Question 1

An upward-sloping yield curve suggests that financial market participants expect short-term interest rates will

Accepted Answer

An upward-sloping yield curve implies that long-term interest rates are higher than short-term interest rates, which indicates that financial market participants expect short-term interest rates to increase in the future. This is because investors demand a higher return on their investment to compensate for the higher risk associated with longer-term investments.

Question 2

Assume that the one-year interest rate is on the vertical axis of the IS-LM model and that the yield curve is initially upward sloping.Suppose that financial market participants expect that the central bank will pursue a monetary contraction in the future.Given this information,we would expect which of the following to occur?

Accepted Answer

The yield curve will become steeper because the expected future monetary contraction will increase the expected future short-term interest rates relative to the expected future long-term interest rates.

Question 3

Suppose financial market participants expect short-term rates in the future to be less than current short-term interest rates.Given this information,we would expect

Accepted Answer

If financial market participants expect short-term rates in the future to be less than current short-term interest rates, this suggests that there may be a potential for a decrease in borrowing costs in the future. This would result in an increase in demand for short-term bonds and therefore a decrease in their yields. As a result, the yield curve is likely to slope downward, indicating a lower yield for longer-term bonds compared to shorter-term bonds.

Question 4

A "junk bond" is a bond with a

Accepted Answer

A junk bond is a bond that has a high default risk, meaning there's a higher likelihood that the issuer will default on the bond and not repay the principal and interest to the investor.

Question 5

Suppose a bond promises to make a single payment at maturity.These types of bond are called

Accepted Answer

Discount bonds are bonds that do not pay periodic interest but are sold at a discount to their face value and promise to make a single payment at maturity.

Question 6

A bond has a face value of $10,000,a price of $12,000,and coupon payments of $2000 for two years.The coupon rate of this bond is

Accepted Answer

The coupon rate is calculated as the annual coupon payment divided by the face value of the bond. Here, the annual coupon payment is $2,000 and the face value is $10,000, so the coupon rate is $2,000 / $10,000 = 0.20 or 20%.

Question 7

A bond has a face value of $1,000,a price of $1,200,and coupon payments of $100 for two years.The "current yield" of this bond is

Accepted Answer

The current yield is calculated as the annual coupon payment divided by the bond's current price. Here, it's $100 / $1,200 = 0.0833 or 8.33%.

Question 8

A discount bond is a bond

Accepted Answer

A discount bond is a bond that is issued at a price lower than its face value and has no coupon payments. The bond's return is based solely on the difference between the initial purchase price and the face value at maturity.

Question 9

Suppose that financial market participants expect that the central bank will pursue a monetary expansion in the future.Also assume that the yield curve is initially upward sloping.Given this information,we would expect which of the following to occur?

Accepted Answer

If market participants expect a future monetary expansion, they anticipate lower future interest rates. This expectation would lead to a decrease in long-term interest rates (i₂t), causing the yield curve to flatten or potentially invert, not steepen.

Question 10

Which of the following bonds (of equal maturity)would have the largest risk premium?

Accepted Answer

Junk bonds have the highest risk premium as they are issued by companies with a higher likelihood of default and have lower credit ratings. All the other options have lower risk premiums as they are associated with lower default risk.

Question 11

Suppose the current one-year interest rate is 4%,and financial markets expect the one-year interest rate next year to be 8%.Given this information,the yield to maturity on a two-year bond will be approximately

Accepted Answer

Assuming the yield curve is upward sloping, we can use the expectation theory to estimate the yield to maturity on a two-year bond. According to this theory, the yield on a two-year bond is the average of the expected one-year rate in the first year and the expected one-year rate in the second year. In this case, the expected one-year rate in the first year is 4% and the expected one-year rate in the second year is 8%. Therefore, the yield to maturity on a two-year bond can be estimated as the average of these two rates, which is 6%.

Question 12

For this question,assume that one-year and two-year bonds have the same risk; therefore,you can ignore risk here.Assuming that there is arbitrage between one-year bonds and two-year bonds,we know that the expected rate of return on two-year bonds

Accepted Answer

In an arbitrage-free market, the expected rate of return on two-year bonds should equal the expected rate of return from holding a one-year bond for one year, assuming risk is the same and ignoring any other factors. This is because if the returns were different, investors would buy the bond with the higher return and sell the bond with the lower return, leading to an arbitrage opportunity until the returns equalize.

Question 13

The length of time over which a bond promises to make payments to the holder is called which of the following?

Accepted Answer

The length of time over which a bond promises to make payments to the holder is referred to as the bond's maturity or term to maturity, not specifically mentioned in the provided options.

Question 14

Which of the following statements about indexed bonds is correct?

Accepted Answer

Indexed bonds were relatively recently introduced in the United States, but they have existed in England for several decades. Indexed bonds have a nominal interest rate that rises when the inflation rate rises, making them a popular choice for investors who want to protect themselves against inflation.

Question 15

Suppose the current one-year interest rate is 4%.Also assume that financial markets expect the one-year interest rate next year to be 5%,and expect the one-year rate to be 6% the year after that.Given this information,the yield to maturity on a three-year bond will be approximately

Accepted Answer

The yield to maturity on a three-year bond can be approximated by taking the average of the expected one-year interest rates over the three-year period, which would be (4%+5%+6%)/3 = 5%. Therefore, the best choice is B.

Question 16

Suppose there is a decrease in the short-term interest rate.Give this reduction in the current short-term interest rate,which of the following will most likely occur?

Accepted Answer

Generally, when short-term interest rates decrease, long-term interest rates also decrease, but by a lesser amount. This is because long-term rates are influenced by a variety of factors, including inflation expectations and the overall health of the economy, while short-term rates are more sensitive to changes in monetary policy. Therefore, the long-term rate will decrease, but by less than the short-term rate.

Question 17

Which of the following best explains why the long-term interest rate will generally change by less than 1% when the short-term interest rate changes by 1%?

Accepted Answer

Financial market participants typically do not expect short-term interest rate changes to persist fully in the future. Therefore, they will not adjust long-term interest rates as much as short-term interest rates.

Question 18

Assume that the current one-year rate is 5% and the two-year rate is 7%.Given this information,the one-year rate expected one year from now is

Accepted Answer

The expected one-year rate one year from now can be calculated using the formula for forward rates: (1 + two-year rate)^2 = (1 + current one-year rate) * (1 + expected one-year rate). Solving for the expected one-year rate gives approximately 9%.

Question 19

Suppose the yield curve is initially horizontal.Suppose the current one-year interest rate increases by 4% while the expected future one-year interest rate does not change.Which of the following will tend to occur?

Accepted Answer

When the current one-year interest rate increases by 4% and the expected future one-year interest rate remains unchanged, the two-year interest rate (i₂t) will tend to increase by less than the full 4% increase in the one-year rate due to the averaging effect over two years, resulting in an increase of about 2%.

Question 20

Which of the following represents the ratio of coupon payments to the face value of a bond?

Accepted Answer

The ratio of coupon payments to the face value of a bond is known as the coupon rate. This rate is usually expressed as a percentage and represents the amount that the bond issuer will pay in interest to the bondholder each year.

Quiz 14: Financial Markets and Expectations