Exam 6: Understanding Financial Markets and Institutions

One-year interest rates are 3%. The market expects one-year rates to be 5% one year from now. The market also expects one-year rates to be 7% two years from now. Assume that the unbiased expectations theory holds. Which of the following is correct?

Interest rates You are considering an investment in 30-year bonds issued by a corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.50 percent. Your broker has determined the following information about economic activity and the corporation bonds: Real interest rate = 2.50% Default risk premium = 1.75% Liquidity risk premium = 0.70% Maturity risk premium = 1.50% What is the inflation premium? What is the fair interest rate on the corporation's 30-year bonds?

According to this theory of term structure of interest rates, at any given point in time, the yield curve reflects the market's current expectations of future short-term rates.

Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following 3 years (i.e., years 2, 3 and 4 respectively) are as follows: ₁R₁ = 5%, E(₂r₁) = 6%, E(₃r₁) = 7.5% E(₄r₁) = 7.85% Using the unbiased expectations theory, calculate the current (long-term) rates for three-year- and four-year-maturity Treasury securities.

Unbiased Expectations Theory Suppose we observe the three-year Treasury security rate (₁R₃) to be 6 percent, the expected one-year rate next year E(₂r₁) to be 3 percent, and the expected one-year rate the following year E(₃r₁) to be 5 percent. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year Treasury security rate, ₁R₁?

What is a derivative security and what determines its value?

Interest rates A 2-year Treasury security currently earns 5.25 percent. Over the next two years, the real interest rate is expected to be 3.00 percent per year and the inflation premium is expected to be 2.00 percent per year. What is the maturity risk premium on the 2-year Treasury security?

A 2-year Treasury security currently earns 5.13%. Over the next 2 years, the real interest rate is expected to be 2.15% per year and the inflation premium is expected to be 1.75% per year. Calculate the maturity risk premium on the 2-year Treasury security.

Which of these statements is true?

This theory argues that individual investors and financial institutions have specific maturity preferences, and to encourage buyers to hold securities with maturities other than their most preferred requires a higher interest rate.

Interest rates A corporation's 10-year bonds have an equilibrium rate of return of 7 percent. For all securities, the inflation risk premium is 1.50 percent and the real interest rate is 3.0 percent. The security's liquidity risk premium is 0.15 percent and maturity risk premium is 0.70 percent. The security has no special covenants. What is the bond's default risk premium?

Assume the current interest rate on a one-year Treasury bond (₁R₁) is 5.50%, the current rate on a two-year Treasury bond (₁R₂) is 5.95%, and the current rate on a three-year Treasury bond (₁R₃) is 8.50%. If the unbiased expectations theory of the term structure of interest rates is correct, what is the one-year interest rate expected on Treasury bills during year 3, ₃f₁?

All of the following are factors that affect nominal interest rates except ___________.

An example of an illiquid asset is _____________________.

Suppose we observe the following rates: ₁R₁ = 13%, ₁R₂ = 16%, and E(₂r₁) = 10%. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L₂?

This is the risk that an asset's sale price will be lower than its purchase price.

Which of the following is not correct with respect to derivative securities?

Classify the following transactions as taking place in the primary or secondary markets: a. A company issues new common stock. b. A company issues common stock in an IPO. c. A shareholder sells preferred stock out of its marketable securities portfolio. d. A mutual fund buys previously issued bonds. e. An insurance company sells another company's common stock. f. A company buys another company's stock from a mutual fund.

Interest rates The Wall Street Journal reports that the rate on 3-year Treasury securities is 7.00 percent, and the 6-year Treasury rate is 7.25 percent. From discussions with your broker, you have determined that expected inflation premium is 1.75 percent next year, 2.25 percent in Year 2, and 2.40 percent in Year 3 and beyond. Further, you expect that real interest rates will be 3.75 percent annually for the foreseeable future. What is the maturity risk premium on the 6-year Treasury security?

All of the following are secondary market transactions except ___________.