Deck 10: The Level and Structure of Interest Rates

Question 1

The yield to maturity is determined by a trial-and-error process. The first step in this trial and error process is ________.

A) Compute the present value of each cash flow using the best guess interest rate.
B) Total the present value of the cash flows using the best guess interest rate.
C) Select an interest rate.
D) Compare the total present value using the best guess interest rate with the market price of the bond.

Answer 1

C

Question 2

Which of the below statements about consumptions and savings is FALSE?

A) A chief influence on the saving decision is the individual's marginal rate of time preference, which is the willingness to trade some consumption now for more future consumption.
B) Generally, higher current income means the person will save more, although people with the same income may have different time preferences.
C) A variable affecting savings is the reward for saving, or the rate of interest on loans that savers make with their unconsumed income.
D) The total savings (or the total supply of loans) available at any time is the sum of everybody's savings and a negative function of the interest rate.

Answer 2

D

Question 3

The ________, originally developed by John Maynard Keynes, analyzes the equilibrium level of the interest rate through the interaction of the supply of money and the public's aggregate demand for holding money.

A) loanable funds theory of interest rates
B) expectation theory of interest rates
C) liquidity preference theory
D) Fisher theory

Answer 3

C

Question 4

In the absence of inflation, the nominal rate ________ the real rate.

A) equals
B) is greater than
C) is less than
D) greater than or equal to

Question 5

Which of the below statements is FALSE?

A) Although an increase in the money supply is an economically expansionary policy, the resultant increase in income depends substantially on the amount of slack in the economy at the time of the Fed's action.
B) In Fisher's terms, the interest rate reflects the interaction of the savers' marginal rate of time preference and borrowers' marginal productivity of capital.
C) Changes in the money supply can affect the level of interest rates through the liquidity effect, the income effect, and the price expectations effect; their relative magnitudes depend upon the level of economic activity at the time of the change in the money supply.
D) Because the price level (and expectations regarding its changes) affects the money demand function, the liquidity effect is an increase in the interest rate.

Question 6

The ________ rate of interest is determined by interaction of the supply and demand functions. As a cost of borrowing and a reward for lending, the rate must reach the point where total supply of savings ________ total demand for borrowing and investment.

A) equilibrium; is greater
B) minimum; equals
C) equilibrium; equals
D) minimum; is greater

Question 7

The public (consisting of individuals and firms) holds money for several reasons. Which of the below is three of these?

A) Difficulty of translations, precaution against expected events, and speculation about possible rises in the interest rate.
B) Ease of transactions, precaution against unexpected events, and speculation about possible rises in the interest rate.
C) Ease of unexpected events, precaution against transactions, and speculation about possible rises in the interest rate.
D) Speculation about transactions, fear against unexpected events, and precaution about possible rises in the interest rate.

Question 8

The ________ the market price, the higher the yield to maturity.

A) higher
B) less risky
C) more safe
D) lower

Question 9

An interest rate is the price paid by a ________ to a ________ for the use of resources during some interval.

A) borrower; debtor
B) lender; creditor
C) borrower; lender
D) lender; borrower

Question 10

The loanable funds theory of interest rates proposes that the general level of interest rates is determined by the complex interaction of two forces. Which of the below is ONE of these forces?

A) One force is that the total demand for funds by firms, governments, and households (or individuals) is negatively related to the interest rate including the government's demand.
B) One force affecting the level of the interest rate is the total supply of funds by firms, governments, banks, and individuals with rising rates causing banks to be less eager to extend more loans.
C) One force is that the total demand for funds by firms, governments, and households (or individuals) is positively related to the interest rate except the government's demand.
D) One force affecting the level of the interest rate is the total supply of funds by firms, governments, banks, and individuals with rising rates causing firms and individuals to save and lend more.

Question 11

The relationship between inflation and interest rates is the well-known Fisher's Law, which can be expressed this way: (1 + i) = (1 + r) × (1 + i) where ________.

A) r is the nominal rate.
B) i is the real rate.
C) p is the expected percentage change in the price level of goods and services over the loan's life.
D) the nominal rate, p, reflects both the real rate and expected inflation.

Question 12

The ________ represents the initial reaction of the interest rate to a change in the money supply.

A) Income effect
B) Price expectation effect
C) Liquidity effect
D) Interest rate effect

Question 13

Which of the below IS considered by Fisher's theory.

A) Fisher's theory takes into account the power of the government (in concert with depository institutions) to create money.
B) Fisher's theory considers the government's often large demand for borrowed funds, which is frequently immune to the level of the interest rate
C) Fisher's theory takes into account the possibility that individuals and firms might invest in cash balances.
D) Fisher's theory considers an interest rate on loans that embodies no premium for default risk because borrowing firms are assumed to meet all obligations.

Question 14

A ________ is an instrument in which the issuer (debtor/borrower) promises to repay to the lender/investor the amount borrowed plus interest over some specified period of time.

A) bond
B) common stock
C) preferred stock
D) T-bill

Question 15

By the ________, we mean the rate on a loan whose borrower will not default on any obligation.

A) risk-free rate
B) short term
C) real rate
D) long term

Question 16

The ________ should reflect the coupon interest that will be earned plus either (1) any capital gain that will be realized from holding the bond to maturity, or (2) any capital loss that will be realized from holding the bond to maturity.

A) yield on a bond investment
B) dividend yield on a bond investment
C) bid-ask spread
D) yield on a stock investment

Question 17

By the ________, we mean the rate that would prevail in the economy if the average prices for goods and services were expected to remain constant during the loan's life.

