Question 1

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

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Question 2

Which of the following statements is CORRECT?

Accepted Answer

The answer of Which of the following statements is CORRECT?
...

Question 3

Which of the following statements is CORRECT?

Accepted Answer

The pure expectations theory implies that the shape of the yield curve only depends on expectations of future short-term interest rates. An upward sloping yield curve implies that investors expect interest rates to rise in the future, while a downward sloping yield curve implies that investors expect interest rates to decline in the future. Therefore, statement C is correct. Downward sloping yield curves are consistent with the expectations theory as long as investors expect short-term interest rates to decline in the future. Statements A, B, D, and E are incorrect.

Question 4

If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?

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Question 5

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

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Question 6

Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, and they are non-callable, so they cannot be retired early. Also, they are equally liquid, and we assume that the Treasury yield curve is based on the pure expectations theory. Under these conditions, which of the following statements is CORRECT?

Accepted Answer

The pure expectations theory states that the shape of the yield curve is determined solely by investors' expectations of future interest rates. If the yield curve is upward sloping, it means that investors expect interest rates to rise in the future. In this case, Long Corp's 20-year bond, which has a longer maturity, will be more sensitive to changes in interest rates and thus will have a higher yield compared to Short Corp's 10-year bond. However, if Short Corp has less default risk than Long Corp, investors will demand a lower yield on Short Corp's bonds to compensate for the lower risk. Therefore, Short's bonds would have a lower yield compared to Long's bonds in this scenario.

Question 7

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

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Question 8

If the pure expectations theory holds, which of the following statements is CORRECT?

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Question 9

Which of the following statements is CORRECT?

Accepted Answer

The pure expectations theory states that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates, and it assumes that the maturity risk premium for long-term Treasury bonds is zero. This theory does not suggest that the yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond, does not make any statement about the real risk-free rate being higher for corporate than for Treasury bonds, and does not indicate that liquidity premiums are higher for Treasury than for corporate bonds.

Question 10

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

Accepted Answer

To find the real risk-free rate of return, we can use the formula: r = r* + IP, where r is the nominal rate, IP is the expected inflation rate, and r* is the real risk-free rate. Rearranging the formula, we get r* = r - IP. Plugging in the given values, we get r* = 7.00% - 3.20% = 3.80%. We use the arithmetic average because we are not given any cross-product terms. Therefore, the correct answer is A) 3.80%.

Question 11

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Accepted Answer

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Question 12

Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?

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Question 13

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

If the U.S. Treasury issued $50 billion of short-term securities and sold them to the public, this would increase the supply of short-term securities in the market. This would lead to a decrease in prices and an increase in interest rates, as investors demand a higher return for purchasing these securities. Therefore, the most likely effect on short-term securities' prices and interest rates would be that prices would decline and interest rates would rise.

Question 14

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

The formula for calculating the expected inflation rate is:
Expected inflation rate = Nominal yield on TIPS - Real yield on TIPS
Real yield on TIPS = Nominal yield on T-bond - MRP on T-bond
Plugging in the given values, we get:
Expected inflation rate = 2.15% - (5.05% - 0.90%) = 2.00%
Therefore, the expected inflation rate over the next 10 years is 2.00%.

Question 15

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?

Accepted Answer

The equilibrium rate of return is calculated as the sum of the real risk-free rate and the expected inflation rate. Therefore, the equilibrium rate of return on a 1-year Treasury bond is 3.05% + 2.75% = 5.80%.

Question 16

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Accepted Answer

According to the given information, 
Real risk-free rate (r*) = 3.00%
Expected future inflation rate (IP) = 2.25%
Maturity risk premium (MRP) = 0.10%(t)

Using the Fisher equation, we can calculate the nominal rate required to compensate for inflation and provide the desired real rate of return:
Nominal rate = Real rate + Inflation rate
Nominal rate = r* + IP

For a 1-year Treasury security, the maturity risk premium will be MRP = 0.10%(1) = 0.10%

Nominal rate = 3.00% + 2.25% + 0.10% = 5.35%

Therefore, the expected rate of return on a 1-year Treasury security is 5.35%. The best choice is option B.

Question 17

If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT?

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Question 18

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-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

The answer of Suppose the real risk-free rate is 3.50%...

Question 19

Which of the following statements is CORRECT?

Accepted Answer

The answer of Which of the following statements is CORRECT?
...

Question 20

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

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Quiz 6: Bonds and Their Valuation

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?

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?

If the pure expectations theory holds, which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?

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?

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?

If the pure expectations theory is correct (that is, the maturity risk premium is zero) , which of the following is CORRECT?

Which of the following statements is CORRECT?