Exam 6: Interest Rates

Short Corp just issued bonds that will mature in 10 years,and Long Corp issued bonds that will mature in 20 years.Both bonds promise to pay a semiannual coupon,they are not callable or corvertible,and they are equally liquid.Further assume that the Treasury yield curve is based only on the pure expectations theory.Under these conditions,which of the following statements is CORRECT?

One of the four most fundamental factors that affect the cost of money as discussed in the text is the current state of the weather.If the weather is dark and stormy,the cost of money will be higher than if it is bright and sunny,other things held constant.

A bond trader observes the following information: $\cdot$ The Treasury yield curve is downward sloping. $\cdot$ Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. $\cdot$ Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information,which of the following statements is most CORRECT?

If the pure expectations theory of the term structure is correct,which of the following statements would be CORRECT?

Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 5.80%.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 = 1.3% 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?

Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates - the real risk-free rate plus a set of premiums - is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math. As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory. We should note one issue that can be confusing if it is not handled carefully - the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use. Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems. The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero. -The real risk-free rate is 3.05%,inflation is expected to be 3.60% this year,and the maturity risk premium is zero.Ignoring any cross-product terms,i.e. ,if averaging is required,use the arithmetic average,what is the equilibrium rate of return on a 1-year Treasury bond?

One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security.The higher the risk,the higher the security's required return,other things held constant.

Suppose the real risk-free rate is 3.00%,the average expected future inflation rate is 4.00%,and a maturity risk premium of 0.10% per year to maturity applies,i.e. ,MRP = 0.10%(t),where t is the years to maturity.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is NOT valid? Include the cross-product term,i.e. ,if averaging is required,use the geometric average.(Round your final answer to 2 decimal places. )

The real risk-free rate is expected to remain constant at 3% in the future,a 2% rate of inflation is expected for the next 2 years,after which inflation is expected to increase to 4%,and there is a positive maturity risk premium that increases with years to maturity.Given these conditions,which of the following statements is CORRECT?

Crockett Corporation's 5-year bonds yield 6.35%,and 5-year T-bonds yield 4.45%.The real risk-free rate is r* = 2.80%,the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds,the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T-bonds,and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) $\times$ 0)1%,where t = number of years to maturity.What inflation premium (IP)is built into 5-year bond yields?

Keys Corporation's 5-year bonds yield 5.10% and 5-year T-bonds yield 4.40%.The real risk-free rate is r* = 2.5%,the inflation premium for 5-year bonds is IP = 1.50%,the liquidity premium for Keys' bonds is LP = 0.5% versus zero for T-bonds,and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) $\times$ 0)1%,where t = number of years to maturity.What is the default risk premium (DRP)on Keys' bonds?

Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates - the real risk-free rate plus a set of premiums - is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math. As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory. We should note one issue that can be confusing if it is not handled carefully - the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use. Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems. The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero. -Suppose the rate of return on a 10-year T-bond is 6.90%,the expected average rate of inflation over the next 10 years is 2.0%,the MRP on a 10-year T-bond is 0.9%,no MRP is required on a TIPS,and no liquidity premium is required on any Treasury security.Given this information,what should the yield be on a 10-year TIPS? Disregard cross-product terms,i.e. ,if averaging is required,use the arithmetic average.

Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates - the real risk-free rate plus a set of premiums - is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math. As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory. We should note one issue that can be confusing if it is not handled carefully - the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use. Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems. The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero. -If 10-year T-bonds have a yield of 6.2%,10-year corporate bonds yield 7.9%,the maturity risk premium on all 10-year bonds is 1.3%,and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds,what is the default risk premium on the corporate bond?

Assume that interest rates on 20-year Treasury and corporate bonds are as follows: $\text { T-bond } = 7.72 \% \quad \text { AAA } = 8.72 \% \quad \text { A } = 9.64 \% \quad \text { BBB } = 10.18 \%$ The differences in these rates were probably caused primarily by:

Koy Corporation's 5-year bonds yield 8.00%,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) $\times$ 0)1%,where t = number of years to maturity.What is the default risk premium (DRP)on Koy's bonds?

The four most fundamental factors that affect the cost of money are (1)production opportunities, (2)time preferences for consumption, (3)risk,and (4)the skill level of the economy's labor force.

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory,which of the following statements is CORRECT?

Assume the following: The real risk-free rate,r*,is expected to remain constant at 3%.Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter.The maturity risk premium is zero.Given this information,which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?