Deck 6: Interest Rates and Bond Valuation

Question 1

A real rate of interest is the compensation paid by the borrower of funds to the lender measured in today's dollars.

Answer 1

False

Question 2

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

Answer 2

False

Question 3

The liquidity preference theory suggests that short-term interest rates should be lower than long-term interest rates most of the time.

Answer 3

True

Question 4

Historically,the rate of return on U.S.Treasury bills is usually greater than the rate of inflation.

Question 5

An interest rate or a required rate of return represents the cost of money.

Question 6

A flat yield curve means that the rates do not vary much at different maturities.

Question 7

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

Question 8

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

Question 9

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

Question 10

The nominal rate of interest on a bond is 8% and the expected inflation premium is 4%.This results in an approximate real rate of interest of 4% on the bond.

Question 11

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 12

An inverted yield curve is a downward-sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.

Question 13

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

Question 14

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 15

The term structure of interest rates is a graphical presentation of the relationship between the maturity and rate of return.

Question 16

The nominal interest rate on a risk-free investment is approximately equal to the sum of the real rate of interest plus an inflation premium.

Question 17

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 18

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

Question 19

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

Question 20

The nominal interest rate on a risky investment equals the risk-free rate plus a risk premium.

Question 21

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

Question 22

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

A)normal yield curve
B)inverted yield curve
C)flat yield curve
D)lognormal curve

Question 23

Ai Lun,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 consumer prices have been rising steadily at a 2% rate for several years.What should Ai Lun's estimate of the real rate be?

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

Question 24

The term structure of interest rates is the relationship between ________.

A)the present value of principal and coupon rate of the bonds
B)the general expectation of inflation and nominal rate of return for bonds
C)the general expectation of inflation and real rate of return for bonds
D)the maturity and rate of return for bonds with similar level of risk

Question 25

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)interest parity theory

Question 26

The components of risk premium includes business risk,financial risk,interest rate risk,liquidity risk,and tax risk.

Question 27

The ________ rate of interest is the rate that balances the supply of savings and the demand for investment funds.

A)Nominal
B)Real
C)Risk-free
D)Equilibrium

Question 28

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

Question 29

According to the expectations hypothesis,a(n)________ yield curve reflects higher expected future rates of interest.

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

Question 30

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

A)normal yield curve
B)inverted yield curve
C)flat yield curve
D)lognormal yield curve

Question 31

Generally,an increase in risk will result in ________.

A)a lower required return or interest rate
B)a higher required return or interest rate
C)a higher inflation premium
D)a lower real interest rate

Question 32

According to the expectations hypothesis,a(n)________ yield curve reflects lower expected future rates of interest.

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

Question 33

A(n)________ is a graphic depiction of the relation between the maturity and rate of return for bonds with similar risks.

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

Question 34

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

Question 35

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

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

Question 36

Although no investment is truly risk free,________ are generally viewed as the closest thing we can come to in the real world to a risk-free investment.

A)U.S.Treasury securities
B)AAA-rated corporate bonds
C)secured bonds
D)zero-coupon bonds

Question 37

Nico invested an amount a year ago and 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 38

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 39

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)linear yield curve

Question 40

The liquidity preference theory suggests that long-term interest rates tend to be higher than short-term rates (and therefore the yield curve slopes up)due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities.

Question 41

Current interest rates on bonds of different maturities look like this:
Maturity Rate
1-year 2.50%
2-year 2.75%
3-year 3.00%
If the expectations hypothesis is true,what interest rate would you expect a 2-year bond to pay,1 year from now?

Question 42

Which of the following explains the general shape of the yield curve?

A)Expectations theory
B)Perfect market theory
C)Capital asset pricing theory
D)Securities market theory

Question 43

Standard debt provisions specify certain record keeping and general business practices that must be followed by the bond issuer.

Question 44

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

Question 45

Suppose the expectations hypothesis is true.The interest rate on a bond maturing in one year is 2%,and the interest rate on a bond maturing in two years is 3%.The interest rate that investors expect next year on a one-year bond is ________.

A)2%
B)3%
C)4%
D)5%

Question 46

Restrictive covenants,coupled with standard debt provisions,help the lender to monitor the borrower's activities to ensure efficient use of funds.

Question 47

________ mainly explains the tendency for the yield curve to be upward sloping.

A)Expectations theory
B)Liquidity preference theory
C)Market segmentation theory
D)Investor perception theory

Question 48

The reason for a difference in the yield between a Aaa corporate bond and an otherwise identical Baa bond is the risk premium; other things being equal.

Question 49

In a bond indenture,subordination is the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

Question 50

Which of the following affects the slope of yield curve?

A)tax rates
B)dividend policy
C)selection of accounting standards
D)liquidity preferences

Question 51

Current interest rates on bonds of different maturities look like this:
Maturity Rate
1-year 2.50%
2-year 2.75%
3-year 3.00%
If the expectations hypothesis is true,what interest rate would you expect a 1-year bond to pay,2 years from now?

