Question 1

During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

Accepted Answer

A) True 
 B)False

Question 2

Suppose the rate of return on a 10-year T-bond is 6.55%, 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.

Accepted Answer

A)  2.97% 
B)  3.13% 
C)  3.29% 
D)  3.47% 
E)  3.65%

Question 3

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

Accepted Answer

A)  The yield on a 10-year bond would be less than that on a 1-year bill. 
B)  The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium. 
C)  It is impossible to tell without knowing the coupon rates of the bonds. 
D)  The yields on the two securities would be equal. 
E)  It is impossible to tell without knowing the relative risks of the two securities.

Question 4

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?

Accepted Answer

A)  If the pure expectations theory holds, the Treasury yield curve must be downward sloping. 
B)  If the pure expectations theory holds, the corporate yield curve must be downward sloping. 
C)  If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping. 
D)  If inflation is expected to decline, there can be no maturity risk premium. 
E)  The expectations theory cannot hold if inflation is decreasing.

Question 5

Which of the following statements is CORRECT?

Accepted Answer

A)  Downward sloping yield curves are inconsistent with the expectations theory. 
B)  The actual shape of the yield curve depends only on expectations about future inflation. 
C)  If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. 
D)  If the yield curve is upward sloping, the maturity risk premium must be positive and the inflation rate must be zero. 
E)  Yield curves must be either upward or downward sloping--they cannot first rise and then decline.

Question 6

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.

Accepted Answer

A) True 
 B)False

Question 7

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 8

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%

Question 9

Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things held constant, what would be the most likely effect on short-term securities' prices and interest rates?

Accepted Answer

A)  Prices and interest rates would both rise. 
B)  Prices would rise and interest rates would decline. 
C)  Prices and interest rates would both decline. 
D)  Prices would decline and interest rates would rise. 
E)  There is no reason to expect a change in either prices or interest rates.
Multiple Choice:

Question 10

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)  The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping. 
D)  If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. 
E)  Liquidity premiums are generally higher on Treasury than on corporate bonds.

Question 11

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.

Accepted Answer

A) True 
 B)False

Question 12

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?

Accepted Answer

A)  5.840% 
B)  6.148% 
C)  6.471% 
D)  6.812% 
E)  7.152%

Question 13

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

Accepted Answer

A)  If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise. 
B)  If both 2-year and 3-year Treasury rates are 7%, then 5-year rates must also be 7%. 
C)  If 1-year rates are 6% and 2-year rates are 7%, then the market expects 1-year rates to be 6.5% in one year. 
D)  Reinvestment rate risk is higher on long-term bonds, and interest rate price risk is higher on short-term bonds. 
E)  Interest rate price risk and reinvestment rate risk are relevant to investors in corporate bonds, but these concepts do not apply to Treasury bonds.

Question 14

Suppose 1-year Treasury bonds yield 4.00% while 2-year T-bonds yield 5.10%. Assuming the pure expectations theory is correct, and thus the maturity risk premium for T-bonds is zero, what is the yield on a 1-year T-bond expected to be one year from now?

Accepted Answer

A)  5.90% 
B)  6.21% 
C)  6.52% 
D)  6.85% 
E)  7.19%

Question 15

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "interest rate price risk."

Accepted Answer

A) True 
 B)False

Question 16

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.

Accepted Answer

A) True 
 B)False

Question 17

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?

Accepted Answer

A)  5.94% 
B)  6.60% 
C)  7.26% 
D)  7.99% 
E)  8.78%

Question 18

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.

Accepted Answer

A)  1.81% 
B)  1.90% 
C)  2.00% 
D)  2.10% 
E)  2.21%

Question 19

Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

Accepted Answer

A) True 
 B)False

Question 20

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

Accepted Answer

A) True 
 B)False

Exam 6: Bonds and Their Valuation

During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

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?

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) the skill level of the economy's labor force.

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."

Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things held constant, what would be the most likely effect on short-term securities' prices and interest rates?

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.

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?

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

Suppose 1-year Treasury bonds yield 4.00% while 2-year T-bonds yield 5.10%. Assuming the pure expectations theory is correct, and thus the maturity risk premium for T-bonds is zero, what is the yield on a 1-year T-bond expected to be one year from now?

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "interest rate price risk."

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.

Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

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