Question 1

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward-sloping yield curve.

Accepted Answer

A) True 
 B)False

Question 2

Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT?

Accepted Answer

A)  If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. 
B)  If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds. 
C)  If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. 
D)  If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds. 
E)  If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield. 
A)  If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds. 
B)  If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds. 
C)  If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal. 
D)  If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds. 
E)  If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.

Question 3

If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

Accepted Answer

A) True 
 B)False

Question 4

Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)  The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. 
B)  Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. 
C)  The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long- term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping. 
D)  If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. 
E)  Liquidity premiums are generally higher on Treasury than on corporate bonds. 
A)  The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. 
B)  Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. 
C)  The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long- term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping. 
D)  If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. 
E)  Liquidity premiums are generally higher on Treasury than on corporate bonds.

Question 6

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk."

Accepted Answer

A) True 
 B)False

Question 7

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

Accepted Answer

A) True 
 B)False

Question 8

Which of the following statements is CORRECT?

Accepted Answer

A)  The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. 
B)  The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. 
C)  The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. 
D)  The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. 
E)  The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity. 
A)  The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. 
B)  The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. 
C)  The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. 
D)  The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. 
E)  The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity.

Question 9

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A)  Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. 
B)  If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. 
C)  The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. 
D)  Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. 
E)  The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future. 
A)  Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. 
B)  If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. 
C)  The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. 
D)  Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. 
E)  The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.

Question 11

Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

Accepted Answer

A) True 
 B)False

Question 12

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

Accepted Answer

A)  1.08% 
B)  1.20% 
C)  1.32% 
D)  1.45% 
E)  1.60% 
A)  1.08% 
B)  1.20% 
C)  1.32% 
D)  1.45% 
E)  1.60%

Question 13

Which of the following would be most likely to lead to a higher level of interest rates in the economy?

Accepted Answer

A)  Households start saving a larger percentage of their income. 
B)  Corporations step up their expansion plans and thus increase their demand for capital. 
C)  The level of inflation begins to decline. 
D)  The economy moves from a boom to a recession. 
E)  The Federal Reserve decides to try to stimulate the economy. 
A)  Households start saving a larger percentage of their income. 
B)  Corporations step up their expansion plans and thus increase their demand for capital. 
C)  The level of inflation begins to decline. 
D)  The economy moves from a boom to a recession. 
E)  The Federal Reserve decides to try to stimulate the economy.

Question 14

One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

Accepted Answer

A) True 
 B)False

Question 15

The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT?

Accepted Answer

A)  Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond. 
B)  Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds. 
C)  Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds. 
D)  The 10-year Treasury bond must have a higher yield than the 5-year corporate bond. 
E)  The 10-year corporate bond must have a higher yield than the 5-year corporate bond. 
A)  Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond. 
B)  Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds. 
C)  Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds. 
D)  The 10-year Treasury bond must have a higher yield than the 5-year corporate bond. 
E)  The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Question 16

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Accepted Answer

A)  1.81% 
B)  1.90% 
C)  2.00% 
D)  2.10% 
E)  2.21% 
A)  1.81% 
B)  1.90% 
C)  2.00% 
D)  2.10% 
E)  2.21%

Question 17

Keys Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys' bonds is LP = 0.5% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t − 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds?

Accepted Answer

A)  1.17% 
B)  1.30% 
C)  1.43% 
D)  1.57% 
E)  1.73% 
A)  1.17% 
B)  1.30% 
C)  1.43% 
D)  1.57% 
E)  1.73%

Question 18

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) weather conditions.

Accepted Answer

A) True 
 B)False

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)  If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. 
B)  If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. 
C)  Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. 
D)  If the maturity risk premium (MRP) equals zero, the yield curve must be flat. 
E)  The yield curve can never be downward sloping. 
A)  If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. 
B)  If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. 
C)  Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. 
D)  If the maturity risk premium (MRP) equals zero, the yield curve must be flat. 
E)  The yield curve can never be downward sloping.

Question 20

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

Accepted Answer

A)  5.32% 
B)  5.60% 
C)  5.89% 
D)  6.20% 
E)  6.51% 
A)  5.32% 
B)  5.60% 
C)  5.89% 
D)  6.20% 
E)  6.51%

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward-sloping yield curve.

If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong.

Which of the following statements is CORRECT?

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk."

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

Which of the following statements is CORRECT?

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

Which of the following statements is CORRECT?

Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

Which of the following would be most likely to lead to a higher level of interest rates in the economy?

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) weather conditions.

Which of the following statements is CORRECT?

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

The Value of Money

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Multinational Financial Management

Financial and Operating Leverage: Analysis and Calculation

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Exam 6: Interest Rates

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward-sloping yield curve.

If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong.

Which of the following statements is CORRECT?

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk."

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

Which of the following statements is CORRECT?

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

Which of the following statements is CORRECT?

Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

Which of the following would be most likely to lead to a higher level of interest rates in the economy?

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) weather conditions.

Which of the following statements is CORRECT?

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

The Value of Money

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Multinational Financial Management

Financial and Operating Leverage: Analysis and Calculation

Filters