Question 1

Which of the following statements is CORRECT?

Accepted Answer

A) If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. 
B) If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. 
C) Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. 
D) If the maturity risk premium (MRP) equals zero, the yield curve must be flat. 
E) The yield curve can never be downward sloping. 
A) If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. 
B) If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. 
C) Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. 
D) If the maturity risk premium (MRP) equals zero, the yield curve must be flat. 
E) The yield curve can never be downward sloping.

Question 2

Which of the following statements is CORRECT?

Accepted Answer

A) The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. 
B) The most likely explanation for an inverted yield curve is that investors expect inflation to increase. 
C) The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. 
D) If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. 
E) Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted. 
A) The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. 
B) The most likely explanation for an inverted yield curve is that investors expect inflation to increase. 
C) The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. 
D) If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. 
E) Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A) Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. 
B) If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. 
C) The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. 
D) Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. 
E) The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future. 
A) Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. 
B) If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. 
C) The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. 
D) Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. 
E) The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.

Question 4

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.

Accepted Answer

A) True 
 B)False

Question 5

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?

Accepted Answer

A) 7.36% 
B) 7.75% 
C) 8.16% 
D) 8.59% 
E) 9.04% 
A) 7.36% 
B) 7.75% 
C) 8.16% 
D) 8.59% 
E) 9.04%

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. 
B) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. 
C) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. 
D) The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. 
E) The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity. 
A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. 
B) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. 
C) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. 
D) The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. 
E) The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity.

Question 7

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

Accepted Answer

A) Long-term interest rates are more volatile than short-term rates. 
B) Inflation is expected to decline in the future. 
C) The economy is not in a recession. 
D) Long-term bonds are a better buy than short-term bonds. 
E) Maturity risk premiums could help to explain the yield curve's upward slope. 
A) Long-term interest rates are more volatile than short-term rates. 
B) Inflation is expected to decline in the future. 
C) The economy is not in a recession. 
D) Long-term bonds are a better buy than short-term bonds. 
E) Maturity risk premiums could help to explain the yield curve's upward slope.

Question 8

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."

Accepted Answer

A) True 
 B)False

Question 9

Kay Corporation's 5-year bonds yield 6.20% 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 default risk premium for Kay's bonds is DRP = 1.30% 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 liquidity premium (LP)on Kay's bonds?

Accepted Answer

A) 0.36% 
B) 0.41% 
C) 0.45% 
D) 0.50% 
E) 0.55% 
A) 0.36% 
B) 0.41% 
C) 0.45% 
D) 0.50% 
E) 0.55%

Question 10

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 rS1U1B1RFS1U1B0 = [(1 + r*)(1 + IP)]S1U1P10.5S1S1P0 - 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rS1U1B1RFS1U1B0 = 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)S1U1P12S1S1P0 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)S1U1P12S1S1P0/(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 real risk-free rate is 3.00%,the average expected future inflation rate is 2.25%,and a maturity risk premium of 0.10% per year to maturity applies,i.e.,MRP = 0.10%(t),where t is the number of years to maturity.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is NOT valid? Disregard cross-product terms,i.e.,if averaging is required,use the arithmetic average.

Accepted Answer

A) 5.08% 
B) 5.35% 
C) 5.62% 
D) 5.90% 
E) 6.19% 
A) 5.08% 
B) 5.35% 
C) 5.62% 
D) 5.90% 
E) 6.19%

Question 11

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 rS1U1B1RFS1U1B0 = [(1 + r*)(1 + IP)]S1U1P10.5S1S1P0 - 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rS1U1B1RFS1U1B0 = 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)S1U1P12S1S1P0 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)S1U1P12S1S1P0/(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 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.

Accepted Answer

A) 5.38% 
B) 5.66% 
C) 5.96% 
D) 6.27% 
E) 6.60% 
A) 5.38% 
B) 5.66% 
C) 5.96% 
D) 6.27% 
E) 6.60%

Question 12

Which of the following statements is CORRECT,other things held constant?

Accepted Answer

A) If companies have fewer good investment opportunities, interest rates are likely to increase. 
B) If individuals increase their savings rate, interest rates are likely to increase. 
C) If expected inflation increases, interest rates are likely to increase. 
D) Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. 
E) Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills. 
A) If companies have fewer good investment opportunities, interest rates are likely to increase. 
B) If individuals increase their savings rate, interest rates are likely to increase. 
C) If expected inflation increases, interest rates are likely to increase. 
D) Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. 
E) Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

Question 13

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 rS1U1B1RFS1U1B0 = [(1 + r*)(1 + IP)]S1U1P10.5S1S1P0 - 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rS1U1B1RFS1U1B0 = 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)S1U1P12S1S1P0 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)S1U1P12S1S1P0/(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 real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is valid? Disregard cross-product terms,i.e.,if averaging is required,use the arithmetic average.

