CHAPTER 8

TRUE/FALSE QUESTIONS

(T) 1. Capital market securities are used to finance real capital investments.

(F) 2. Capital market securities have better liquidity than capital market securities.

(T) 3. Money market securities are all debt securities, while capital market securities
are either debt or equity securities.

(T) 4. Capital market interest rates tend to be higher than money market rates for any
issuer.

(T) 5. Life insurance companies are more likely to invest in corporate capital market
securities than commercial banks.

(T) 6. Investors may invest in capital market securities either directly or indirectly.

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(F) 7. Both governments and businesses issue both debt and equity capital market

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securities.

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(F) 8. Households owe more financially than they own.
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(T) 9. Financial institutions and households own about the same amount of financial
assets.

(T) 10. In the U.S. there are more mortgages outstanding than corporate bonds.
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(F) 11. Yields on U.S. Treasury "ask" prices are higher than yields quoted on "bid"
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prices.

(T) 12. A U.S. Treasury STRIP is a zero-coupon bond.

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(T) 13. Most State and Local government bonds are sold to finance education.
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(T) 14. A serial bond issue matures over a period of years.

(T) 15. Households are the major investor in municipal bonds.

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(F) 16. U.S. Treasury TIPS protect investors primarily from default risk.
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(T) 17. A state turnpike authority is more likely to issue revenue bonds than general
obligation bonds.
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(F) 18. Lower marginal tax rates increase the demand for tax-exempt securities.

(T) 19. The money market provides liquidity for deficit units; the capital market finances
economic growth.

(T) 20. The primary market for junk bonds expanded for higher risk firms as the

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 secondary market for junk bonds developed.

(T) 21. Capital market borrowing by businesses is generally repaid from the cash flow
generated by the assets financed.

(F) 22. Commercial banks purchase more tax-exempt securities when loan losses
increase.

(F) 23. One of the fastest growing loan areas for commercial banks in the 1980s was
financial guarantees.

(T) 24. Revenue bonds are generally considered more risky than general obligation
bonds.

(F) 25. The after-tax return on a 9 percent tax-exempt municipal bond to a commercial
bank in the 34 percent tax bracket is 5.94 percent.
MULTIPLE-CHOICE QUESTIONS

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(c) 1. Which of the following is not an example of capital market securities?

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a. common stocks

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b. convertible bonds
c. commercial paper

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d. mortgages
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(c) 2. Most general obligation bonds are sold through
a. direct placement.
b. negotiated bids.
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c. competitive bids.
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d. all of the above.

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(b) 3. Which of the following firms is least likely to hold tax-exempt municipal bonds?
a. commercial banks
b. pension funds
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c. mutual funds
d. households
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(d) 4. The secondary markets for capital market securities have facilitated economic
growth in our country because
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a. they help provide marketability for capital market claims.

b. they have increased people's willingness to buy capital market claims.
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c. they make people more willing to invest because they can more easily
diversify their risk.
d. all of the above
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(a) 5. Everything else being equal, a bond will sell at a higher yield if it
a. has a call provision.
b. has low default risk.
c. can be converted to stock.
d. is listed on an exchange.

(d) 6. Which of the following would be least likely to purchase a tax-exempt municipal

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 bond?
a. commercial bank
b. casualty insurance company
c. mutual fund
d. individuals in low tax brackets

(d) 7. The biggest supplier of funds in the capital markets are

a. financial institutions
b. state and local governments
c. federal government
d. households and non profits

(d) 8. Regulators provide a valuable function for the capital markets because they
a. try to keep the market participants honest.
b. try to prevent excessive speculation from destabilizing the market.
c. make sure all pertinent information about publicly traded securities is
disclosed.

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d. all of the above

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(b) 9. In the 1980s low credit quality businesses were able to first issue their new bond

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securities in which market?
a. municipal bond market

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b. junk bond market
c. rs e
stock market
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d. secondary market

(a) 10. A capital market financing is most likely to finance

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a. new plant and equipment.

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b. seasonal inventory needs.

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c. a quarterly dividend payment.

d. the sale of common stock.

(d) 11. The household sector is the largest surplus sector and invests in the capital
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market
a. directly by purchasing stocks and bonds.
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b. directly by issuing assets payable in the capital market.

c. both directly (owning stocks) and indirectly (pension fund reserves, etc.)
d. both a and c above
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(a) 12. Letters of credit are mostly associated with

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a. financial guarantees.
b. investment banking.
c. a bond indenture.
d. a commercial bank seasonal loan.
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(c) 13. Life insurance companies and pension funds buy corporate bonds for which two
major reasons?
a. tax sheltering and high yield
b. liquidity and high after-tax returns
c. liability maturity matching and high after-tax returns
d. low risk and liquidity

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 (b) 14. All of the following bond terms relate to maturity except
a. serial.
b. indenture.
c. sinking fund.
d. call provision.

(c) 15. An investor in the 34 percent federal tax bracket would probably select what
investment (all with similar default risk)?
a. 7% municipal bond
b. 10% corporate bond
c. 11% mortgage
d. 9% Treasury bond

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(d) 16. If average corporate bond and tax-exempt municipal bond rates were 8.33% and

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6.25% respectively, at what marginal tax rate would an investor be indifferent
between the two?

