Deck 5: The Cost of Money Interest Rates

Question 1

_____ is the tendency of prices to increase over time.

A) Maturity
B) Recession
C) Inflation
D) Risk
E) Liquidity

Answer 1

C

Question 2

Bonds with higher liquidity have to offer higher interest rates in the market since they can be easily converted into cash on short notice at or near the fair market value for that bond.

Answer 2

False

Question 3

In general, when rates in the financial markets increase, the prices (values) of financial assets decrease.

Answer 3

True

Question 4

As a country increases its borrowing to finance its foreign trade deficit, interest rates are driven up.

Question 5

A bond purchased for $950 was sold for $980 after one year. The interest received during the year is $25. The bond's yield is:

A) 2.23%
B) 5.79%
C) 8.12%
D) 5.25%
E) 9.36%

Question 6

The higher the perceived risk, the higher the required rate of return.

Question 7

The real rate of interest is composed of a risk-free rate of interest plus the default premium and liquidity premium that reflects the riskiness of the security

Question 8

The yield curve is downward sloping, or inverted, if the inflation rates are expected to increase.

Question 9

Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from less efficient firms or from those whose products are not in demand.

Question 10

_____ can be negative if the value of the investment decreases during the period it is held.

A) Risk
B) Dividends
C) Maturity
D) Interests
E) Capital gains

Question 11

Deficit trade balance hinders the Federal Reserve's ability to combat a recession by lowering interest rates.

Question 12

If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase will probably be greater than the increase in rates in the long-term market.

Question 13

Investors with a _____ will demand a higher rate of return.

A) higher time preference for consumption
B) lower exposure to economic risks
C) lower access to production opportunities
D) higher financial creditworthiness
E) lower default premium

Question 14

The value of an asset is the future value of the future cash flows that the asset is expected to generate during its life.

Question 15

_____ is the chance that a financial asset will not earn the return promised.

A) Maturity
B) Production opportunity
C) Time preference for consumption
D) Risk
E) Inflation

Question 16

The expectations theory postulates that the term structure of interest rates is based on expectations regarding future inflation rates.

Question 17

During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with humps) are prevalent.

Question 18

Inflation leads to increase in purchasing power of investors.

Question 19

If you have information that a recession is ending, and the economy is about to enter a boom, and your firm needs to borrow money, it should probably issue long-term rather than short-term debt.

Question 20

Production opportunity is one of the four fundamental factors that affect the:

A) creditworthiness of investors.
B) cost of money.
C) liquidity of securities.
D) inflation of an economy.
E) maturity of an investment.

Question 21

Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2, and 4% thereafter. Also, assume that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP2?

A) 2.1%
B) 1.8%
C) 5.0%
D) 3.0%
E) 2.5%

Question 22

The higher the expected rate of inflation:

A) the lower is the loss in purchasing power of investors.
B) the higher is the required rate of return on investment.
C) the lower is the maturity premium required by the investors.
D) the higher is the money supply in the economy.
E) the lower is the tax rate in the economy.

Question 23

Assume that the expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively. What is the average expected inflation rate over this 5-year period?

A) 6.5%
B) 7.5%
C) 8.0%
D) 6.0%
E) 7.0%

Question 24

Andrew purchased a stock for $175 and sold it for $250. If he earned a dividend income of $30, the stock's yield is:

A) 45%
B) 53%
C) 81%
D) 60%
E) 72%

Question 25

Which of the following statements is true?

A) Treasury bonds have zero default risk.
B) The longer the maturity of a bond, the more risky it is.
C) The real risk-free rate incorporates inflation premium.
D) Liquidity premium is included only for highly liquid securities.
E) The default risk is high for AAA rated corporate bonds.

Question 26

The change in the market value of an asset over some time period is called the _____.

A) yield
B) maturity
C) capital gain
D) interest income
E) dividend income

Question 27

You are given the following data:
$$\begin{array} { l c } r ^ { * } = \text { real risk-free rate } & 4 \% \\& \\\text { Constant inflation premium (IP) } & 7 \% \\\text { Maturity risk premium (MRP) } & 1 \% \\\text { Default risk premium for AAA bonds (DRP) } & 3 \% \\\text { Liquidity premium for long-term T-bonds (LP) } & 2 \%\end{array}$$
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant. Given these conditions, the rate on long-term Treasury bonds is _____.

A) 23%
B) 11%
C) 14%
D) 19%
E) 27%

Question 28

Securities that can be easily converted to cash in the market will have a low:

A) liquidity premium.
B) maturity risk premium.
C) inflation premium.
D) default risk premium.
E) real risk premium.

Question 29

Which of the following is the yield of a bond that offers a risk-free rate of 4% and a risk premium of 2%?

A) 2%
B) 8%
C) 12%
D) 6%
E) 9%

Question 30

Which of the following statements is correct?

