Question 1

Which of the following statements is correct?

Accepted Answer

A)  The maturity premiums embedded in the interest rates on U.S.Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. 
B)  Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. 
C)  According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward. 
D)  The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping. 
E)  If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for U.S.Treasury securities would, other things held constant, have an upward slope. 
A)  The maturity premiums embedded in the interest rates on U.S.Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. 
B)  Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. 
C)  According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward. 
D)  The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping. 
E)  If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for U.S.Treasury securities would, other things held constant, have an upward slope. B

Question 2

Assume that r* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t − 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t − 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter.What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

Accepted Answer

A)  0.25% 
B)  0.50% 
C)  0.63% 
D)  1.00% 
E)  1.13% 
A)  0.25% 
B)  0.50% 
C)  0.63% 
D)  1.00% 
E)  1.13% E

Question 3

Most experts think that in the United States the real risk-free rate fluctuates between

Accepted Answer

A)  one to two percent. 
B)  two to four percent. 
C)  four to seven percent 
D)  eight to twelve percent 
A)  one to two percent. 
B)  two to four percent. 
C)  four to seven percent 
D)  eight to twelve percent B

Question 4

Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2, and 4% thereafter.Assume also that all Treasury bonds are highly liquid and free of default risk.If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP5 − MRP2?

Accepted Answer

A)  2.1% 
B)  1.8% 
C)  5.0% 
D)  3.0% 
E)  2.5% 
A)  2.1% 
B)  1.8% 
C)  5.0% 
D)  3.0% 
E)  2.5%

Question 5

An investor with a six-year investment horizon believes that interest rates are determined only by expectations about future interest rates, (i.e., this investor believes in the expectations theory).This investor should expect to earn the same rate of return over the 6-year time horizon if he or she buys a 6-year bond or a 3-year bond now and another 3-year bond three years from now (ignore transaction costs).

Accepted Answer

A) True 
 B)False

Question 6

Expectations of high inflation lead to low interest rates and vice versa.

Accepted Answer

A) True 
 B)False

Question 7

If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase probably will be greater than the increase in rates in the long-term market.

Accepted Answer

A) True 
 B)False

Question 8

Assume that the current interest rate on a 1-year bond is 8 percent, the current rate on a 2-year bond is 10 percent, and the current rate on a 3-year bond is 12 percent.If the expectations theory of the term structure is correct, what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average.)

Accepted Answer

A)  12.0% 
B)  16.0% 
C)  13.5% 
D)  10.5% 
E)  14.0% 
A)  12.0% 
B)  16.0% 
C)  13.5% 
D)  10.5% 
E)  14.0%

Question 9

The liquidity premium reflects the fact that some investments are more easily converted into cash on a short notice at fair market value than other securities.

Accepted Answer

A) True 
 B)False

Question 10

Which of the following statements is most correct?

Accepted Answer

A)  The maturity premiums embedded in the interest rates on U.S.Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. 
B)  Reinvestment rate risk is lower, other things held constant, on 30-day T-bills than on 30-year T-bonds. 
C)  According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to have an upward slope. 
D)  The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve is normally upward sloping. 
E)  If the maturity risk premium were zero and the rate of inflation were expected to increase in the future, then the yield curve for U.S.Treasury securities would, other things held constant, have an upward slope. 
A)  The maturity premiums embedded in the interest rates on U.S.Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. 
B)  Reinvestment rate risk is lower, other things held constant, on 30-day T-bills than on 30-year T-bonds. 
C)  According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to have an upward slope. 
D)  The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve is normally upward sloping. 
E)  If the maturity risk premium were zero and the rate of inflation were expected to increase in the future, then the yield curve for U.S.Treasury securities would, other things held constant, have an upward slope.

Question 11

Which of the following is not one of the fundamental factors that affect the cost of money?

Accepted Answer

A)  Production opportunities 
B)  Time preferences for consumption 
C)  Exchange rates 
D)  Risk 
E)  Inflation 
A)  Production opportunities 
B)  Time preferences for consumption 
C)  Exchange rates 
D)  Risk 
E)  Inflation

Question 12

Inflationary pressures are usually strongest during business booms.

Accepted Answer

A) True 
 B)False

Question 13

Assume that the current yield curve is upward sloping, or normal.This implies that

Accepted Answer

A)  Short-term interest rates are more volatile than long-term rates. 
B)  Inflation is expected to subside in the future. 
C)  The economy is at the peak of a business cycle. 
D)  Long-term bonds are a better buy than short-term bonds. 
E)  None of the above statements is necessarily implied by the yield curve given. 
A)  Short-term interest rates are more volatile than long-term rates. 
B)  Inflation is expected to subside in the future. 
C)  The economy is at the peak of a business cycle. 
D)  Long-term bonds are a better buy than short-term bonds. 
E)  None of the above statements is necessarily implied by the yield curve given.

