1. Explain how a sinking fund works.
2. What tax advantages are associated with municipal bonds?

3. If an investor is in a 30 percent marginal tax bracket and can purchase a straight (non-municipal bond) at 8.37 percent and a municipal bond at 6.12 percent, which should he or she choose?

4. Assume a $1,000 Treasury bill is quoted to pay 5 percent interest over a six-month period.
a. How much interest would the investor receive?
b. What will be the price of the Treasury bill?
c. What will be the effective yield?
5. The price of a Treasury strip note or bond can be found using Appendix C toward the back of the text. It is simply the present value factor from the table times the maturity (par) value of the Treasury strip. Assume you are considering a $10,000 par value Treasury strip that matures in 25 years. The discount rate is 7 percent. What is the price (present value) of the investment?

6. Why does a bond price change when interest rates change?
7. Given a 15-year bond that sold for $1,000 with a 9 percent coupon rate, what would be the price of the bond if interest rates in the marketplace on similar bonds are now 12 percent? Interest is paid semiannually. Assume a 15-year time period.
8. What is the current yield of an 8 percent coupon rate bond priced at $877.60?
9. What is the yield to maturity for the data in problem 6? Assume there are 10 years left to maturity. It is a $1,000 par value bond. Use the trial-and-error approach with annual analysis.
At a 10% discount rate provides the bond price of $877.60. 10% is the yield to maturity.
10. The following pattern for one-year Treasury bills is expected over the next four years:

a. What return would be necessary to induce an investor to buy a two-year security?
b. What return would be necessary to induce an investor to buy a three-year security?
c. What return would be necessary to induce an investor to buy a four-year security?
d. Diagram the term structure of interest rates for years 1 through 4.
11. As market rates of interest become higher, what impact does this have on duration?

12. You are considering the purchase of two $1,000 bonds. Your expectation is that interest rates will drop, and you want to buy the bond that provides the maximum capital gains potential. The first bond has a coupon rate of 6 percent with four years to maturity, while the second has a coupon rate of 14 percent and comes due six years from now. The market rate of interest (discount rate) is 8 percent. Which bond has the best price movement potential? Use duration to answer the question.


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