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MID TERM 2 QUESTIONS AND ANSWERS WITH SOLUTIONS 2024
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MID TERM 2 QUESTIONS AND ANSWERS WITH SOLUTIONS 2024
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MID TERM 2 QUESTIONS ANDANSWERS WITH SOLUTIONS 2024
ABC Corporation has declared a rights offering to stockholders of record on Friday, December 10th.
Under the offer, shareholders need 10 rights to subscribe to 1 new share at a price of $19. Fractional
shares can be rounded up to purchase 1 full share. As of the ex date, the stock is trading at $24. The
value of the right is:
A. $.45
B. $.50
C. $.55
D. $1.00 - ANSWER $24 - $19/10 = $5/10 = $.50 Value "Ex Rights"
Notice that the market price of $24 was already adjusted on the ex date by the exchange where the
stock trades. Do not try and reduce the price again!
The trust indenture of a bond would include which of the following information?
I Interest rate
II Maturity
III Collateral backing the issue
IV Call provisions - ANSWER The best answer is D.
A corporate bond is issued under a bond contract. The contract spells out the interest rate, maturity,
collateral, call or put provisions, and all other relevant features of the bonds. To ensure that these
covenants are followed, a trustee is appointed to monitor the issuer's compliance with all of these
promises. This document is the trust indenture.
The term "Funded Debt" refers to which of the following issues?
A. Commercial paper with under 270 days to maturity
B. Revenue bond with at least 5 years to maturity
C. Corporate debt with at least 5 years to maturity
D. Treasury bond with at least 5 years to maturity - ANSWER The best answer is C.
The term "funded debt" refers to CORPORATE debt that is considered part of a company's permanent
long term funding. Included is all long term corporate debt. Revenue bonds are issued by municipalities
and T-Bonds are issued by the Government. Commercial paper is a short term financing and is an
"unfunded" debt.
All of the following statements are true regarding a bond that is "registered to principal only" EXCEPT:
A. the bond is negotiable
B. interest coupons are detached from the corpus of the bond
C. interest payments can be redeemed by anyone
D. at maturity, the registered owner receives the face amount of the bond - ANSWER The best answer is
B.
A registered to principal only bond has a physical certificate with the bond's face amount registered in
the owner's name, but interest coupons are attached which are payable to the "bearer." Bearer coupons
can be redeemed by anyone. The bonds are negotiable. No new issues have been sold in the U.S. since
, 1983 - after this point only fully registered or book entry bonds have been issued. However, these bonds
still trade in the market (at least until 2023, if the bond had 40 years to maturity).
Which of the following statements are TRUE regarding the settlement of trades in U.S. Government
bonds?
I Trades settle next business day
II Trades settle 3 business days after trade date
III Trades settle in Clearing House Funds
IV Trades settle in Federal Funds - ANSWER The best answer is B.
Trades of U.S. Government securities settle next business day in Fed Funds (payment by check is not
permitted since the clearance time is greater). Do not confuse this with settlement of the weekly
Treasury Bill auctions. The Federal Reserve auctions T-Bills each Monday and Tuesday, with the bills
issued, and paid for in Fed Funds, the following Thursday.
Which CMO tranche will be offered at the lowest yield?
A. Plain vanilla
B. Targeted amortization class
C. Planned amortization class
D. Companion - ANSWER Companion tranches are the "shock absorber" tranches, that absorb
prepayment risk out of a TAC (Targeted Amortization Class) tranche; or both prepayment risk and
extension risk out of a PAC (Planned Amortization Class) tranche. Because the companion absorbs both
of these risks, it has the greatest risk and trades at the highest yield. Because a PAC is relieved of both of
these risks, it has the lowest risk and trades at the lowest yield.
Which statements are TRUE about IO tranches?
I When interest rates rise, the price of the tranche falls
II When interest rates rise, the price of the tranche rises
III When interest rates fall, the price of the tranche falls
IV When interest rates fall, the price of the tranche rises - ANSWER The best answer is C.
An IO is an Interest Only tranche. This is a tranche that only receives the interest payments from an
underlying mortgage, and it is created with a corresponding PO (Principal Only) tranche that only
receives the principal payments from that mortgage. The interest portion of a fixed rate mortgage makes
larger payments in the early years, and smaller payments in the later years. These are issued at a
discount to face and each interest payment made brings the "notional principal" of the bond closer to
par. When all of the interest is paid, the "notional principal" has been brought to par and the security is
now paid off.
The price movements of IOs are counterintuitive! Unlike regular bonds, where when interest rates rise,
prices fall, with an IO, when interest rates rise, prices rise! This occurs because when market interest
rates rise, the rate of prepayments falls (extension risk) and the maturity lengthens. Because interest will
now be paid for a longer than expected period, the price rises. Conversely, when interest rates fall
(prepayment risk) the principal is being paid back at an earlier than expected date, so less interest is
being received and the price falls (if interest rates fall drastically, the holder might get less interest back
than what was originally invested).
Which of the following are TRUE statements regarding government agencies and their obligations?
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