Miguel, a recent college graduate who heard that you knew something about investing,wants to ask about investing in bonds. Miguel indicated that, according to hisfriends, the stock market was too volatile and that bonds were a safer place to invest. Miguel admitted that he really didn't know much about either stocks or bonds but that he hoped to start saving so that he could purchase a house in the next 5 years. Miguel also mentioned that he had heard about preferred stock and real estate as alternatives to bonds. His roommate recommended that he buy a preferred stock that paid a $ 4.60 annual dividend or purchase farmland outside of his hometown. Answer the following questions in a way that will help Miguel learn investment concepts.

1. List four advantages and four disadvantages of investing in bonds.

Advantages associated with bonds include:(Select the best choice below.)

A.

1) Making money if interest rates decrease. 2) Reducing risk through diversification. 3) Providing current and steady capital gain. 4) Offering relative safety if held until maturity.

B.

1) Making money if interest rates decrease. 2) Reducing risk through diversification. 3) Providing current and steady income. 4) Offering relative safety if held until maturity.

C.

1) Making money if interest rates increase. 2) Reducing risk through diversification. 3) Providing current and steady income. 4) Offering relative safety if held until maturity.

D.

1) Making money if interest rates decrease. 2) Reducing risk through diversification. 3) Providing current and steady dividend income. 4) Offering relative safety if held until maturity.

Disadvantages associated with bond investing include:(Select the best choice below.)

A.

1) Losing money if interest rates increase. "Interest rate risk" 2) Losing money if an issuer experiences financial problems. "Business risk" 3) Having a bond called if interest rates fall. "Call risk" 4) Lacking liquidity. "Reinvestment risk"

B.

1) Losing money if interest rates increase. "Interest rate risk" 2) Losing money if an issuer experiences financial problems. "Business risk" 3) Having a bond called if interest rates fall. "Call risk" 4) Lacking liquidity. "Liquidity risk"

C.

1) Losing money if interest rates increase. "Interest rate risk" 2) Losing money if an issuer experiences financial problems. "Business risk" 3) Having a bond called if interest rates rise. "Call risk" 4) Lacking liquidity. "Liquidity risk"

D.

1) Losing money if interest rates decrease. "Interest rate risk" 2) Losing money if an issuer experiences financial problems. "Business risk" 3) Having a bond called if interest rates fall. "Call risk" 4) Lacking liquidity. "Liquidity risk"

2. If Miguel thought that interest rates were going to increase, what type and maturity of bond should he purchase? What type and maturity should he avoid? Why?(Select from the drop-down menus.)

If interest rates were to increase, Miguel should purchase

short-term

long-term

high quality bonds.

Short-term

Long-term

bonds are less affected by changes in interest rates than

shorter-maturity

longer-maturity

bonds. Miguel should avoid

short-term

long-term

bonds, especially

zero-coupon

junk

bonds, because the value of these bonds fluctuates wildly with changes in interest rates.

3. Develop a checklist of rules that Miguel should use when purchasing a bond.(Select from the drop-down menus.)

Miguel should consider the following guidelines when investing in bonds:

bullet

If Miguel is in a high marginal tax bracket he should consider a

Treasury bond

municipal bond

corporate bond

.

bullet

He should always keep an eye on the

interest rates

inflation rate

.

bullet

He should avoid bonds issued by firms that might experience financial problems.

bullet

Miguel should consider only high quality bonds.

bullet

He should avoid

callable

putable

bonds.

bullet

He should take steps to match bond maturities to his investment time horizon.

bullet

Miguel should purchase bonds from large U.S. companies or the federal government bonds.

bullet

When in doubt, Miguel should simply buy a Treasury security.

4. To be as safe as possible, what bond maturity should Miguel choose to meet his home purchase goal? What type(s) of risk does this strategy reduce or avoid?(Select all the choices that apply.)

A.

The reason why Miguel would not want to purchase bonds shorter than the investment period is that he could suffer call risk, or the risk associated with a bond maturing when available rates are less than what was previously earned.

B.

Miguel should choose a maturity that matches his investment horizon. By doing this Miguel negates interest rate risk because he knows that he will be paid par value at maturity, so changes in prices due to fluctuations in interest rates are meaningless from a financial perspective.

C.

Miguel should choose a maturity that matches his investment horizon. By doing this Miguel negates interest rate risk because he knows that he will be paid a premium at maturity, so changes in prices due to fluctuations in interest rates are meaningless from a financial perspective.

D.

The reason why Miguel would not want to purchase bonds shorter than the investment period is that he could suffer reinvestment risk, or the risk associated with a bond maturing when available rates are less than what was previously earned.

5. Explain to Miguel why he might want to consider investing in preferred stock rather than bonds.(Select all the choices that apply.)

A.

Preferred stock is a hybrid between common stock and corporate bonds. Preferred stock is similar to bonds in that dividends are fixed and paid before common stock dividends.

B.

Unlike a bond, preferred stock does not have a fixed maturity date and the termination of dividends will not bring on bankruptcy.

C.

Preferred stockholders usually have limited voting rights. Also, because dividends are fixed, preferred shareholders typically don't share in corporate profits.

D.

Even though preferred stockholders do not have voting rights and typically do not share in corporate profits, they can provide a nice stable dividend stream.

6. What is the fair market value of the preferred stock that Miguel is considering purchasing if his required rate of return is

8.1

percent?

The value of the preferred stock is

$nothing

per share.(Round to the nearest cent.)

7. If Miguel really wanted to purchase real estate to meet his objective, would a direct or indirect real estate investment be more appropriate for him? Explain your answer in terms of liquidity, volatility, and safety.(Select from the drop-down menus.)

Indirect

Direct

real estate investments require much time, effort, and expertise in order to make above-average long-term rates of return. If Miguel is, in fact, serious about making a real estate investment, he should consider

a direct

an indirect

one.

Indirect

Direct

real estate investments are appropriate for investors with little expertise in real estate management and those with little time to develop the necessary expertise to be successful. An attractive

direct

indirect

investment worth exploring is a real estate investment trust. Most

direct

indirect

real estate investments lack liquidity. In other words, if Miguel needed to sell

an indirect

a direct

real estate investment in order to generate cash immediately, there is no guarantee that he could find a willing and able buyer and actually get a fair price for his holdings.