Question 1

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 2

Investors with a high time preference for current consumption would be willing to pay a higher price for the same investment than investors with a low time preference for current consumption.

Accepted Answer

A) True 
 B)False

Question 3

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 4

If the United States is running a deficit trade balance with Great Britain, we would expect the value of the British pound to depreciate against the U.S.dollar.

Accepted Answer

A) True 
 B)False

Question 5

Given the following data, find the expected rate of inflation during the next year. r* = real risk-free rate = 3%.
Maturity risk premium on 10-year T-bonds = 2%.It is zero on 1-year bonds, and a linear relationship exists.
Default risk premium on 10-year, A-rated bonds = 1.5%.
Liquidity premium = 0%.
Going interest rate on 1-year T-bonds = 8.5%.

Accepted Answer

A)  3.5% 
B)  4.5% 
C)  5.5% 
D)  6.5% 
E)  7.5%

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

Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively.What is the average expected inflation rate over this 5-year period?

Accepted Answer

A)  6.5% 
B)  7.5% 
C)  8.0% 
D)  6.0% 
E)  7.0%

Question 8

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

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

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 11

You are given the following data:  Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant.Given these conditions, the nominal risk-free rate for T-bills is ____, and the rate on long-term Treasury bonds is ____.

Accepted Answer

A)  4%; 14% 
B)  4%; 15% 
C)  11%; 14% 
D)  11%; 15% 
E)  11%; 17%

Question 12

In the textbook, the nominal interest rate is defined as being equal to the real risk-free rate, plus an inflation premium, plus a default risk premium, plus a liquidity premium, plus a maturity risk premium.

Accepted Answer

A) True 
 B)False

Question 13

Long-term interest rates reflect expectations about future inflation.Inflation has varied significantly from year to year in the past, and as a result, long-term rates can be expected to fluctuate more than short-term rates.

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

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 16

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%

Question 17

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

Accepted Answer

A) True 
 B)False

Question 18

As the demand for funds increase, the demand curve will shift to the ____ resulting in ____ market clearing interest rate.

Accepted Answer

A)  right; higher 
B)  left; higher 
C)  right; lower 
D)  left; lower

Question 19

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

Question 20

Which of the following assets is the most liquid?

Accepted Answer

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

Exam 5: The Cost of Money Interest Rates

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?

Investors with a high time preference for current consumption would be willing to pay a higher price for the same investment than investors with a low time preference for current consumption.

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.

If the United States is running a deficit trade balance with Great Britain, we would expect the value of the British pound to depreciate against the U.S.dollar.

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?

Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively.What is the average expected inflation rate over this 5-year period?

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

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

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.

You are given the following data: Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant.Given these conditions, the nominal risk-free rate for T-bills is , and the rate on long-term Treasury bonds is .

In the textbook, the nominal interest rate is defined as being equal to the real risk-free rate, plus an inflation premium, plus a default risk premium, plus a liquidity premium, plus a maturity risk premium.

Long-term interest rates reflect expectations about future inflation.Inflation has varied significantly from year to year in the past, and as a result, long-term rates can be expected to fluctuate more than short-term rates.

During recessions the demand for funds typically ____.

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

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?

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

As the demand for funds increase, the demand curve will shift to the resulting in market clearing interest rate.

Which of the following assets is the most liquid?