Deck 6: Interest Rates and Bond Valuation

Question 1

The nominal rate of interest is the rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation, where funds suppliers and demanders have no liquidity preference and all outcomes are certain.

Answer 1

False

Question 2

The real rate of interest is the actual rate of interest charged by the suppliers of funds and paid by the demanders.

Answer 2

False

Question 3

An inverted yield curve is downward-sloping and indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

Answer 3

True

Question 4

During the past twenty years, the rate of return on U.S. treasury bills always exceeded the rate of inflation as measured by the consumer price index.

Question 5

The term structure of interest rates is the graphical presentation of the relationship between the annual rate of interest earned on a security purchased on a given day and held to maturity and the remaining time to maturity.

Question 6

An inverted yield curve is upward-sloping and indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

Question 7

A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Question 8

The nominal rate of interest is equal to the sum of the real rate of interest plus an inflation premium plus a risk premium.

Question 9

The longer the maturity of a Treasury (or any other) security, the smaller the interest rate risk.

Question 10

The nominal rate of interest is equal to the sum of the real rate of interest plus the risk free rate of interest.

Question 11

The real rate of interest is the compensation paid by the borrower of funds to the lender. From the borrower's point of view, the real rate represents the cost of borrowing funds.

Question 12

An inverted yield curve is a downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

Question 13

A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Question 14

The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities; this causes the yield curve to be upward-sloping.

Question 15

In theory, the rate of return on U.S. treasury bills should always exceed the rate of inflation as measured by the consumer price index.

Question 16

Although Treasury securities have no risk of default or illiquidity, they do suffer from "maturity risk"the risk that interest rates will change in the future and thereby impact longer maturities more than shorter maturities.

Question 17

An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Question 18

A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a normal yield curve.

Question 19

Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term loans relative to their respective demand.

Question 20

The risk free rate of interest is equal to the sum of the real rate of interest plus an inflation risk premium.

Question 21

________ yield curve reflects lower expected future rates of interest.

A) An upward-sloping
B) A flat
C) A downward-sloping
D) A linear

Question 22

________ yield curve reflects higher expected future rates of interest.

A) An upward-sloping
B) A flat
C) A downward-sloping
D) A linear

Question 23

The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

Question 24

Generally, an increase in risk will result in ________ required return or interest rate.

A) a lower
B) a higher
C) an unchanged
D) an undetermined

Question 25

The ________ is the annual rate of interest earned on a security purchased on a given date and held to maturity.

A) term structure
B) yield curve
C) risk-free rate
D) yield to maturity

Question 26

The liquidity preference theory suggests that short-term rates should be lower than long-term rates.

Question 27

The ________ rate of interest is the actual rate charged by the supplier and paid by the demander of funds.

A) nominal
B) real
C) risk-free
D) inflationary

Question 28

The reason for a difference in the yield between a Aaa corporate bond and an otherwise identical Baa bond is the risk premium; the real interest rate and the inflation rate is the same for both.

Question 29

A yield curve that reflects relatively similar borrowing costs for both short-term and long-term loans is called

A) normal yield curve.
B) inverted yield curve.
C) flat yield curve.
D) none of the above.

Question 30

The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called maturity risk.

Question 31

A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs is called

A) normal yield curve.
B) inverted yield curve.
C) flat yield curve.
D) none of the above.

Question 32

The nominal rate of interest is composed of

A) the real rate plus an inflationary expectation.
B) the real rate plus a risk premium.
C) the risk-free rate plus an inflationary expectation.
D) the risk-free rate plus a risk premium.

Question 33

The ________ rate of interest creates equilibrium between the supply of savings and the demand for investment funds.

A) nominal
B) real
C) risk-free
D) inflationary

Question 34

The ________ rate of interest is typically the required rate of return on a three-month U.S. Treasury bill.

A) nominal
B) real
C) risk-free
D) premium

Question 35

The ________ is/are a graphic depiction of the term structure of interest rates.

