Question 1

Long-term interest rates reflect expectations about future inflation.Inflation has varied significantly from year to year in the past,and as a result,long-term rates can be expected to fluctuate more than short-term rates.

Accepted Answer

Long-term interest rates do reflect expectations about future inflation, but they also incorporate premiums for the risk of holding longer-term securities. These rates are generally less volatile than short-term rates because they average out expected future short-term rates, including fluctuations due to varying inflation expectations over time.

Question 2

Assume investors demand a real rate of return equal to 3 percent and that there is no maturity risk premium associated with Treasury securities.According to the Wall Street Journal,the average nominal yields on risk-free Treasury securities with different maturities are:
Type of security
Yield1-year
4)5%2-year
4)63-year
4)84-year
5)0What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?

Accepted Answer

The answer of Assume investors demand a real rate of...

Question 3

During recessions the demand for funds typically ____.

Accepted Answer

During recessions, there is generally a decline in economic activity, which in turn leads to a decrease in demand for funds. Consumers and businesses tend to cut back on spending, and therefore require less financing from banks and other lenders.

Question 4

The real risk-free rate of interest is 3 percent.Inflation is expected to be 4 percent this coming year,jump to 5 percent next year,and run at 6 percent the year after (Year 3).According to the expectations theory,what should be the interest rate on 3-year,risk-free securities today?

Accepted Answer

The expectations theory suggests that the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. To calculate the expected interest rate for a 3-year security, we add the real risk-free rate to the expected inflation rates for each year, then average them. The calculation is as follows: Year 1: 3% (real risk-free rate) + 4% (inflation) = 7% Year 2: 3% + 5% = 8% Year 3: 3% + 6% = 9% The average of these rates is (7% + 8% + 9%) / 3 = 8%.

Question 5

You read in The Wall Street Journal that 30-day T-bills currently are yielding 8 percent.Your brother-in-law,a broker at Kyoto Securities,has given you the following estimates of current interest rate premiums:
Inflation premium
5%Liquidity premium
1%Maturity risk premium
2%Default risk premium
2%Based on these data,the real risk-free rate of return is

Accepted Answer

To find the real risk-free rate of return, we need to subtract the inflation premium from the 30-day T-bill yield, as the T-bill yield includes the inflation premium. Therefore, the real risk-free rate of return is 8% - 5% = 3%. The other premiums are not relevant for determining the real risk-free rate of return.

Question 6

Assume that the current interest rate on a 1-year bond is 8 percent,the current rate on a 2-year bond is 10 percent,and the current rate on a 3-year bond is 12 percent.If the expectations theory of the term structure is correct,what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average. )

Accepted Answer

The expectations theory suggests that the average of the expected future short-term interest rates will equal the long-term interest rates. The 3-year bond rate (12%) should equal the average of the current 1-year rate (8%), the expected 1-year rate in Year 2, and the expected 1-year rate in Year 3. Solving for the expected rate in Year 3 gives 16%.

Question 7

Default risk premiums

Accepted Answer

Default risk premiums do vary over time, as they are influenced by various factors such as market conditions, the issuer's financial health, and the overall economic environment. Therefore, option D is the correct answer. Options A, B, and C are incorrect as they make incorrect or incomplete statements about default risk premiums.

Question 8

In the textbook,the nominal interest rate is defined as being equal to the real risk-free rate,plus an inflation premium,plus a default risk premium,plus a liquidity premium,plus a maturity risk premium.

Accepted Answer

This is the correct definition of the nominal interest rate, as stated in various finance textbooks and financial literature. The nominal interest rate is the sum of the real risk-free rate (the rate of return an investor would earn on a riskless investment), an inflation premium (based on expected inflation), a default risk premium (reflecting the possibility of default by the borrower), a liquidity premium (compensating investors for the inability to sell the investment at the desired price or time), and a maturity risk premium (compensating investors for the risks associated with the length of the investment term).

Question 9

Most experts think that in the United States the real risk-free rate fluctuates between

Accepted Answer

Most experts agree that the real risk-free rate in the United States fluctuates between two to four percent. This rate is used as a benchmark for determining the appropriate return on investments and is adjusted for inflation to reflect the true rate of return.

Question 10

Which of the following is not one of the fundamental factors that affect the cost of money?

