Question 1

Default risk is held constant when drawing a yield curve.

Accepted Answer

Default risk is held constant when drawing a yield curve because the yield curve is a graphical representation of the relationship between the yield (interest rate) and the maturity of a bond. Default risk is the risk that the issuer of a bond will default on its obligation to pay interest and principal. When drawing a yield curve, the default risk is held constant because it is assumed that all bonds have the same default risk.

Question 2

According to the expectations hypothesis, future changes in short-term interest rates determine the shape of the yield curve.

Accepted Answer

The expectations hypothesis suggests that the shape of the yield curve is determined by investors' expectations about future short-term interest rates. If investors expect rates to rise, the yield curve will be upward sloping; if they expect rates to fall, it will be downward sloping or inverted.

Question 3

A positively sloped yield curve, according to the expectations hypothesis, suggests that short-term interest rates are expected to fall from their current levels.

Accepted Answer

A positively sloped yield curve, according to the expectations hypothesis, suggests that short-term interest rates are expected to rise in the future, not fall.

Question 4

A horizontal yield curve implies that investors in the market expect interest rates to remain essentially unchanged from their present level.

Accepted Answer

A horizontal yield curve indicates that the interest rates for short-term, medium-term, and long-term debt securities are very similar, suggesting that investors expect current interest rates to remain stable over time.

Question 5

The expectations hypothesis assumes that investors act as risk minimizers over their planned holding period.

Accepted Answer

The expectations hypothesis primarily suggests that the shape of the yield curve reflects investors' expectations about future interest rates, rather than directly implying that investors act as risk minimizers over their planned holding period.

Question 6

The expectations hypothesis asserts that investors derive their expectations about future interest rates on the basis of historical experience.

Accepted Answer

The expectations hypothesis suggests that the long-term interest rates are determined by the market's expectations of future short-term interest rates, not based on historical experience.

Question 7

The price elasticity of a security must be positive except when interest rates fall.

Accepted Answer

The price elasticity of a security, often referred to as its duration or interest rate sensitivity, does not have a fixed sign based on interest rate movements. It typically reflects how much the price of a security is expected to change in response to a change in interest rates, and for most bonds, this relationship is negative (prices rise when interest rates fall and vice versa), not positive.

Question 8

An increase in the price of gasoline is an example of inflation.

Accepted Answer

Inflation refers to the overall increase in the price level of goods and services in an economy over a period of time, not the price increase of a single item. An increase in the price of gasoline could contribute to inflation but is not, by itself, inflation.

Question 9

The Consumer Price Index (CPI), and the GDP inflator are common indexes used to measure inflation in a particular area over a particular length of time.

Accepted Answer

The answer of The Consumer Price Index (CPI), and the...

Question 10

The correlation between the rate of inflation and interest rates was relatively high for the 1970s but the correlation between inflation and interest rates was even higher in the U.S. during the 1960s, according to the textbook.

Accepted Answer

During the 1970s, the correlation between inflation and interest rates was higher due to the period of stagflation, where high inflation was coupled with high unemployment and stagnant demand. The 1960s experienced lower inflation rates and thus a different, often lower, correlation between inflation and interest rates.

Question 11

The difference between the real rate of interest and the nominal rate (ignoring the cross-product term) is equal to the inflation premium.

Accepted Answer

The Fisher equation explains that the nominal interest rate is equal to the real interest rate plus the inflation rate, which means the difference between the nominal rate and the real rate is indeed the inflation premium.

Question 12

The Fisher effect assumes that inflation is only partly anticipated by investors.

Accepted Answer

The Fisher effect states that the nominal interest rate is equal to the real interest rate plus the expected inflation rate, implying that inflation is fully anticipated by investors.

Question 13

According to the inflation-caused wealth effect, people will borrow and lend the same amount of funds at any expected real interest rate, regardless of the expected inflation rate.

Accepted Answer

The inflation-caused wealth effect suggests that if people expect higher inflation, they might feel poorer in real terms and therefore might be less inclined to borrow, while lenders might demand higher nominal interest rates to compensate for the expected loss in purchasing power, affecting the amounts borrowed and lent at any given real interest rate.

Question 14

The price elasticity of a security usually is measured from its par value and coupon rate.

Accepted Answer

The answer of The price elasticity of a security usually...

Question 15

The price elasticity of a debt security is always negative.

Accepted Answer

The price elasticity of a debt security is negative because as the price of the security increases, the yield decreases, and vice versa. This is because the yield is calculated as the annual interest payment divided by the price of the security.

Question 16

The price elasticity of a debt security measures to speed of change in price with a change in interest rates.

Accepted Answer

The price elasticity of a debt security, often referred to as duration or interest rate sensitivity, measures the percentage change in price for a given change in yield or interest rates, not the speed of change.

Question 17

For the same change in yield, capital gains from a fixed-income debt security (such as a bond) will be smaller than capital losses.

Accepted Answer

Capital gains and losses from a fixed-income security are symmetrical for the same change in yield, meaning they are equal in magnitude but opposite in direction.

Question 18

The greater the price elasticity of a security the greater its price change for any given change in market interest rates.

Accepted Answer

Price elasticity of a security refers to how sensitive its price is to changes in market interest rates. A higher elasticity means the security's price is more sensitive and will experience larger changes in response to interest rate movements.

Question 19

The elasticity of a debt security is not affected by its coupon rate, but the security's maturity does affect its elasticity; longer-maturity debt instruments usually have greater elasticity.

Accepted Answer

The elasticity of a debt security, which reflects its sensitivity to interest rate changes, is affected by both its coupon rate and its maturity. Lower coupon rates and longer maturities generally increase a bond's sensitivity to interest rate changes, thus affecting its elasticity.

Question 20

A debt security with a low coupon rate compared to one with a high coupon rate, both having the same maturity date, will behave as though it has a longer maturity than the high-coupon security.

Accepted Answer

A debt security with a low coupon rate is more sensitive to interest rate changes than one with a high coupon rate, making its price more volatile and effectively giving it the characteristics of having a longer maturity. This is because the present value of its cash flows (which are smaller due to the lower coupon rate) is more affected by changes in interest rates.

Quiz 7: Effects of Inflation and Yield Curves on Stock Prices and Investments