Question 52

Suppose the expectations hypothesis is true.The current rate of return on a one-year bond is 3%,and the current rate of return on a 2-year bond is 2.5%.What is the expected rate of return next year on a one-year bond?

A)2%
B)0.5%
C)1.5%
D)1%

Question 53

The coupon rate on a bond represents the percentage of the bond's par value that will be paid annually,typically in two equal semiannual payments,as interest.

Question 54

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

Question 55

Jeff is trying to forecast what the annual interest rate on a three-year bond will be two years from now,and he believes that the expectations hypothesis is the basis upon which he should build his forecast.Currently the rates of return on bonds of different maturities look like this: Maturity Rate
1-year 3.00%
2-year 3.50%
3-year 3.75%
4-year 4.00%
5-year 4.00%
Based on the expectations hypothesis,what forecast should Jeff make for the return on a three-year bond,two years in the future?

A)4.0%
B)4.25%
C)4.33%
D)13%

Question 56

Assume 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

Suppose the expectations hypothesis is true.If the yield curve is flat this means that ________.

A)investors do not expect interest rates to change in the future
B)investors expect interest rates to rise in the future
C)investors expect interest rates to fall in the future
D)investors do not require a premium for expected inflation

Question 58

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

Question 59

Explain liquidity risk,default risk,and interest rate risk.

Question 60

Which of the following is TRUE of the risk premium?

A)T-bills have a have a higher risk premium compared with Treasury bonds.
B)Government bonds have a higher risk premium compared with corporate bonds.
C)Junk bonds have a lower risk premium investment-grade bonds.
D)The lower-rated corporate issues have a higher risk premium than that of the higher rated corporate issues.

Question 61

Bond indentures include restrictive covenants.These provisions protect the bondholders against ________.

A)increase in inflation rate
B)increase in borrower's risk
C)decrease in liquidity risk
D)maturity risk

Question 62

________ means that subsequent creditors agree to wait until all claims of the are senior debt satisfied before having their claims satisfied.

A)Security interest
B)Subordination
C)Sinking fund requirement
D)Bond indenture

Question 63

The purpose of the restrictive debt covenant that requires that subsequent borrowing be subordinated to the original loan is to ________.

A)maintain a minimum level of liquidity
B)limit the amount of fixed-payment obligations
C)ensure a long-run cash shortage does not cause an inability to meet current obligations
D)protect the original lender in the priority of claims during liquidation

Question 64

Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

Question 65

The purpose of the restrictive debt covenant that imposes fixed assets restrictions 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 the firm from liquidation and ensure its ability to repay the debt

Question 66

An example of a standard debt provision is to ________.

A)limit the corporation's annual cash dividend payments
B)pay taxes and other liabilities when due
C)restrict the corporation from disposing of fixed assets
D)maintain a minimum level of liquidity

Question 67

The purpose of the debt covenant that prohibits borrowers from entering into certain types of leases is to ________.

A)protect the lender by controlling the risk and marketability of the borrower's security investments alternatives
B)limit the amount of fixed-payment obligations
C)ensure a cash shortage does not cause an inability to meet current obligations
D)limit the annual cash dividends paid by the firm

Question 68

The bond indenture identifies any collateral pledged against a bond and specifies how it is to be maintained.

Question 69

Restrictive covenants place operating and financial constraints on the borrower.

Question 70

The purpose of the 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)limit the annual cash dividends paid by the firm

Question 71

The lower a bond's default risk,the higher is the interest rate.

Question 72

A ________ is a restrictive provision in a bond indenture,providing 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 73

In most cases,the longer the maturity of a bond,the higher is the cost of a bond to the issuer.

Question 74

The purpose of the restrictive debt covenant that prohibits the sale of accounts receivable is to ________.

A)assure the lender that additional borrowing is constrained
B)limit the amount of fixed-payment obligations
C)prevent the firm from selling current assets to raise cash to pay current obligations
D)limit the payment of annual cash dividends

Question 75

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(n)________.

A)common stock
B)corporate bond
C)indenture
D)preferred stock

Question 76

Which of the following is a restrictive covenant?

A)to maintain satisfactory accounting records
B)to pay the taxes due
C)to supply audited financial statements
D)to impose fixed asset restrictions

Question 77

A sinking-fund requirement requires a corporate to make semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.

Question 78

The purpose of the restrictive debt covenant that limits the distribution of profits to shareholders is to ________.

A)assure the lender that additional borrowing is constrained or may be subordinated to the original loan
B)limit the amount of fixed-payment obligations
C)ensure a cash shortage does not cause an inability to meet current obligations
D)avoid default of payments to bondholders

Question 79

A(n)________ is a paid individual,corporation,or a commercial bank trust department that acts as a third party to a bond indenture.

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

Question 80

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