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a. 30%
b. rs e
18%
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c. 33%
d. 25%
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(a) 17. With reference to the question above, an investor in the 34 percent marginal
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corporate tax bracket would purchase

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a. the tax-exempt bond.

b. the corporate bond.
c. neither security.
d. the higher pre-tax yield.
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(c) 18. The three major investors in municipal bonds are

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a. casualty insurance companies, pension funds, and individual investors.

b. commercial banks, casualty insurance companies, and life insurance
companies.
c. individual investors, commercial banks, and casualty insurance
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companies.
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d. mutual funds, pension funds, and commercial banks.

(d) 19. The incentive to securitize a portfolio of loans is

a. the profit from the loan revenue.
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b. the profit from the interest on the asset-backed securities issued.

c. the profit from the fees paid for financial guarantees.
d. the profit from the difference between the loan revenue and the costs of
guarantees and return on the asset-backed securities.

(c) 20. Securitization of loan portfolios, such as credit card loans and mortgage loans,
will occur if

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 a. the financial market will pay more for the loan portfolio than the issued
asset-backed securities.
b. a financial guarantee is obtained from a commercial bank.
c. the financial market will pay more for the issued asset-backed securities
than the loan portfolio.
d. the borrowers permit their loan to be securitized.

(d) 21. All but one of the following are associated with credit enhancements for asset-
backed securities?
a. Cash-collateral accounts that are deposits set aside to cover losses.
b. Financial guarantees from bond insurance companies.
c. Standby letters of credit from major commercial banks.
d. A guarantee to pay from the borrowers.

(b) 22. Credit-rating agency ratings are associated with which of the following investor
risks?
a. interest rate risk

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b. default risk

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c. purchasing power risk

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d. reinvestment risk

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(c) 23. rs e
Bonds issued by foreign entities in the United States are called:
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a. foreign bonds
b. American depository receipts
c. Yankee bonds
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d. Samurai bonds
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(d) 24. All but one of the following may be associated with the increased globalization
of bond markets?
a. the globalization of business activity
b. increased volatility in foreign exchange rates
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c. Improved computer and telecommunications technology

d. the reduction in trade barriers and standardization of regulations.
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(c) 25. Investors in U.S. Treasury STRIPS are primarily interested in eliminating which
of the following bond investor risks?
a. default risk
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b. price risk
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c. reinvestment risk
d. foreign exchange risk

(c) 26. Industrial development bonds (IDBs) are debt securities issued by:
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a. the federal government

b. non profit organizations
c. state and local government agencies
d. non financial businesses.

(d) 27. The largest investor in municipal bonds is:

a. commercial banks

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 b. property and casualty insurance companies
c. life insurance companies
d. households

(b) 28. The fastest growing debt sector in the U. S. is:

a. Treasury debt
b. federal agency debt
c. mortgage debt
d. corporate debt

(d) 29. The demand for junk bonds came primarily from
a. life insurance companies
b. savings & loans association
c. pension funds
d. all of the above

(a) 30. The quality of a financial guarantee depends on the reputation and financial

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strength of the

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a. the guarantor

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b. the investor

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c. the borrower
d. none of the above

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 ESSAY QUESTIONS

1. Compare and contrast the characteristics of the securities of the money market with those
of the capital market.

Answer: Money market securities are short-term, usually less than nine months, while
capital market securities are from five to one hundred years. The money market is
largely a “primary” market with secondary market activity. The capital market is a
secondary market with some primary market additions. All money market securities are
unsecured debt, while equities and debt, some collateralized, make up the capital market.

2. What might determine whether an individual investor buys corporate or municipal

bonds? Give an example.

Answer: Everything else being the same, an individual investor would select the higher
after-tax return; so the relative yields and marginal tax rate of the investor will likely
determine the choice of corporate bonds or muni’s. For example with a 7% yield

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available on a corporate bond, for an individual in the 28% marginal tax bracket would

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have to find an equivalent (term and rating) 5.04% municipal or state bond. For

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individuals’ pension money in a tax-deferred program, one would invest in the taxable

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securities.

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3. List and discuss the risks faced by bond investors.
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Answer: Bond investors may face a variety of risk including default risk, inflation risk,
price risk and reinvestment risk (coupon bond), foreign exchange risk and/or political risk
if an international investment, and market risk (risk of a constant ready market).
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4. U.S. Treasury STRIPS are of interest to individuals with IRA's or $401k pension plans.
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Why?

Answer: Zero coupon bonds are of interest to individuals investing via tax deferred
pension plans for a couple reasons. One, an individual, buying a STRIP outside a
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qualified pension plan will pay annual interest on the imputed rate on the zeros, but not if
in a qualified plan. Second, zeros held to maturity earn the expected yield to maturity
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and are not subject to reinvestment risk. One will know the “pile” of cash in the plan at
the end of the maturity.
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5. What factors have contributed to the increased globalization of bond markets?

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Answer: There have been a number of cumulative factors that, overtime, has contributed
to the increased globalization of bond markets. The development of standardized legal
remedies, the development of markets in more stable economies, and a vast amount of
quality government debt has attracted investors into financial investment. Exchange rate
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stability, computerization, and information processing technology have provided the

ability for markets to develop as well.

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