(Questions are in bold print followed by answers.)
2. What is meant by a mortgage-backed security?
A mortgage-backed security is a security backed by one or more mortgage loans. Like a bond that is callable, a mortgage-backed security allows the investor to grant the borrower an option.
4. What is the cash flow of a 10-year bond that pays coupon interest semiannually, has a coupon rate of 7%, and has a par value of $100,000?
The principal or par value of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date. The coupon rate multiplied by the principal of the bond provides the dollar amount of the coupon (or annual amount of the interest payment). A 10-year bond with a 7% annual coupon rate and a principal of $100,000 will pay semiannual interest of (0.07/2)($100,000) = $3,500 for 10(2) = 20 periods. Thus, the cash flow is $3,500. In addition to this periodic cash, the issuer of the bond is obligated to pay back the principal of $100,000 at the time the last $3,500 is paid.
6. Give three reasons why the maturity of a bond is important.
There are three reasons why the term to maturity of a bond is important. First, the term to maturity indicates the time period over which the holder of the bond can expect to receive the coupon payments and the number of years before the principal will be paid in full. Second, the term to maturity is important because the yield on a bond depends on it. The shape of the yield curve determines how the term to maturity affects the yield. Third, the price of a bond will fluctuate over its life as yields in the market change. The volatility of a bond’s price is dependent on its maturity. More specifically, with all other factors constant, the longer the maturity of a bond, the greater the price volatility resulting from a change in market yields.
8. Explain whether or not an investor can determine today what the cash flow of a...