Question 14

Which of the following statements is most correct?

Accepted Answer

A)  The more highly developed a nation's financial system is, the more likely funds are to flow from savers to borrowers by direct transfers as opposed to through financial intermediaries. 
B)  If people in the aggregate have a strong time preference for current consumption as opposed to future consumption, this factor will cause interest rates to be lower than if preferences were more toward future consumption. 
C)  If investors expect the rate of inflation to increase in the future, this would tend to cause the current short-term interest rate to be higher than current long-term rates. 
D)  The existence of maturity risk premiums is due to the fact that a change in interest rates has more effect on the prices of short-term than long-term bonds. 
E)  If a 1-year Treasury bond has a yield of 5 percent, if the expected rate of inflation during the coming year is 3 percent, and if the maturity risk and liquidity premiums on 1-year bonds are zero, then the real risk-free rate r* must be 2 percent. 
A)  The more highly developed a nation's financial system is, the more likely funds are to flow from savers to borrowers by direct transfers as opposed to through financial intermediaries. 
B)  If people in the aggregate have a strong time preference for current consumption as opposed to future consumption, this factor will cause interest rates to be lower than if preferences were more toward future consumption. 
C)  If investors expect the rate of inflation to increase in the future, this would tend to cause the current short-term interest rate to be higher than current long-term rates. 
D)  The existence of maturity risk premiums is due to the fact that a change in interest rates has more effect on the prices of short-term than long-term bonds. 
E)  If a 1-year Treasury bond has a yield of 5 percent, if the expected rate of inflation during the coming year is 3 percent, and if the maturity risk and liquidity premiums on 1-year bonds are zero, then the real risk-free rate r* must be 2 percent.

Question 15

The two reasons most experts give for the existence of a positive maturity risk premium are (1) because investors are assumed to be risk averse, and (2) because investors prefer to lend long while firms prefer to borrow short.

Accepted Answer

A) True 
 B)False

Question 16

An inverted yield curve

Accepted Answer

A)  Exists when short-term rates exceed long-term rates. 
B)  Exists when long-term rates exceed short-term rates. 
C)  Represents the "normal term structure." 
D)  Signifies that investors can get higher returns by investing in bonds than by investing in stocks. 
E)  Signifies that investors can get higher returns on stocks than on bonds. 
A)  Exists when short-term rates exceed long-term rates. 
B)  Exists when long-term rates exceed short-term rates. 
C)  Represents the "normal term structure." 
D)  Signifies that investors can get higher returns by investing in bonds than by investing in stocks. 
E)  Signifies that investors can get higher returns on stocks than on bonds.

Question 17

Long-term bonds are more vulnerable to reinvestment rate risk than short-term bonds.

Accepted Answer

A) True 
 B)False

Question 18

Which of the following statements is correct?

Accepted Answer

A)  If different markets existed for long-term and short-term bonds, but lenders and borrowers could move freely between markets, (1) the market segmentation theory could not really be an important determinant of the yield curve, and (2) maturity risk premiums could not be significant. 
B)  Because the default risk premium (DRP) and the liquidity premium (LP) are both essentially zero for U.S.Treasury securities, the Treasury yield curve is influenced more heavily by expected inflation than corporate bonds' yield curves, i.e., we can be sure that a given amount of expected inflation will have more effect on the slope of the Treasury yield curve than on the corporate yield curve. 
C)  According to the market segmentation theory, investors prefer to buy debt with short maturities.Therefore, the fundamental conclusion from this theory is that the yield curve normally should slope upwards. 
D)  It is theoretically possible for the yield curve to have a downward slope, and there have been times when such a slope existed.That situation was probably caused by investors' liquidity preferences, i.e., by the factors which underlie the liquidity preference theory. 
E)  Yield curves for government and corporate bonds can be constructed from data that exist in the marketplace.If the yield curves for several companies were plotted on a graph, along with the yield curve for U.S.Treasury securities, the company with the largest total of DRP plus LP would have the highest yield curve. 
A)  If different markets existed for long-term and short-term bonds, but lenders and borrowers could move freely between markets, (1) the market segmentation theory could not really be an important determinant of the yield curve, and (2) maturity risk premiums could not be significant. 
B)  Because the default risk premium (DRP) and the liquidity premium (LP) are both essentially zero for U.S.Treasury securities, the Treasury yield curve is influenced more heavily by expected inflation than corporate bonds' yield curves, i.e., we can be sure that a given amount of expected inflation will have more effect on the slope of the Treasury yield curve than on the corporate yield curve. 
C)  According to the market segmentation theory, investors prefer to buy debt with short maturities.Therefore, the fundamental conclusion from this theory is that the yield curve normally should slope upwards. 
D)  It is theoretically possible for the yield curve to have a downward slope, and there have been times when such a slope existed.That situation was probably caused by investors' liquidity preferences, i.e., by the factors which underlie the liquidity preference theory. 
E)  Yield curves for government and corporate bonds can be constructed from data that exist in the marketplace.If the yield curves for several companies were plotted on a graph, along with the yield curve for U.S.Treasury securities, the company with the largest total of DRP plus LP would have the highest yield curve.