A) risk-free rate
B) short term
C) real rate
D) long term

Question 18

The ________ of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date.

A) principal value (or simply principal)
B) face value
C) redemption value
D) All of these

Question 19

Which of the below statements about the rate of interest and cost of capital is FALSE?

A) The maximum that a firm will invest depends on the rate of interest, which is the cost of loans; the firm will invest only as long as the marginal productivity of capital exceeds or equals the rate of interest.
B) Firms will reject only projects whose gain is not less than their cost of financing.
C) The firm's demand for borrowing is negatively related to the interest rate; if the rate is high, only limited borrowing and investment make sense.
D) At a low rate of interest, more projects offer a profit, and the firm wants to borrow more; his negative relationship exists for each and all firms in the economy.

Question 20

By the ________, we mean the rate on a loan that has one year to maturity.

A) risk-free rate
B) short term
C) real rate
D) long term

Question 21

Explain what is meant by the liquidity effect.

Question 22

Which of the below statements is FALSE?

A) The spread between Treasury securities and non-Treasury securities that are identical in all respects except for credit quality is referred to as a credit spread.
B) The spread between any two maturity sectors of the market is called a maturity spread or yield curve spread.
C) An option that is included in a bond issue is referred to as a prepayment option.
D) The most common type of option in a bond issue is a call provision.

Question 23

In Fisher's terms, the interest rate reflects the interaction of the savers' marginal productivity of capital and borrowers' marginal rate of time preference.

Question 24

The factors that affect the spread include ________.

A) the type of issuer and the expected liquidity of the issue
B) the provisions that grant either the issuer or the investor the obligation to do something and the taxability of the interest received by the issuer
C) the investor's perceived creditworthiness and the term or maturity of the investor's horizon.
D) All of these

Question 25

Consider an investor facing a 40% marginal tax rate who purchases a tax-exempt issue with a yield of 3.00%. The equivalent taxable yield is 5.00%.

Question 26

The highest-grade bonds are designated by Moody's by the symbol ________.

A) Ba
B) A
C) Aa
D) Aaa

Question 27

The difference between the yield on any two bond issues is called a ________.

A) yield difference
B) difference spread
C) coupon rate spread
D) yield spread

Question 28

There are several interesting points about the relationship among the coupon rate, market price, and yield to maturity. Which of the below is NOT one of these.

A) If the market price is equal to the par value, then the yield to maturity is equal to the coupon rate.
B) If the market price is less than the par value, then the yield to maturity is greater than the coupon rate.
C) If the market price is greater than the par value, then the yield to maturity is greater than the coupon rate.
D) If the market price is greater than the par value, then the yield to maturity is less than the coupon rate.

Question 29

The most recently auctioned Treasury issues for each maturity are referred to as ________.

A) off-the-run issues or current coupon issues.
B) minimum interest rate or base interest rate
C) on-the- run or current coupon issues.
D) benchmark interest rate or minimum interest rate.

Question 30

Explain the distinction between the real rate of interest and the nominal rate of interest.

Question 31

Consider an 20-year bond with a coupon rate of 8% and a par value of $1,000. The cash flow for this bond is ________ every six months for the first 39 semi-annual periods and then ________ for the last (or 40th) six-month period.

A) $1,040; $40
B) $40; $1,040
C) $80; $1,080
D) $80; $1,000

Question 32

Market participants talk of interest rates on non-Treasury securities as ________ to a particular on-the-run Treasury security (or a spread to any particular benchmark interest rate selected). This spread reflects the additional risks the investor faces by acquiring a security that is not issued by the U.S. government and, therefore, can be called a ________.

A) "trading at a premium"; risk premium
B) "trading at a spread"; risk premium
C) "trading at a premium"; risk spread
D) "trading at a discount"; discount premium

Question 33

Treasury securities are used to develop the benchmark interest rates. There are two categories of U.S. Treasury securities: ________.

A) discount and coupon securities.
B) discount and coupon stocks.
C) interest rate and coupon securities.
D) discount and compound securities.

Question 34

Convertible bonds are securities issued by state and local governments and by their creations, such as "authorities" and special districts.

Question 35

Within the corporate market sector, issuers are classified as ________.

A) (1) utilities, (2) industrials, (3) finance, and (4) banks.
B) (1) high-risk, (2) medium-risk, (3) low-risk, and (4) no-risk.
C) (1) foreign, (2) domestic, (3) European, and (4) Asian.
D) (1) intramarket, (2) extramarket, (3) ultramarket, and (4) intermarket.

Question 36

Interest is the price paid for the permanent use of resources, and the amount of a loan is its principal.

Question 37

The liquidity preference theory is Keynes's view that the rate of interest is set in the market for money balances.

Question 38

Suppose a taxable bond issue offers a yield of 6% and is acquired by an investor facing a marginal tax rate of 30%. The after-tax yield would then be 1.80%.

Question 39

The relationship between the swap rate and maturity of a swap is called the maturity rate yield curve, or more commonly referred to as the maturity curve.

Question 40

The loanable funds theory is an extension of Fisher's theory and proposes that the equilibrium rate of interest reflects the demand and supply of funds, which depend on savers' willingness to save, borrowers' expectations regarding the profitability of investing, and the government's action regarding money supply.

Question 41

One would expect that if a country has a government bond market, the yields in that market would be the best benchmark. That is not necessarily the case. There are several advantages of using a swap curve over a country's government securities yield curve. Explain ONE of these advantages.

Question 42

There are several interesting points about the relationship among the coupon rate, market price, and yield to maturity. Briefly explain these relationships.