Question 1

If the real risk-free rate is 112 basis points, the maturity risk premium is 177 basis points and the one-year inflation premium is 263 basis points, what is the nominal risk-free rate?
A) 2.63%.
B) 2.89%.
C) 3.75%.
D) 4.40%.
E) 5.52%.

Accepted Answer

C

Question 2

Which of the following items reflects the size of the market for the security in question?
A) Real risk-free rate.
B) Inflation premium.
C) Default risk premium.
D) Liquidity premium.
E) Maturity risk premium.

Accepted Answer

The liquidity premium reflects the size of the market for the security in question because it compensates investors for the risk of not being able to buy or sell the security quickly without affecting its price. A larger, more liquid market typically has a smaller liquidity premium, while a smaller, less liquid market has a larger liquidity premium.

Question 3

Which of the following items reflects the time value of money?
A) Real risk-free rate.
B) Inflation premium.
C) Default risk premium.
D) Liquidity premium.
E) Maturity risk premium.

Accepted Answer

The real risk-free rate reflects the time value of money as it represents the return on an investment with no risk of financial loss, accounting for the time preference of money.

Question 4

Which of the following items reflects the financial stability of the company that issued the security in question?
A) Real risk-free rate.
B) Inflation premium.
C) Default risk premium.
D) Liquidity premium.
E) Maturity risk premium.

Accepted Answer

The default risk premium reflects the financial stability of the company issuing the security. It represents the extra yield that investors demand for the risk that the issuer may default on its debt obligations.

Question 5

Which of the following items reflects the expected changes in purchasing power over the life of the security in question?
A) Real risk-free rate.
B) Inflation premium.
C) Default risk premium.
D) Liquidity premium.
E) Maturity risk premium.

Accepted Answer

The inflation premium reflects the expected changes in purchasing power over the life of the security. It compensates investors for the anticipated erosion of the purchasing power of their money due to inflation.

Question 6

Which of the following rules regarding interest rate premiums are true?
A) All bonds with maturities longer than one year must have maturity risk premiums.
B) All securities must have the real risk-free rate and an appropriate inflation premium.
C) US government securities do not have default risk or liquidity risk premiums.
D) All of the above are true.
E) None of the above is true.

Accepted Answer

All the statements provided are accurate descriptions of interest rate premiums and their application to various securities. Maturity risk premiums are necessary for bonds with maturities longer than one year due to the increased uncertainty and potential for interest rate changes over a longer period. All securities indeed must include the real risk-free rate and an appropriate inflation premium to compensate for the time value of money and the erosion of purchasing power due to inflation. US government securities are considered free of default risk, given the government's ability to raise funds through taxation or printing money, and they are highly liquid, thus not requiring liquidity risk premiums.

Question 7

The yield curve represents:
A) The relationship between bond yields and stock returns.
B) The relationship between default risk and time to maturity.
C) The relationship between short-term and long-term interest rates.
D) The relationship between risk and return.
E) The relationship between yield and price.

Accepted Answer

The yield curve represents the relationship between short-term and long-term interest rates, typically of bonds of the same credit quality. It is a graphical representation showing how the yields on bonds of different maturities compare.

Question 8

Use the following data to answer questions below
Assume the following premiums reflect current market conditions:
rS1U1P1*S1S1P0S1U1B1 S1U1B0= 3.15%;
IP (1-year bonds) = 2.35%;
IP (3-year bonds) = 2.65%;
IP (5-year bonds) = 2.90%;
DRP (AAA corporate bonds) = 0.60%;
DRP (AA+ corporate bonds) = 0.85%;
LP (AAA corporate bonds) = 0.22%;
LP (AA+ corporate bonds) = 0.30%;
MRP = 0.1% × (t − 1) where t is the number of years to maturity.
-Calculate the interest rate for a 1-year AA+ corporate bond.

Accepted Answer