A) The probability of default is higher on short -term bonds than on long-term bonds.
B) Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
C) According to the market segmentation theory, the yield curve is expected to slope downward.
D) Borrowers prefer to borrow on a short-term basis, as a result, the yield curve is downward sloping.
E) If the inflation was expected to decrease in the future, then the yield curve would have an upward slope.

Question 31

Assume that real risk-free rate (r*) = 1.0%; the maturity risk premium is found as MRP = 0.2% × (t - 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07% × (t - 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

A) 0.25%
B) 0.50%
C) 0.63%
D) 1.00%
E) 1.13%

Question 32

Which of the following indicates that the cost of money will increase?

A) Increase in inflation of an economy.
B) Increase in liquidity of an asset.
C) Decrease in federal deficit of a country.
D) Decrease in money supply in the market.
E) Decrease in tax rates for corporates.

Question 33

A corporate bond that yields 12% includes a risk-free rate of 7% and a default premium of 3%. The bond's maturity risk premium is _____.

A) 1%
B) 10%
C) 4%
D) 2%
E) 6%

Question 34

Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. Which of the possible bonds listed below best satisfies your uncle's criteria?

A) An AAA bond with 10 years to maturity.
B) A BBB perpetual bond.
C) A BBB bond with 10 years to maturity.
D) A AAA bond with 5 years to maturity.
E) A BBB bond with 5 years to maturity.

Question 35

Which of the following rates indicate the rate that will exist in an inflation-free world?

A) Maturity risk-free rate
B) Real risk-free rate
C) Default risk-free rate
D) Liquidity risk-free rate
E) Target risk-free rate

Question 36

Assume that a 3-year Treasury note has no maturity premium, and that the real, risk-free rate of interest is 3 percent. If the T-note carries a yield to maturity of 13 percent, and if the expected average inflation rate over the next 2 years is 11 percent, what is the implied expected inflation rate during Year 3?

A) 7%
B) 8%
C) 9%
D) 17%
E) 18%

Question 37

Other things held constant,:

A) the "liquidity preference theory" would generally lead to an upward sloping yield curve.
B) the "market segmentation theory" would generally lead to an upward sloping yield curve.
C) the "expectations theory" would generally lead to an upward sloping yield curve.
D) the yield curve under "normal" conditions would be horizontal (i.e., flat).
E) a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.

Question 38

You read in The Wall Street Journal that 30-day T-bills are currently yielding 8 percent. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:
Inflation premium 5%
Liquidity premium 1%
Maturity risk premium 2%
Default risk premium 2%
Based on these data, the real risk-free rate of return is:

A) 0%.
B) 1%.
C) 2%.
D) 3%.
E) 4%.

Question 39

Which of the following bonds have the highest default risk for a given return?

A) A U.S Treasury bond with a 2-year maturity.
B) An AAA corporate bond with a 7-year maturity.
C) A BBB corporate bond with a 3-year maturity.
D) A CCC corporate bond with a 10-year maturity.
E) An AAA corporate bond with a 3-year maturity.

Question 40

Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5% in each of the next three years and 6% each year after the third year. The maturity risk premium is estimated to be 0.1% × (t - 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero). The real risk-free rate is assumed to be constant over time. What is the real risk-free rate of interest?

A) 0.25%
B) 0.50%
C) 1.00%
D) 1.75%
E) 2.50%

Question 41

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

A) The yield on the 10-year bond is less than the yield on a 1-year bond.
B) The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums.
C) It is impossible to tell without knowing the coupon rates of the bonds.
D) The yields on the two bonds are equal.
E) It is impossible to tell without knowing the relative risks of the two bonds.

Question 42

The existence of an upward sloping yield curve proves that the _____ is correct, because an upward sloping curve necessarily implies that lenders will lend short-term funds at lower rates than they lend long-term funds.

A) liquidity preference theory
B) expectations theory
C) market segmentation theory
D) open market theory
E) reinvestment theory

Question 43

If the Federal Reserve loosens money supply then:

A) inflation will decrease.
B) interest rates will decrease.
C) sale of Treasury securities will increase.
D) credit supply will decrease.
E) economic activity will decrease.

Question 44

During _____, both the demand for money and the rate of inflation tend to fall, which prompts the Fed to increase the money supply, and as a result, interest rates decline.

A) expansions
B) a fiscal deficit
C) recessions
D) economic booms
E) a foreign trade deficit

Question 45

Open market operations are operations in which:

A) the municipal authorities bring out policies that provide better social security benefits.
B) the government improves the infrastructure of the economy to attract foreign investors.
C) the Federal Reserve buys or sells Treasury securities to expand or contract the U.S. money supply.
D) private companies establish agencies to trade their stocks in the market.
E) the public establishes a non-profit entity to trade in the market on behalf of the community.

