Question 1

_____ is the tendency of prices to increase over time.

Accepted Answer

Inflation is the tendency of prices to increase over time. It occurs when the purchasing power of money declines, leading to an increase in the prices of goods and services.

Question 2

Bonds with higher liquidity have to offer higher interest rates in the market since they can be easily converted into cash on short notice at or near the fair market value for that bond.

Accepted Answer

Bonds with higher liquidity tend to have lower interest rates because they are more easily traded and investors are more willing to buy them, which drives down the interest rate needed to attract buyers. Bonds with lower liquidity, on the other hand, may offer higher interest rates as compensation for the increased risk and difficulty in trading them.

Question 3

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

Accepted Answer

This is because as rates increase, investors have other options to invest their money that provide higher returns. As a result, demand for financial assets with lower returns decreases, causing their prices to decrease.

Question 4

As a country increases its borrowing to finance its foreign trade deficit, interest rates are driven up.

Accepted Answer

When a country borrows to finance its foreign trade deficit, there is an increase in the demand for money in the economy. This increase in demand for money leads to an increase in interest rates, as lenders raise rates to compensate for the higher level of risk involved in lending to the government or businesses that are deficit financing. Therefore, as a country increases its borrowing to finance its foreign trade deficit, interest rates are driven up.

Question 5

A bond purchased for $950 was sold for $980 after one year. The interest received during the year is $25. The bond's yield is:

Accepted Answer

The bond's yield can be calculated using the following formula:

Yield = (Interest + (Sale Price - Purchase Price)) / Purchase Price

Yield = (25 + (980 - 950)) / 950 
Yield = 5.79%

Therefore, the answer is choice B, 5.79%.

Question 6

The higher the perceived risk, the higher the required rate of return.

Accepted Answer

This is a commonly accepted principle in finance. When investors perceive an investment as riskier, they will demand a higher rate of return to compensate for that risk. This is because they want to be rewarded for taking on the additional risk, and they want to ensure that the return they receive is commensurate with the amount of risk they are taking.

Question 7

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

Accepted Answer

The real rate of interest is the nominal rate minus inflation, not including risk premiums like default or liquidity premiums.

Question 8

The yield curve is downward sloping, or inverted, if the inflation rates are expected to increase.

Accepted Answer

The yield curve is downward sloping or inverted when short-term interest rates are higher than long-term interest rates. This can happen for a variety of reasons, such as expectations of an economic recession, but inflation rates alone do not determine the shape of the yield curve.

Question 9

Firms with the most profitable investment opportunities are willing and able to pay the most for capital, so they tend to attract it away from less efficient firms or from those whose products are not in demand.

Accepted Answer

This statement is true. Firms with profitable investment opportunities have the potential to generate greater returns on capital, which makes them more attractive to investors. As a result, they are willing to pay more for capital and can often secure funding at lower costs compared to less efficient firms or those with less promising investment opportunities.

Question 10

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

Accepted Answer

Capital gains can be negative if the value of the investment decreases during the period it is held, as opposed to dividends and interests, which are predetermined payments, and risk and maturity, which do not directly relate to the actual return on the investment.

Question 11

Deficit trade balance hinders the Federal Reserve's ability to combat a recession by lowering interest rates.

Accepted Answer

A deficit trade balance implies that a country is importing more goods and services than it is exporting. This leads to a decrease in the demand for the country's currency, making it difficult for the Federal Reserve to lower interest rates. Lowering interest rates would further decrease the demand for the currency and worsen the trade balance deficit, leading to inflation and other economic problems. Thus, deficit trade balance hinders the Federal Reserve's ability to combat a recession by lowering interest rates.

Question 12

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

Accepted Answer

When the Federal Reserve tightens the money supply, it becomes costlier for banks to borrow money, leading to an increase in short-term interest rates. However, the long-term market may not be impacted to the same extent due to factors such as inflation expectations and demand for long-term bonds. Therefore, the increase in short-term rates is likely to be greater than the increase in long-term rates.

Question 13

Investors with a _____ will demand a higher rate of return.

Accepted Answer

Investors with a higher time preference for consumption value the present more than the future, so they will demand a higher rate of return to compensate for the opportunity cost of not consuming their money now.

Question 14

The value of an asset is the future value of the future cash flows that the asset is expected to generate during its life.

Accepted Answer

The value of an asset is typically considered to be the present value of the future cash flows it is expected to generate, not the future value.

Question 15

_____ is the chance that a financial asset will not earn the return promised.

Accepted Answer

Risk refers to the uncertainty or volatility surrounding the expected returns of a financial asset, i.e., the possibility that actual returns could be lower than expected or even negative. This risk could be due to various factors such as market changes, political instability, creditworthiness, default risk, etc.

Question 16

The expectations theory postulates that the term structure of interest rates is based on expectations regarding future inflation rates.

Accepted Answer

The expectations theory indeed suggests that the shape of the yield curve is determined by the market's expectations of future inflation rates. Specifically, if investors anticipate an increase in inflation in the future, they will demand higher yields for longer-term bonds to compensate for the erosion of the purchasing power of their principal and interest payments. This, in turn, leads to a steepening of the yield curve. Conversely, if inflation is expected to decrease, the opposite occurs, and the curve flattens or even inverts.

Question 17

During or near peaks of business activity, yield curves that are flat or downward sloping (possibly with humps) are prevalent.

Accepted Answer

The answer of During or near peaks of business activity,...

Question 18

Inflation leads to increase in purchasing power of investors.

Accepted Answer

Inflation has the opposite effect on purchasing power- it decreases the value of currency and therefore reduces the purchasing power of investors.

Question 19

If you have information that a recession is ending, and the economy is about to enter a boom, and your firm needs to borrow money, it should probably issue long-term rather than short-term debt.

Accepted Answer

If the economy is about to boom, interest rates are likely to increase in the future. Issuing long-term debt now locks in a lower interest rate, which can be beneficial for the firm in the long run. Short-term debt would need to be refinanced at a higher rate later on when interest rates increase.

Question 20

Production opportunity is one of the four fundamental factors that affect the:

Accepted Answer

Production opportunity affects the cost of money because it represents the potential return on investment in productive assets, influencing interest rates and the availability of funds.

Quiz 5: The Cost of Money Interest Rates