A) yield curve
B) supply and demand functions
C) risk-return profile
D) aggregate demand curve

Question 36

Generally, long-term loans have higher interest rates than short-term loans because of

A) the general expectation of higher future rates of inflation.
B) lender preferences for shorter-term, more liquid loans.
C) greater demand for long-term rather than short-term loans relative to the supply of such loans.
D) all of the above.

Question 37

The liquidity preference theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

Question 38

The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called default risk.

Question 39

The expectations theory suggests that the shape of the yield curve reflects investors expectations about future inflation rates.

Question 40

An upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs is called

A) normal yield curve.
B) inverted yield curve.
C) flat yield curve.
D) none of the above.

Question 41

The risk premium over and above the risk free rate consists of a number of components, including all of the following EXCEPT

A) default risk.
B) inflation risk.
C) tax treatment risk.
D) liquidity risk.

Question 42

At any time, the slope of the yield curve is affected by

A) inflationary expectations.
B) liquidity preferences.
C) the comparative equilibrium of supply and demand in the short-term and long-term market segments.
D) all of the above.

Question 43

Restrictive covenants are contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower.

Question 44

Restrictive covenants, coupled with standard debt provisions, allow the lender to monitor and control the borrower's activities in order to protect itself against increases in borrower risk.

Question 45

In a practical sense, the longer the term of a bond, the greater the default risk associated with the bond.

Question 46

The theory that explains only the tendency for the yield curve to be upward sloping is

A) expectations hypothesis.
B) liquidity preference theory.
C) market segmentation theory.
D) investor perception theory.

Question 47

The yield curve in an economic period where lower future inflation is expected would most likely be

A) upward-sloping.
B) flat.
C) downward-sloping.
D) linear.

Question 48

Standard debt provisions specify certain criteria of satisfactory record keeping and reporting, tax payment, and general business maintenance on the part of the lending firm.

Question 49

To carry out the sinking fund requirements, corporations often make semi-annual or annual payments to trustees, who uses these funds to retire bonds by purchasing them in the marketplace.

Question 50

A trustee is a paid party representing the bond issuer in the bond indenture.

Question 51

The purpose of the restrictive debt covenant that imposes fixed assets restrictions is to limit the amount of fixed-payment obligations.

Question 52

What is the nominal rate of return on an IBM bond if the real rate of interest is 3 percent, the inflation risk premium is 2 percent, the U.S. T-bill rate is 5 percent, the maturity risk premium on the IBM bond is 3 percent, the default risk premium on the IBM bond is 2 percent, and the liquidity risk premium on the bond is 1 percent?

A) 16%
B) 13%
C) 11%
D) 9%

Question 53

Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.

Question 54

The theory suggesting that for any given issuer, long-term interest rates tends to be higher than short-term rates is called

A) expectation hypothesis.
B) liquidity preference theory.
C) market segmentation theory.
D) none of the above.

Question 55

Nico bought an investment one year ago and just calculated his return on investment. He found that his purchasing power had increased by 15 percent as a result of his investment. If inflation during the year was 4 percent, then Nico's ________.

A) real return on investment is more than 15 percent
B) nominal return on investment is more than 15 percent
C) nominal return on investment is less than 11 percent
D) real return on investment is equal to 4 percent

Question 56

Consider the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based on this information, the shape of the yield curve is

A) upward sloping.
B) downward sloping.
C) flat.
D) normal.

Question 57

The three theories cited to explain the general shape of the yield curve are all of the following EXCEPT

A) expectations hypothesis.
B) market segmentation theory.
C) liquidity preference theory.
D) security markets theory.

Question 58

The size of the bond offering and the cost of issuing the bond (as a percentage of the amount raised) are inversely related.

Question 59

The yield curve in an economic period where higher future inflation is expected would most likely be

A) upward-sloping.
B) flat.
C) downward-sloping.
D) linear.

