Deck 6: Interest Rates and Bond Valuation

Question 1

Risk-free rate of interest is equal to the sum of the real rate of interest plus an inflation premium.

Answer 1

True

Question 2

A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Answer 2

True

Question 3

The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by demander.

Answer 3

True

Question 4

A nominal rate of interest is equal to the sum of the real rate of interest plus the risk free rate of interest.

Question 5

In theory, the rate of return on U.S. Treasury bills should always exceed the rate of inflation as measured by the consumer price index.

Question 6

The liquidity preference theory suggests that short-term interest rates should be lower than long-term interest rates.

Question 7

The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

Question 8

An interest rate or a required rate of return represents the cost of money.

Question 9

The nominal rate of interest on a bond is 7% and an inflation premium of 3%. This results in a real rate of interest of 4% on the bond.

Question 10

Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term loans relative to their respective demand.

Question 11

A flat yield curve means that the rates do not vary much at different maturities.

Question 12

The liquidity preference theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

Question 13

A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a normal yield curve.

Question 14

A flat yield curve indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

Question 15

Nominal rate of interest is equal to the sum of the real rate of interest plus an inflation premium plus a risk premium.

Question 16

The term structure of interest rates is a graphical presentation of the relationship between the maturity and rate of return.

Question 17

An inverted yield curve is a downward-sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.

Question 18

A real rate of interest is the compensation paid by the borrower of funds to the lender.

Question 19

The expectations theory suggests that the shape of the yield curve reflects investors expectations about future interest rates.

Question 20

Longer the maturity of a Treasury security, the smaller the interest rate risk.

Question 21

A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Question 22

The ________ rate is typically the nominal rate of interest on a three-month U.S. Treasury bill.

A) expected
B) real
C) risk-free
D) premium

Question 23

A(n) ________ is a graphic depiction between the maturity and rate of return for bonds with similar risks.

A) yield curve
B) supply function
C) risk-return profile
D) aggregate demand curve

Question 24

Nico Nelson, a management trainee at a large New York-based bank, is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent and has decided to use the consumer price index as a proxy for expected inflation. What is the estimated real rate of interest if the CPI is currently 2 percent?

A) 5%
B) 1%
C) 3%
D) 2%

Question 25

The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called default risk.

Question 26

The ________ is the compound annual rate of interest earned on a debt security purchased on a given date and held to maturity.

A) risk premium
B) yield curve
C) risk-free rate
D) yield to maturity

Question 27

A(n) ________ yield curve reflects lower expected future rates of interest.

A) upward-sloping
B) flat
C) downward-sloping
D) linear

Question 28

________ rate of interest is the actual rate charged by the supplier and paid by the demander of funds.

A) Nominal
B) Real
C) Risk-free
D) Inflationary

Question 29

An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Question 30

The components of risk premium includes business risk, financial risk, interest rate risk, liquidity risk, and tax risk.

Question 31

________ rate of interest creates equilibrium between the supply of savings and the demand for investment funds.

A) Nominal
B) Real
C) Risk-free
D) Inflationary

Question 32

Nico invested an amount a year ago and calculated his return on investment. He found that his purchasing power had increased by 15 percent as a result of his investment. If inflation during the year was 4 percent, then Nico's ________.

A) real return on investment is more than 15 percent
B) nominal return on investment is more than 15 percent
C) nominal return on investment is less than 11 percent
D) real return on investment is equal to 4 percent

Question 33

Generally, an increase in risk will result in ________.

A) a lower required return or interest rate
B) a higher required return or interest rate
C) a higher return on investment
D) a lower return on investment

Question 34

The reason for a difference in the yield between a Aaa corporate bond and an otherwise identical Baa bond is the risk premium; other things being equal.

Question 35

The inflation risk premium on a bond is 2 percent, the U.S. T-bill rate is 5 percent, the maturity risk premium on the bond is 3 percent, the default risk premium on the bond is 2 percent, and the liquidity risk premium on the bond is 1 percent. Calculate its nominal rate of return.

A) 16%
B) 13%
C) 11%
D) 9%

Question 36

The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities; this causes the yield curve to be upward-sloping.

Question 37

The term structure of interest rates is the relationship between ________.

A) the present value of principal and coupon rate of the bonds
B) the general expectation of inflation and nominal rate of return for bonds
C) the general expectation of inflation and real rate of return for bonds
D) the maturity and rate of return for bonds with similar level of risk

Question 38

A(n) ________ yield curve reflects higher expected future rates of interest.

A) upward-sloping
B) flat
C) downward-sloping
D) linear

Question 39

Nominal rate of interest is equal to ________.

A) the real rate plus an inflationary expectation
B) the real rate plus a risk premium
C) the risk-free rate plus an inflationary expectation
D) the risk-free rate plus a risk premium

Question 40

The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called maturity risk.

Question 41

Which of the following explains the general shape of the yield curve of a bond?

A) Expectations theory
B) Perfect market theory
C) Capital asset pricing theory
D) Securities market theory

Question 42

The yield curve in an economic period where higher future inflation is expected would be ________.

A) upward-sloping
B) flat
C) downward-sloping
D) lognormal

Question 43

The theory suggesting that for any given issuer, long-term interest rates tends to be higher than short-term rates is called ________.

