Exam 6: Interest Rates

Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?

If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*.

Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? The cross-product term should be considered , i.e., if averaging is required, use the geometric average.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.

Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds?

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward-sloping yield curve.

Koy Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Koy's bonds?

An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal."

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT?

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2 year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

Which of the following statements is CORRECT?

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 4.10%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Assuming the pure expectations theory is correct, which of the following statements is CORRECT?

The risk that interest rates will decline, and that decline will lead to a decline in the income provided by a bond portfolio as interest and maturity payments are reinvested, is called "reinvestment rate risk."