Question

1. When a bond issuer terminates a bond prior to its original maturity, it is exercising a privilege granted to the bond issuer in the bond contract. That privilege is known as a _____.

a. preemptive right

b. sinking fund provision

c. call back provision

d. protective provision

2. At what tax rate (t) would an investor be indifferent to the following two bonds: a taxable corporate bond yielding 4 percent and a comparable nontaxable municipal bond yielding 3 percent?

a. .03 * (1 - t) = .04

b. .04 * (1 - t) = .03

c. .04 + (1 - t) = .03

d. .03 *.04= 1-t

3.  Which of the following bond has the highest interest rate risk?

a. 30-y & 2% coupon

b. 10-y & 4% coupon

c. 20-y & 4% coupon

d. 30-y & 4% coupon

Answer 1

1) c. Call back provision

Call provision allows company to buy back the bond issued , i.e to redeem the bond in case interest rate falls.

2) b. 0.04 * (1-t) = 0.03

Investor has to pay tax on the interest, hence actual interest earned by the investor is Interest rate(1-tax rate)

Thus  investor would be indifferent when Interest rate(1-tax rate) = Interest rate on non taxable bond

Thus answer = 0.04 * (1-t) = 0.03

3) d. 30-y & 4% coupon

Higher the duration of the bond , higher the interest rate risk, hence between bonds having maturity of 10years , 20 years and 30 years, bond with maturity of 30 years will have highest interest rate risk

Higher the cuopon rate higher is the interest rate risk. hence Answer is 30-y & 4% coupon