Question 46

A normal yield curve that is upward sloping implies that:

A) the returns on short-term securities are higher than the returns on long-term securities of similar risk.
B) the returns on long-term securities are equal to the returns on short-term securities of similar risk.
C) the returns on short-term securities are lower than the returns on long-term securities of similar risk.
D) the returns on bonds with higher maturity risks are lower than the returns on bonds with lower maturity risks.
E) the returns on bonds with a lower default risks are higher than the returns on bonds with higher default risks.

Question 47

Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero. If the annual rate of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what rate of interest should you expect on a 1-year Treasury bond one year from now?

A) 9.0%
B) 9.5%
C) 10.0%
D) 10.5%
E) 11.0%

Question 48

The Federal Reserve purchases U.S. Treasury securities to:

A) loosen the money supply.
B) reduce the credit availability.
C) increase the interest rates.
D) decrease the inflation.
E) increase the tax rates.

Question 49

When the economy is expanding too quickly and the Federal Reserve (Fed) wants to control future growth in the economy, the Fed will:

A) decrease the money supply.
B) reduce the taxes levied on the public.
C) increase the expenditure incurred in social benefits.
D) purchase securities from the public.
E) provide subsidies to the corporations.

Question 50

Which of the following factors will lead to an increase in interest rates?

A) Deflation
B) Federal deficit
C) Contraction
D) Recession
E) Trade surplus

Question 51

Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7% respectively. Assume that the pure expectations theory holds and that the market is in equilibrium. Which of the following statements is correct?

A) The maturity risk premium is positive.
B) Interest rates are expected to fall over the next two years.
C) The market expects one-year rates to be 7% one year from today.
D) The default risk premium is highest for Year 2.
E) The liquidity risk premium is highest for Year 1.

Question 52

If the U.S. runs a large foreign trade deficit, then the:

A) sales of Treasury securities will decrease.
B) interest rates will increase.
C) government subsidies will increase.
D) money supply will increase.
E) tax revenue will decrease.

Question 53

Assume that the current yield curve is upward sloping or normal. This implies that

A) short-term interest rates are more volatile than long-term rates.
B) inflation is expected to subside in the future.
C) the economy is at the trough of a business cycle.
D) long-term bonds are less attractive to investors than short-term bonds.
E) short-term interest rates are lower than the long-term interest rates.

Question 54

If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates?

A) Prices and interest rates will both rise.
B) Prices will rise and interest rates will decline.
C) Prices and interest rates will both decline.
D) Prices will decline and interest rates will rise.
E) There will be no changes in either prices or interest rates.

Question 55

Assume that the current interest rate on a 1-year bond is 8 percent, the current rate on a 2-year bond is 10 percent, and the current rate on a 3-year bond is 12 percent. If the expectations theory of the term structure is correct, what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average.)

A) 12.0%
B) 16.0%
C) 13.5%
D) 10.5%
E) 14.0%

Question 56

During periods of _____, the general tendency is toward higher interest rates.

A) inflation
B) recession
C) contraction
D) fiscal surplus
E) monetary deficit

Question 57

Which of the following actions of the Federal Reserve will reduce federal deficit?

A) Lending more money.
B) Purchase of securities.
C) Printing money.
D) Reduction of taxes.
E) Increase expenditures.

Question 58

A federal deficit occurs when:

A) a government issues securities to the public.
B) stock prices of private companies decrease.
C) social security benefits given to citizens are reduced.
D) a government's expenses are more than its tax revenues.
E) money supply in the market is low.

Question 59

If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are invalid, and we observe a downward sloping yield curve, which of the following is a true statement?

A) Investors expect interest rates to be constant over time.
B) Investors expect interest rates to increase in the future.
C) Investors expect interest rates to decrease in the future.
D) Investors require a positive maturity risk premium.
E) The maturity risk premium must be positive.

Question 60

Other things constant, the larger the federal deficit,:

A) the lower the level of expenses of a country.
B) the higher the level of income of a country.
C) the lower the level of tax rates.
D) the lower the level of inflation rate.
E) the higher the level of interest rates.

Question 61

If a stock pays a dividend of $10 and the investors need 8% return on their investment, then the investors should pay _____ for the stock.

A) $150
B) $200
C) $350
D) $125
E) $75

Question 62

The value of an asset is determined by discounting the future cash flows generated by the asset using the:

A) tax rate.
B) interest rate.
C) inflation rate.
D) deficit rate.
E) surplus rate.

Question 63

A foreign trade deficit occurs when a country's:

A) imports are greater than its exports.
B) tax revenue is greater than its expenditure.
C) savings rate is higher than its borrowing rate.
D) purchase of Treasury securities is more than sale of Treasury securities.
E) cash reserves are higher than the expenses.