Question 60

Nico Nelson, a management trainee at a large New York-based bank is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent and has decided to use the consumer price index as a proxy for expected inflation. What is the estimated real rate of interest if the CPI is currently 2 percent?

A) 5%
B) 1%
C) 3%
D) 2%

Question 61

Restrictive covenants, which are also known as standard debt provisions, place operating and financial constraints on the borrower.

Question 62

All of the following are examples of long-term debt EXCEPT

A) bonds.
B) lines of credit.
C) term loans.
D) debentures.

Question 63

________ is a paid individual, corporation, or commercial bank trust department that acts as a third party to a bond indenture to ensure that the issuer does not default on its contractual responsibilities to the bondholders.

A) A trustee
B) An investment banker
C) A bond issuer
D) A bond rating agency

Question 64

The length of the maturity on a bond offering affects its cost. In general, the longer the maturity, the lower the cost.

Question 65

A debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms is called a

A) discount bond.
B) corporate bond.
C) bond indenture.
D) treasury bond.

Question 66

An example of a standard debt provision is the

A) limiting of the corporation's annual cash dividend payments.
B) requirement to pay taxes and other liabilities when due.
C) restricting the corporation from disposing of fixed assets.
D) constraints on subsequent borrowing.

Question 67

The legal contract setting forth the terms and provisions of a corporate bond is a(n)

A) indenture.
B) debenture.
C) loan document.
D) promissory note.

Question 68

A ________ is a restrictive provision on a bond which provides for the systematic retirement of the bonds prior to their maturity.

A) redemption clause
B) sinking-fund requirement
C) conversion feature
D) subordination clause

Question 69

The major factor(s) affecting the cost, or interest rate, on a bond is (are) its

A) maturity.
B) size of the offering.
C) issuer risk.
D) basic cost of money.
E) all of the above

Question 70

A sinking-fund requirement is a restrictive provision often included in a bond indenture providing for periodic payments representing only interest and a large lump-sum payment at the maturity of the loan representing the entire loan principal.

Question 71

The purpose of the restrictive debt covenant that requires maintaining a minimum level of net working capital is to

A) protect the lender by controlling the risk and marketability of the borrower's security investment alternatives.
B) limit the amount of fixed-payment obligations.
C) ensure a cash shortage does not cause an inability to meet current obligations.
D) prevent liquidation of assets through large salary increases of key employees.

Question 72

In a bond indenture, the term security interest refers to the fact that most firms that issue bonds are required to establish sinking fund provisions to protect bondholders.

Question 73

The cost of long-term debt generally ________ that of short-term debt.

A) is less than
B) is equal to
C) is greater than
D) has no relation to

Question 74

The length of the maturity on a bond offering affects its cost. In general, the longer the maturity, the higher the cost.

Question 75

All of the following are examples of restrictive debt covenants EXCEPT

A) prohibition on selling accounts receivable.
B) supplying the creditor with audited financial statements.
C) constraint on subsequent borrowing.
D) prohibition on entering certain types of lease arrangements.

Question 76

All of the following are examples of standard debt provisions EXCEPT

A) maintaining all facilities in good working order.
B) paying taxes and liabilities when due.
C) maintaining satisfactory accounting records.
D) limiting the annual dividend payment.

Question 77

In a bond indenture, the term security interest refers to collateral pledged against the bond.

Question 78

A ________ is a complex and lengthy legal document stating the conditions under which a bond has been issued.

A) bond debenture
B) warrant
C) sinking fund
D) bond indenture

Question 79

If a bond pays $1,000 plus interest at maturity, $1,000 is called the

A) stated value.
B) market value.
C) par value.
D) long-term value.

Question 80

All of the following are examples of restrictive debt covenants EXCEPT

A) limiting the firm's annual cash dividend payments.
B) supplying audited financial records.
C) prohibiting combinations with other firms.
D) management restrictions to maintaining certain key employees.