Question 1

The higher the perceived risk associated with an investment, the higher its required rate of return.

Accepted Answer

A) True 
 B)False

Question 2

A deficit trade balance hinders the Federal Reserve's ability to lower interest rates when combatting a recession.

Accepted Answer

A) True 
 B)False

Question 3

_____ can be negative if the value of the investment decreases during the period it is held.

Accepted Answer

A) Risk 
B) Dividends 
C) Maturity 
D) Interests 
E) Capital gains

Question 4

Which of the following statements is correct?

Accepted Answer

A) The probability of default is higher on short-term bonds than on long-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, the yield curve is expected to slope downward. 
D) Borrowers prefer to borrow on a short-term basis, as a result, the yield curve is downward sloping. 
E) If the inflation is expected to decrease in the future, then the yield curve should have an upward slope.

Question 5

In the financial market context, _____ is the chance that a financial asset will not earn the return promised.

Accepted Answer

A) maturity 
B) production opportunity 
C) time preference for consumption 
D) risk 
E) inflation

Question 6

Which of the following indicates that the cost of money will increase?

Accepted Answer

A) Increase in the rate of inflation in an economy 
B) Increase in liquidity of an asset 
C) Decrease in federal deficit of a country 
D) Increase in money supply 
E) Decrease in tax rates for corporations

Question 7

Assume that the expectations theory of the term structure of interest rates is correct, and other term structure theories are invalid. If a downward sloping yield curve is observed, which of the following is a correct statement?

Accepted Answer

A) Investors expect interest rates to be constant over time. 
B) Investors expect interest rates to increase in the future. 
C) Investors expect interest rates to decrease in the future. 
D) Investors require a negative maturity risk premium. 
E) The inflation premium must be greater than 2 percent.

Question 8

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

Accepted Answer

A) True 
 B)False

Question 9

Bonds with higher liquidity must offer higher interest rates in the market, because such investments can be easily converted into cash on short notice at or near the amounts originally invested.

Accepted Answer

A) True 
 B)False

Question 10

In general, when rates in the financial markets increase, the prices (values) of financial assets decrease.

Accepted Answer

A) True 
 B)False

Question 11

Assume that the expectations theory holds and that liquidity and maturity risk premiums are zero. The annual rate of interest on a two-year Treasury bond is 10.5 percent and the rate on a one-year Treasury bond is 12 percent. What is the expected one-year interest rate during the second year?

Accepted Answer

A) 9.0% 
B) 9.5% 
C) 10.0% 
D) 10.5% 
E) 11.0%

Question 12

Which of the following is the yield of a bond that offers a risk-free rate of 4 percent and a risk premium of 2 percent?

Accepted Answer

A) 2% 
B) 8% 
C) 12% 
D) 6% 
E) 9%

Question 13

If a stock pays a dividend of $10, and the investors need 8 percent return on their investment, then the investors should pay _____ for the stock.

Accepted Answer

A) $150 
B) $200 
C) $350 
D) $125 
E) $75

Question 14

The value of an asset is determined by discounting the future cash flows generated by the asset using the:

Accepted Answer

A) tax rate. 
B) interest rate. 
C) inflation rate. 
D) deficit rate. 
E) surplus rate.

Question 15

Following are the yields on selected Treasury securities:
$\begin{array}{cc}
\text { Maturity } & \text { Yield } \
\hline \text { 2 years } & 1.6 \% \
\text { 3 years } & 2.2 \
\text { 4 years } & 2.4
\end{array}$
?Using the expectations theory, compute the expected one-year interest rate in Year 3. That is, compute the rate that is expected to exist only during Year 3. (Base your answer on an arithmetic average rather than a geometric average.)

Accepted Answer

A) 2.2% 
B) 1.6% 
C) 3.4% 
D) 1.9% 
E) 3.0%

Question 16

Assume that a three-year Treasury note (T-note) has no maturity premium, and that the real risk-free rate of interest is 3 percent. If the T-note carries a nominal risk-free rate of return of 13 percent and if the expected average inflation rate over the next two years is 9 percent, what is the implied expected inflation rate during Year 3?

Accepted Answer

A) 7% 
B) 12% 
C) 9% 
D) 11% 
E) 18%

Question 17

Andrew purchased a stock for $175 and sold it for $250 one year later. If he earned a dividend income of $30, the stock's yield is:

Accepted Answer

A) 42 percent. 
B) 53 percent. 
C) 81 percent. 
D) 60 percent. 
E) 72 percent.

Question 18

The real rate of interest is composed of a risk-free rate of interest plus the default risk premium and liquidity premium that reflects the riskiness of the security.

Accepted Answer

A) True 
 B)False

Question 19

Following is information about three bonds:
?$\begin{array} { l l c } 
 { \text { Issuer } } & \text { Yield } & \text { Time to Maturity } \\hline
\text { Treasury } & 2.0 \% & 6 \text { months } \
\text { Company A } & 5.0 & 5 \text { years } \
\text { Company B } & 5.3 & 8 \text { years }
\end{array}$
?
Although none of the bonds has a liquidity premium, any bond with a maturity equal to one year or greater has a maturity risk premium (MRP). Except for their terms to maturity, the characteristics of the Company A and Company B bonds are the same (including their default risk). The average inflation rate is expected to remain constant during the next 10 years. What is the default risk premium (DRP) associated with the bonds issued by Company A and Company B?

Accepted Answer

A) 3.0% 
B) 0.3% 
C) 0.6% 
D) 3.2% 
E) 2.5%

Question 20

Assume that real risk-free rate (r*) = 1.00%; the maturity risk premium is found as MRP = 0.20% × (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 (LP) is 0.50 percent for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7 percent, 6 percent, and 5 percent during the next three years and then 4 percent thereafter. What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds? (Round answer to two decimal places.)

Accepted Answer

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

Exam 5: The Cost of Money Interest Rates

The higher the perceived risk associated with an investment, the higher its required rate of return.

A deficit trade balance hinders the Federal Reserve's ability to lower interest rates when combatting a recession.

_____ can be negative if the value of the investment decreases during the period it is held.

Which of the following statements is correct?

In the financial market context, _____ is the chance that a financial asset will not earn the return promised.

Which of the following indicates that the cost of money will increase?

Assume that the expectations theory of the term structure of interest rates is correct, and other term structure theories are invalid. If a downward sloping yield curve is observed, which of the following is a correct statement?

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

Bonds with higher liquidity must offer higher interest rates in the market, because such investments can be easily converted into cash on short notice at or near the amounts originally invested.

In general, when rates in the financial markets increase, the prices (values) of financial assets decrease.

Assume that the expectations theory holds and that liquidity and maturity risk premiums are zero. The annual rate of interest on a two-year Treasury bond is 10.5 percent and the rate on a one-year Treasury bond is 12 percent. What is the expected one-year interest rate during the second year?

Which of the following is the yield of a bond that offers a risk-free rate of 4 percent and a risk premium of 2 percent?

If a stock pays a dividend of $10, and the investors need 8 percent return on their investment, then the investors should pay _____ for the stock.

The value of an asset is determined by discounting the future cash flows generated by the asset using the:

Andrew purchased a stock for $175 and sold it for $250 one year later. If he earned a dividend income of $30, the stock's yield is:

The real rate of interest is composed of a risk-free rate of interest plus the default risk premium and liquidity premium that reflects the riskiness of the security.