Deck 5: The Cost of Money Interest Rates

Question 1

_____ 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

Answer 1

  E

Question 2

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

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

Answer 2

  C

Question 3

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

A)42 percent.
B)53 percent.
C)81 percent.
D)60 percent.
E)72 percent.

Answer 3

  D

Question 4

_____ is the tendency of prices to increase over time. 

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

Question 5

Everything else equal, which of the following actions would tend to increase interest rates in the financial markets?

A)Investors' time preferences for consumption increase.
B)Investors are exposed to fewer economic risks.
C)Production opportunities decrease throughout the economy.
D)The overall creditworthiness of borrowers improves significantly.
E)The default probabilities of corporations decline substantially.

Question 6

Everything else the same, the higher the expected rate of inflation, _____. 

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

Question 7

The production opportunities that exist in the economy represents one of the four fundamental factors that affect the:

A)creditworthiness of investors.
B)cost of money.
C)liquidity of securities.
D)political risk that is inherent in an economy.
E)maturity of an investment.

Question 8

Which of the following statements describes a liquidity premium?

A)It is a premium added by investors to the real risk-free rate of return to account for inflation that is expected to exist during the life of an investment.
B)It is a premium that denotes the difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability.
C)It is a premium that investors add to account for the risk of fluctuations in the interest rate of an investment.
D)It is a premium investors add to the real risk-free rate of return to account for the risk of longer maturity bonds having greater default risks.
E)It is a premium that is added to the rate on a security if the security cannot be converted to cash on short notice at a price that is close to the original cost.

Question 9

In the financial market context, _____ 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 10

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 is expected to decrease in the future, then the yield curve should have an upward slope.

Question 11

Which of the following is true of the real risk-free rate of interest?

A)Most experts think that the real risk-free rate fluctuates in the range of 15 to 20 percent in the United States.
B)The real risk-free rate must include a component for the average inflation.
C)The real risk-free rate is the sum of nominal rate of interest and the average inflation rate.
D)It is easy to measure the real risk-free rate precisely.
E)It is the rate of interest that would exist on default-free U.S. Treasury securities if no inflation were expected in the future.

Question 12

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 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)An AAA bond with 5 years to maturity
E)A BBB bond with 5 years to maturity

Question 13

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%
B)9%
C)8%
D)5%
E)7%

Question 14

Assume that a three-year Treasury note (T-note) has no maturity premium, and that the real risk-free rate of interest is 3 percent. If the T-note carries a nominal risk-free rate of return of 13 percent and if the expected average inflation rate over the next two years is 9 percent, what is the implied expected inflation rate during Year 3?

A)7%
B)12%
C)9%
D)11%
E)18%

Question 15

Assume that real risk-free rate (r*) = 1.00%; the maturity risk premium is found as MRP = 0.20% × (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 (LP) is 0.50 percent for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7 percent, 6 percent, and 5 percent during the next three years and then 4 percent thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds? (Round answer to two decimal places.)

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

Question 16

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 percent.
B)1 percent.
C)2 percent.
D)3 percent.
E)4 percent.

Question 17

Assume that the real risk-free rate is 4 percent, and that inflation is expected to be 9 percent in Year 1, 6 percent in Year 2, and 4 percent 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 percent, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 - MRP2? (Round answer to one decimal place.)

A)2.1%
B)1.8%
C)0.5%
D)3.1%
E)2.6%

Question 18

Treasury securities that mature in 6 years currently have an interest rate of 8.50 percent. Inflation is expected to be 5 percent in each of the next three years and 6 percent each year thereafter. The maturity risk premium is estimated to be 0.10% × (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)5.50%
B)0.50%
C)1.00%
D)1.75%
E)2.50%