A) expectation hypothesis
B) liquidity preference theory
C) market segmentation theory
D) interest parity theory

Question 44

An upward-sloping yield curve that indicates cheaper short-term borrowing costs than long-term borrowing costs is called as ________.

A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal yield curve

Question 45

In a bond indenture, subordination is the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

Question 46

Restrictive covenants are contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower.

Question 47

Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based on this information, the shape of the yield curve is ________.

A) upward sloping
B) downward sloping
C) flat
D) normal

Question 48

Coupon interest rate on a bond represents the percentage of the bond's par value that will be paid annually, typically in two equal semiannual payments, as interest.

Question 49

The restrictive debt covenant that imposes fixed assets is to guarantee fixed-payment obligations by maintaining a specified level of fixed assets.

Question 50

Explain liquidity, default risk, and maturity risk premiums.

Question 51

Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.

Question 52

A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs is called ________.

A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) linear yield curve

Question 53

Restrictive covenants, coupled with standard debt provisions, help the lender to monitor the borrower's activities to ensure efficient use of funds.

Question 54

Which of the following affects the slope of yield curve?

A) tax rates
B) dividend policy
C) selection of accounting standards
D) liquidity preferences

Question 55

________ mainly explains the tendency for the yield curve to be upward sloping.

A) Expectations theory
B) Liquidity preference theory
C) Market segmentation theory
D) Investor perception theory

Question 56

A trustee is a paid party representing the bond issuer in the bond indenture.

Question 57

The yield curve in an economic period where lower future inflation is expected would be ________.

A) upward-sloping
B) flat
C) downward-sloping
D) exponential

Question 58

A yield curve that reflects relatively similar borrowing costs for both short-term and long-term loans is called as ________.

A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal curve

Question 59

Which of the following is true of risk premium?

A) T-bills have a have a higher risk premium than that of Treasury bonds.
B) The government bonds have a higher risk premium than that of corporate bonds.
C) The speculative corporate issues have a lower risk premium than that of the higher rated corporate issues.
D) The lower-rated corporate issues have a higher risk premium than that of the higher rated corporate issues.

Question 60

Standard debt provisions specify certain record keeping and general business practices that must be ensured by the bond issuer.

Question 61

In a bond indenture, the term "security interest" refers to the fact that most firms that issue bonds are required to establish sinking fund provisions to protect bondholders.

Question 62

Restrictive covenants place operating and financial constraints on the borrower.

Question 63

A(n) ________ is a paid individual, corporation, or a commercial bank trust department that acts as a third party to a bond indenture.

A) trustee
B) investment banker
C) bond issuer
D) bond rating agency

Question 64

The bond indenture identifies any collateral pledged against a bond and specifies how it is to be maintained.

Question 65

Which of the following is a restrictive covenant?

A) to maintain satisfactory accounting records
B) to pay the taxes due
C) to supply audited financial statements
D) to impose fixed asset restrictions

Question 66

A debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms is called a(n) ________.

A) common stock
B) corporate bond
C) indenture
D) preferred stock

Question 67

To carry out systematic retirement of bonds, a corporation makes semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.

Question 68

The purpose of the restrictive debt covenant that prohibits the sale of accounts receivable is to ________.

A) assure the lender that additional borrowing is constrained
B) limit the amount of fixed-payment obligations
C) limit the realization of current assets to cash
D) limit the payment of annual cash dividends

Question 69

In a bond indenture, the term "security interest" refers to collateral pledged against the bond.

Question 70

________ means that subsequent creditors agree to wait until all claims of the are senior debt satisfied before having their claims satisfied.

A) Security interest
B) Subordination
C) Sinking fund requirement
D) Bond indenture

Question 71

The purpose of the restrictive debt covenant that imposes fixed assets restrictions is to ________.

A) protect the lender by controlling the risk and marketability of the borrower's security investment alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) prevent the firm from liquidation and ensure its ability to repay the debt

Question 72

Longer the maturity, higher is the cost of a bond.

Question 73

The legal contract setting forth the terms and provisions of a corporate bond is a(n) ________.

A) indenture
B) debenture
C) loan document
D) promissory note

Question 74

The purpose of the debt covenant that prohibits borrowers from entering into certain types of leases is to ________.

A) protect the lender by controlling the risk and marketability of the borrower's security investments alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) limit the annual cash dividends paid by the firm

Question 75

Bond indentures include restrictive covenants.These provisions protect the bondholders against ________.

A) increase in inflation rate
B) increase in borrower's risk
C) decrease in liquidity risk
D) maturity risk

Question 76

Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied.

Question 77

The purpose of the restrictive debt covenant that requires that subsequent borrowing be subordinated to the original loan is to ________.

A) maintain a minimum level of liquidity
B) limit the amount of fixed-payment obligations
C) ensure a long-run cash shortage does not cause an inability to meet current obligations
D) protect the original lender in the priority of claims during liquidation

Question 78

The lower a bond's default risk, the higher is the interest rate.

Question 79

A ________ is a restrictive provision in a bond indenture, providing for the systematic retirement of the bonds prior to their maturity.

A) redemption clause
B) sinking-fund requirement
C) conversion feature
D) subordination clause

Question 80

The purpose of the debt covenant that requires maintaining a minimum level of net working capital is to ________.

A) protect the lender by controlling the risk and marketability of the borrower's security investment alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) limit the annual cash dividends paid by the firm