Question 1

Suppose financial institutions,such as savings and loans,were required by law to make long-term,fixed interest rate mortgages,but,at the same time,were largely restricted,in terms of their capital sources,to deposits that could be withdrawn on demand.Under these conditions,these financial institutions should prefer a "normal" yield curve to an inverted curve.

Accepted Answer

A) True 
 B)False  True

Question 2

The existence of an upward sloping yield curve proves that the liquidity preference theory is correct,because an upward sloping curve necessarily implies that firms must offer a maturity risk premium in order to induce investors to lend for longer periods.

Accepted Answer

A) True 
 B)False  False

Question 3

The real risk-free rate of interest is 3 percent.Inflation is expected to be 4 percent this coming year,jump to 5 percent next year,and run at 6 percent the year after (Year 3).According to the expectations theory,what should be the interest rate on 3-year,risk-free securities today?

Accepted Answer

A)   18%
B)   12%
C)   6%
D)   8%
E)   10% D

Question 4

Which of the following assets is the most liquid?

Accepted Answer

A)   Stock
B)   Treasury bills
C)   Corporate bonds
D)   Cash

Question 5

The fundamental factors that affect the cost of money include

Accepted Answer

A)   production opportunities
B)   inflation
C)   risk
D)   time preference for consumption
E)   all of the above

Question 6

If the expectations theory of the term structure of interest rates is correct,and if the other term structure theories are invalid,and we observe a downward sloping yield curve,which of the following is a true statement?

Accepted Answer

A)   Investors expect short-term rates to be constant over time.
B)   Investors expect short-term rates to increase in the future.
C)   Investors expect short-term rates to decrease in the future.
D)   It is impossible to say unless we know whether investors require a positive or negative maturity risk premium.
E)   The maturity risk premium must be positive.

Question 7

If the liquidity preference theory of the term structure is correct,we would expect the size of the maturity risk premium to increase with maturity.Thus,we might observe an upward sloping yield curve,even if future short-term rates are expected to decrease.

Accepted Answer

A) True 
 B)False

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 probably will be greater than the increase in rates in the long-term market.

Accepted Answer

A) True 
 B)False

Question 9

The term structure is defined as the relationship between interest rates and maturities of similar securities.

Accepted Answer

A) True 
 B)False

Question 10

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

Question 11

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%

Question 12

Suppose your firm must raise funds immediately,and it has decided to use debt financing to do so.If you believe that the economy is at the peak of a boom,but it is just about to enter a recession,your firm would probably be better off if it issued long-term debt rather than short-term debt.

Accepted Answer

A) True 
 B)False

Question 13

The return realized by investors comes only from the change in value of an asset over time

Accepted Answer

A) True 
 B)False

Question 14

During recessions the demand for funds typically ____.

Accepted Answer

A)   increases
B)   stays the same
C)   decreases
D)   doubles

Question 15

Interest rates on 1-year,2-year,and 3-year Treasury bills are 5%,6%,and 7%,respectively.Assume that the pure expectations theory holds and that the market is in equilibrium.Which of the following statements is most correct?

Accepted Answer

A)   The maturity risk premium is positive.
B)   Interest rates are expected to rise over the next two years.
C)   The market expects one-year rates to be 5.5% one year from today.
D)   Answers a,b,and c are all correct.
E)   Only answers b and c are correct.

Question 16

When the federal government runs a deficit the interest rates generally increases due to increased demand for funds.

Accepted Answer

A) True 
 B)False

Question 17

Suppose that the annual expected rates of inflation over each of the next five years are 5 percent,6 percent,9 percent,13 percent,and 12 percent,respectively.What is the average expected rate of inflation over the 5-year period?

Accepted Answer

A)   6%
B)   7%
C)   8%
D)   9%
E)   10%

Question 18

Assume that a 3-year Treasury note has no maturity premium,and that the real,risk-free rate of interest is 3 percent.If the T-note carries a yield to maturity of 13 percent,and if the expected average inflation rate over the next 2 years is 11 percent,what is the implied expected inflation rate during Year 3?

Accepted Answer

A)   7%
B)   8%
C)   9%
D)   17%
E)   18%

Question 19

The dollar return earned on a debt investment is comprised of the interest payments received and the change in value of the debt instrument in the financial markets.

Accepted Answer

A) True 
 B)False

Question 20

Firms with the least profitable opportunities are willing and able to pay the most for capital.

Accepted Answer

A) True 
 B)False

Exam 5: The Cost of Money Interest Rates

The existence of an upward sloping yield curve proves that the liquidity preference theory is correct,because an upward sloping curve necessarily implies that firms must offer a maturity risk premium in order to induce investors to lend for longer periods.

The real risk-free rate of interest is 3 percent.Inflation is expected to be 4 percent this coming year,jump to 5 percent next year,and run at 6 percent the year after (Year 3) .According to the expectations theory,what should be the interest rate on 3-year,risk-free securities today?

Which of the following assets is the most liquid?

The fundamental factors that affect the cost of money include

If the expectations theory of the term structure of interest rates is correct,and if the other term structure theories are invalid,and we observe a downward sloping yield curve,which of the following is a true statement?

If the liquidity preference theory of the term structure is correct,we would expect the size of the maturity risk premium to increase with maturity.Thus,we might observe an upward sloping yield curve,even if future short-term rates are expected to decrease.

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 term structure is defined as the relationship between interest rates and maturities of similar securities.

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

Suppose your firm must raise funds immediately,and it has decided to use debt financing to do so.If you believe that the economy is at the peak of a boom,but it is just about to enter a recession,your firm would probably be better off if it issued long-term debt rather than short-term debt.

The return realized by investors comes only from the change in value of an asset over time

During recessions the demand for funds typically ____.

Interest rates on 1-year,2-year,and 3-year Treasury bills are 5%,6%,and 7%,respectively.Assume that the pure expectations theory holds and that the market is in equilibrium.Which of the following statements is most correct?

When the federal government runs a deficit the interest rates generally increases due to increased demand for funds.

Suppose that the annual expected rates of inflation over each of the next five years are 5 percent,6 percent,9 percent,13 percent,and 12 percent,respectively.What is the average expected rate of inflation over the 5-year period?

The dollar return earned on a debt investment is comprised of the interest payments received and the change in value of the debt instrument in the financial markets.

Firms with the least profitable opportunities are willing and able to pay the most for capital.