Question 19

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

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

Question 20

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

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

Question 21

Following is information about three bonds:
? $\begin{array} { l l c } { \text { Issuer } } & \text { Yield } & \text { Time to Maturity } \\\hline\text { Treasury } & 2.0 \% & 6 \text { months } \\\text { Company A } & 5.0 & 5 \text { years } \\\text { Company B } & 5.3 & 8 \text { years }\end{array}$
?
Although none of the bonds has a liquidity premium, any bond with a maturity equal to one year or greater has a maturity risk premium (MRP). Except for their terms to maturity, the characteristics of the Company A and Company B bonds are the same (including their default risk). The average inflation rate is expected to remain constant during the next 10 years. What is the default risk premium (DRP) associated with the bonds issued by Company A and Company B?

A)3.0%
B)0.3%
C)0.6%
D)3.2%
E)2.5%

Question 22

Which of the following statements is true?

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

Question 23

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

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

Question 24

Following are the yields on selected Treasury securities:
$\begin{array}{cc}\text { Maturity } & \text { Yield } \\\hline \text { 2 years } & 1.6 \% \\\text { 3 years } & 2.2 \\\text { 4 years } & 2.4\end{array}$
?Using the expectations theory, compute the expected one-year interest rate in Year 3. That is, compute the rate that is expected to exist only during Year 3. (Base your answer on an arithmetic average rather than a geometric average.)

A)2.2%
B)1.6%
C)3.4%
D)1.9%
E)3.0%

Question 25

Which of the following statements is correct?

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

Question 26

Which of the following bonds has the greatest default risk?

A)A U.S Treasury bond with a two-year maturity
B)An AAA corporate bond with a seven-year maturity
C)A BBB corporate bond with a three-year maturity
D)A CCC corporate bond with a 10-year maturity
E)An AAA corporate bond with a 10-year maturity

Question 27

You are given the following data:
$\begin{array} {| l | c | } \hline r ^ { * } = \text { real risk-free rate } & 4 \% \\\hline \text { Constant inflation premium (IP) } & 7 \% \\\hline \text { Maturity risk premium (MRP) } & 1 \% \\\hline \text { Default risk premium for AAA bonds (DRP) } & 3 \% \\\hline \begin{array} { l } \text { Liquidity premium for long-term Treasury } \\\text { bonds (T-bonds) (LP) }\end{array} & 2 \% \\\hline\end{array}$
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 percent
B)11 percent
C)14 percent
D)19 percent
E)27 percent

Question 28

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 29

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 30

Securities that can be easily converted into cash on short notice at a price that is close to the original cost generally have a:

A)low liquidity premium.
B)high maturity risk premium.
C)high inflation premium.
D)low budget risk premium.
E)high real risk premium.

Question 31

Which of the following is true of the market segmentation theory?

A)According to the market segmentation theory, the shape of the yield curve depends on investors' expectations about future inflation rates.
B)According to the market segmentation theory, the yield curve can only be upward sloping at any given time.
C)According to the market segmentation theory, lenders prefer to make short-term loans rather than long-term loans.
D)According to the market segmentation theory, the yield curve can only be flat at any given time.
E)According to the market segmentation theory, the slope of the yield curve depends on supply/demand conditions of a security in the long- and short-term markets.

Question 32

The current interest rate on a one-year bond is 4 percent and the current rate on a two-year bond is 4.4 percent. If the expectations theory of the term structure is correct, what is the one-year interest rate expected during Year 2? That is, compute the rate that is expected to exist only during Year 2. (Base your answer on an arithmetic average rather than a geometric average.)

A)4.8%
B)4.2%
C)4.4%
D)0.4%
E)8.4%

Question 33

The _________ theory that has been developed to explain the shape of the yield curve suggests that the curve should normally be upward sloping, because, everything else equal, an upward sloping curve implies that lenders prefer to lend short-term funds at lower rates than they lend long-term funds. 

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

Question 34

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

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

Question 35

Assume that the expectations theory holds and that liquidity and maturity risk premiums are zero. The annual rate of interest on a two-year Treasury bond is 10.5 percent and the rate on a one-year Treasury bond is 12 percent. What is the expected one-year interest rate during the second year?

