
DP = the default risk premium, which is the reward for taking on
the risk of default in the case of a loan or bond or the risk of
loss of principal for other assets
MP = the maturity premium, which is the compensation for lending
money for long periods of time
LP = the liquidity premium, which is the reward for investing in
an asset that may not be readily converted to cash at a fair market
value
EP= the exchange-rate risk premium, which is the reward for
investing in an asset that is not denominated in the investor's
home currency.
Diff: 3
Topic: 9.2 Principles of Pricing of Financial Assets
Objective: 9.2 the components of an asset's discount rate or
required rate of return
3 Price Volatility of Financial Assets
1) An asset's maturity is a factor that affects its price
sensitivity to a change in yield. In fact, a bond's price
sensitivity to a change in the discount rate is positively related
to the bond's maturity. Consider the case of two bonds that have
the same coupon rate, and the same required yield but different
maturities. If the required rate were to change, the price
sensitivity of the bond with the longer maturity would be greater
than that of the bond with the shorter maturity. Give an
illustration of this.
Answer: An illustration of this link between maturity and price
change appears in Table 9-2, which shows the price of a bond that
pays $50 annually and $1,000 at maturitya 5% coupon ratefor various
maturities and discount rates. Table 9-3, which is based on Table
9-2, shows the differences across maturities in a bond's dollar
price decline and percentage price decline for an increase in the
discount rate of 100 basis points. For example, if the discount
rate rises from 9% to 10%, the price of a four-year bond falls from
$870.41 to $841.51, which represents a price decline of $28.90 and
a percentage price decline of 3.32%. In contrast, a similar rise in
the discount rate causes the price of a 20-year bond to fall
considerably more, from $634.86 to $574.32, which represents a
price decline of $60.54 and a percentage price decline of
9.54%.
Diff: 3
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.8 what factors affect the price sensitivity of a
financial asset to changes in interest rates
2) Explain the difference between modified duration and
effective duration. In your also give an example of when the
difference can be dramatic.
Answer: When a duration is calculated under the assumption that
the cash flows do not change when interest rates change, the
resulting duration is called modified duration. In contrast, a
duration calculated assuming that the cash flow changes when
interest rates change is called effective duration. The difference
between modified duration and effective duration for some assets
can be quite dramatic. For example, with some of the more complex
financial instruments, the modified duration could be four while
the effective duration could be 25. This means that an investor
might believe that the price of the asset will change by
approximately 4% for a 100 basis point change in interest rates
(modified duration) when, in fact, it would change by approximately
25% for a 100 basis point change in interest rates (effective
duration).
Diff: 3
Topic: 9.3 Price Volatility of Financial Assets
Objective: 9.8 what factors affect the price sensitivity of a
financial asset to changes in interest rates
1Copyright 2010 Pearson Education Inc. Publishing as Prentice
Hall
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