Question 19

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

Accepted Answer

A)  The yield on the 10-year bond is less than the yield on a 1-year bond. 
B)  The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums. 
C)  It is impossible to tell without knowing the coupon rates of the bonds. 
D)  The yields on the two bonds are equal. 
E)  It is impossible to tell without knowing the relative risks of the two bonds. 
A)  The yield on the 10-year bond is less than the yield on a 1-year bond. 
B)  The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums. 
C)  It is impossible to tell without knowing the coupon rates of the bonds. 
D)  The yields on the two bonds are equal. 
E)  It is impossible to tell without knowing the relative risks of the two bonds.

Question 20

Assume investors demand a real rate of return equal to 3 percent and that there is no maturity risk premium associated with Treasury securities.According to the Wall Street Journal, the average nominal yields on risk-free Treasury securities with different maturities are:   What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?

Accepted Answer

A)  5.0%; 2.0% 
B)  4.5%; 1.5% 
C)  3.0%; 1.8% 
D)  5.6%; 2.6% 
E)  There is not enough information to answer this question. 
A)  5.0%; 2.0% 
B)  4.5%; 1.5% 
C)  3.0%; 1.8% 
D)  5.6%; 2.6% 
E)  There is not enough information to answer this question.

Which of the following statements is correct?

Most experts think that in the United States the real risk-free rate fluctuates between

Expectations of high inflation lead to low interest rates and vice versa.

If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase probably will be greater than the increase in rates in the long-term market.

The liquidity premium reflects the fact that some investments are more easily converted into cash on a short notice at fair market value than other securities.

Which of the following statements is most correct?

Which of the following is not one of the fundamental factors that affect the cost of money?

Inflationary pressures are usually strongest during business booms.

Assume that the current yield curve is upward sloping, or normal.This implies that

Which of the following statements is most correct?

The two reasons most experts give for the existence of a positive maturity risk premium are (1) because investors are assumed to be risk averse, and (2) because investors prefer to lend long while firms prefer to borrow short.

An inverted yield curve

Long-term bonds are more vulnerable to reinvestment rate risk than short-term bonds.

Which of the following statements is correct?

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

An Overview of Finance

Financial Assets Instruments

Financial Markets and the Investment Banking Process

Financial Intermediaries and the Banking System

Business Organizations and the Tax Environment

Analysis of Financial Statements

Financial Planning and Control

Time Value of Money

Valuation Concepts

Risk and Rates of Return

The Cost of Capital

Capital Budgeting

Capital Structure and Dividend Policy Decisions

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Investment Concepts

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Exam 5: The Cost of Money Interest Rates

Which of the following statements is correct?

Most experts think that in the United States the real risk-free rate fluctuates between

Expectations of high inflation lead to low interest rates and vice versa.

If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase probably will be greater than the increase in rates in the long-term market.

The liquidity premium reflects the fact that some investments are more easily converted into cash on a short notice at fair market value than other securities.

Which of the following statements is most correct?

Which of the following is not one of the fundamental factors that affect the cost of money?

Inflationary pressures are usually strongest during business booms.

Assume that the current yield curve is upward sloping, or normal.This implies that

Which of the following statements is most correct?

The two reasons most experts give for the existence of a positive maturity risk premium are (1) because investors are assumed to be risk averse, and (2) because investors prefer to lend long while firms prefer to borrow short.

An inverted yield curve

Long-term bonds are more vulnerable to reinvestment rate risk than short-term bonds.

Which of the following statements is correct?

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

An Overview of Finance

Financial Assets Instruments

Financial Markets and the Investment Banking Process

Financial Intermediaries and the Banking System

Business Organizations and the Tax Environment

Analysis of Financial Statements

Financial Planning and Control

Time Value of Money

Valuation Concepts

Risk and Rates of Return

The Cost of Capital

Capital Budgeting

Capital Structure and Dividend Policy Decisions

Working Capital Management

Investment Concepts

Security Valuation and Selection

Filters