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

Question 36

Following is information about three bonds:
?
?  $\begin{array} { l l c } { \text { Issuer } } & \text { Yield } & \text { Time to Maturity } \\\hline\text { Treasury } & 2.0 \% & 6 \text { months } \\\text { Company A } & 5.0 & 5 \text { years } \\\text { Company B } & 5.3 & 8 \text { years }\end{array}$
?
Although none of the bonds has a liquidity premium, any bond with a maturity equal to one year or greater has a maturity risk premium (MRP). Except for their terms to maturity, the characteristics of the Company A and Company B bonds are the same (including their default risk). The average inflation rate is expected to remain constant during the next 10 years. What is the annual MRP?

A)0.1%
B)1.1%
C)1.0%
D)0.7%
E)4.1%

Question 37

Everything else the same, 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 one-year Treasury bond (T-bond)?

A)The yield on the 10-year bond is less than the yield on a one-year bond.
B)The yield on a 10-year bond will always be higher than the yield on a one-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 38

The yield on a one-year Treasury bond is 5 percent, and the yield on a two-year Treasury bond is 6 percent. 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 negative.
B)Interest rates are expected to fall over the next two years by 3 percent.
C)The market expects one-year interest rate during the second year to be 7 percent.
D)The default risk premium is highest for Year 2.
E)The liquidity risk premium is highest for Year 1.

Question 39

Assume that the expectations theory of the term structure of interest rates is correct, and other term structure theories are invalid. If a downward sloping yield curve is observed, which of the following is a correct 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 negative maturity risk premium.
E)The inflation premium must be greater than 2 percent.

Question 40

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

A)12%
B)16%
C)13%
D)10%
E)14%

Question 41

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 on social benefits.
D)purchase securities from the public.
E)provide subsidies to the corporations.

Question 42

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 43

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 44

Which of the following is true of federal deficit?

A)Other things held constant, the larger the federal deficit, the lower the level of government expenses.
B)Other things held constant, the larger the federal deficit, the higher the level of the national income.
C)Other things held constant, the larger the federal deficit, the more taxes the government collects.
D)Other things held constant, the larger the federal deficit, the lower the inflation rate in the economy of a country.
E)Other things held constant, the larger the federal deficit, the higher the level of interest rates on borrowings.

Question 45

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 46

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

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

Question 47

Everything else equal, if the United States runs a large foreign trade deficit, the financing of the deficit will:

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

Question 48

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

A)inflation
B)recession
C)contraction
D)fiscal surplus
E)securitization

Question 49

Bonds with higher liquidity must offer higher interest rates in the market, because such investments can be easily converted into cash on short notice at or near the amounts originally invested. 

Question 50

A federal deficit occurs when _____. 

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

Question 51

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 52

Open market operations occur when _____. 

A)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 53

Inflation leads to an increase in the purchasing power of investors. 

Question 54

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

Question 55

The higher the perceived risk associated with an investment, the higher its required rate of return. 

Question 56

If the Federal Reserve loosens the money supply to control growth in the economy, _____. 

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 57

A foreign trade deficit occurs when a country's _____. 

A)imports are greater than its exports
B)tax revenues are greater than its expenditures
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 its expenses

Question 58

During _____, both the demand for money and the rate of inflation tend to fall, which prompts the Fed to take actions to decrease interest rates. 

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

Question 59

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

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

Question 60

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

Question 61

During or near peaks of business activity, yield curves generally are either flat or downward sloping. 

Question 62

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

Question 63

Everything else equal, as a country increases its borrowing to finance its foreign trade deficit, interest rates will be driven up. 

Question 64

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

Question 65

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

Question 66

A deficit trade balance hinders the Federal Reserve's ability to lower interest rates when combatting a recession. 

Question 67

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

Question 68

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