Accepted Answer

A) 5.14% 
B) 5.42% 
C) 5.70% 
D) 5.99% 
E) 6.28% 
A) 5.14% 
B) 5.42% 
C) 5.70% 
D) 5.99% 
E) 6.28%

Question 14

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

Accepted Answer

A) Tax effects. 
B) Default and liquidity risk differences. 
C) Maturity risk differences. 
D) Inflation differences. 
E) Real risk-free rate differences. 
A) Tax effects. 
B) Default and liquidity risk differences. 
C) Maturity risk differences. 
D) Inflation differences. 
E) Real risk-free rate differences.

Question 15

Inflation is expected to increase steadily over the next 10 years,there is a positive maturity risk premium on both Treasury and corporate bonds,and the real risk-free rate of interest is expected to remain constant.Which of the following statements is CORRECT?

Accepted Answer

A) The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. 
B) The yield on any corporate bond must exceed the yields on all Treasury bonds. 
C) The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds. 
D) The stated conditions cannot all be true: they are internally inconsistent. 
E) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope. 
A) The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. 
B) The yield on any corporate bond must exceed the yields on all Treasury bonds. 
C) The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds. 
D) The stated conditions cannot all be true: they are internally inconsistent. 
E) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

Question 16

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?

Accepted Answer

A) The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. 
B) The interest rate today on a 2-year bond should be approximately 6%. 
C) The interest rate today on a 2-year bond should be approximately 7%. 
D) The interest rate today on a 3-year bond should be approximately 7%. 
E) The interest rate today on a 3-year bond should be approximately 8%. 
A) The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. 
B) The interest rate today on a 2-year bond should be approximately 6%. 
C) The interest rate today on a 2-year bond should be approximately 7%. 
D) The interest rate today on a 3-year bond should be approximately 7%. 
E) The interest rate today on a 3-year bond should be approximately 8%.

Question 17

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%.What rate of return would you expect on a 1-year Treasury security,assuming the pure expectations theory is valid? Include cross-product terms,i.e.,if averaging is required,use the geometric average.

Accepted Answer

A) 5.21% 
B) 5.49% 
C) 5.78% 
D) 6.07% 
E) 6.37% 
A) 5.21% 
B) 5.49% 
C) 5.78% 
D) 6.07% 
E) 6.37%

Question 18

A bond trader observes the following information:
​
•The Treasury yield curve is downward sloping.
•Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.
•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?

Accepted Answer

A) A 10-year corporate bond must have a higher yield than a 5-year Treasury bond. 
B) A 10-year Treasury bond must have a higher yield than a 10-year corporate bond. 
C) A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. 
D) The corporate yield curve must be flat. 
E) Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping. 
A) A 10-year corporate bond must have a higher yield than a 5-year Treasury bond. 
B) A 10-year Treasury bond must have a higher yield than a 10-year corporate bond. 
C) A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. 
D) The corporate yield curve must be flat. 
E) Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping.

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. 
B) The real risk-free rate is higher for corporate than for Treasury bonds. 
C) Most evidence suggests that the maturity risk premium is zero. 
D) Liquidity premiums are higher for Treasury than for corporate bonds. 
E) The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates. 
A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. 
B) The real risk-free rate is higher for corporate than for Treasury bonds. 
C) Most evidence suggests that the maturity risk premium is zero. 
D) Liquidity premiums are higher for Treasury than for corporate bonds. 
E) The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

Question 20

Suppose the real risk-free rate is 3.00%,the average expected future inflation rate is 2.25%,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.

Accepted Answer

A) 5.15% 
B) 5.42% 
C) 5.69% 
D) 5.97% 
E) 6.27% 
A) 5.15% 
B) 5.42% 
C) 5.69% 
D) 5.97% 
E) 6.27%

Exam 6: Interest Rates

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

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?

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

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."

Which of the following statements is CORRECT,other things held constant?

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

Inflation is expected to increase steadily over the next 10 years,there is a positive maturity risk premium on both Treasury and corporate bonds,and the real risk-free rate of interest is expected to remain constant.Which of the following statements is CORRECT?

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?

Which of the following statements is CORRECT?

An Overview of Financial Management

Financial Markets and Institutions

Financial Statements, cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds and Their Valuation

Risk and Rates of Return

Stocks and Their Valuation

The Cost of Capital

The Basics of Capital Budgeting

Cash Flow Estimation and Risk Analysis

Real Options and Other Topics in Capital Budgeting

Capital Structure and Leverage

Distributions to Shareholders: Dividends and Share Repurchases

Working Capital Management

Financial Planning and Forecasting

Derivatives and Risk Management

Multinational Financial Management

Hybrid Financing: Preferred Stock, leasing, warrants, and Convertibles

Mergers and Acquisitions

Continuous Compounding and Discounting

Zero Coupon Bonds

Bankruptcy and Reorganization

Calculating Beta Coefficients

Using the Capm to Estimate the Risk-Adjusted Cost of Capital

Techniques for Measuring Beta Risk

Degree of Leverage

Filters

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