Accepted Answer

Exchange rates are not one of the fundamental factors that affect the cost of money. However, factors such as production opportunities, time preferences for consumption, risk, and inflation can affect the cost of money. Production opportunities reflect the potential return on investment, time preferences for consumption reflect the willingness to defer consumption for future investment, risk reflects the uncertainty of investment returns, and inflation reflects the decrease in purchasing power over time.

Question 11

The fundamental factors that affect the cost of money include

Accepted Answer

All of the options listed (production opportunities, inflation, risk, and time preference for consumption) can contribute to changes in the cost of money. Production opportunities refer to the potential returns that investors could receive from alternative investment opportunities, which can impact the demand for and supply of money. Inflation can influence the cost of money because borrowers may demand higher interest rates to offset the effect of inflation on the value of future payments. Risk may impact the cost of money due to the perceived default risk of the borrower, which could lead to a higher interest rate. Finally, time preference for consumption refers to the desire by many individuals to have goods and services now rather than later, which could influence the interest rate.

Question 12

Assume that the real risk-free rate,r*,is 4 percent,and that inflation is expected to be 9% in Year 1,6% in Year 2,and 4% thereafter.Assume also that all Treasury bonds are highly liquid and free of default risk.If 2-year and 5-year Treasury bonds both yield 12%,what is the difference in the maturity risk premiums (MRPs)on the two bonds,i.e. ,what is MRP₅ − MRP₂?

Accepted Answer

The Fisher equation states that the nominal interest rate (i) is the sum of the real risk-free rate (r*) and the expected inflation rate (π), adjusted for the maturity risk premium (MRP) when dealing with Treasury bonds longer than one year. The equation can be represented as: i = r* + π + MRP.Given:- Real risk-free rate (r*) = 4%- Inflation Year 1 = 9%, Year 2 = 6%, Year 3 and beyond = 4%- 2-year and 5-year Treasury bonds yield = 12%First, calculate the expected inflation rates for the 2-year and 5-year periods using the given inflation rates. For the 2-year bond, the average expected inflation rate is (9% + 6%) / 2 = 7.5%. For the 5-year bond, the average expected inflation rate is (9% + 6% + 4% + 4% + 4%) / 5 = 5.4%.Using the Fisher equation, we can solve for the MRP of each bond by rearranging the equation to MRP = i - r* - π.For the 2-year bond:MRP_2 = 12% - 4% - 7.5% = 0.5%For the 5-year bond:MRP_5 = 12% - 4% - 5.4% = 2.6%The difference in the MRPs is:MRP_5 - MRP_2 = 2.6% - 0.5% = 2.1%Therefore, the difference in the maturity risk premiums on the two bonds is 2.1%.

Question 13

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

Accepted Answer

When the Fed tightens the money supply, it reduces the amount of money available for borrowing, which leads to an increase in short-term interest rates. This increase is usually greater than the increase in long-term rates because short-term rates are more directly affected by changes in the money supply, whereas long-term rates are influenced by a variety of factors such as inflation expectations and economic growth prospects.

Question 14

Which of the following assets is the most liquid?

Accepted Answer

Cash is the most liquid asset as it can be easily and immediately converted to any other asset or used for transactions without any delay or loss of value. Stocks, treasury bills, and corporate bonds have varying degrees of liquidity and may require some time and effort to convert to cash.

Question 15

Assume that a 3-year Treasury note has no maturity premium,and that the real,risk-free rate of interest is 3 percent.If the T-note carries a yield to maturity of 13 percent,and if the expected average inflation rate over the next 2 years is 11 percent,what is the implied expected inflation rate during Year 3?

Accepted Answer

The answer of Assume that a 3-year Treasury note has...

Question 16

The ____ premium is compensation for possibility that the borrower will not be able to debt's interest and principal on time.

Accepted Answer

The premium for default risk is the compensation for the possibility that the borrower will not be able to pay back the debt's interest and principal on time. This risk is known as default risk. Choices A, B, and C refer to other types of risks associated with investing in debt securities.

Question 17

What is the yield on a one-year corporate bond with a $1,000 face value that pays a 12% annual dividend if it was purchased for $950 and held until maturity?

Accepted Answer

The yield is calculated as (Coupon Payment + (Face Value - Purchase Price)) / Purchase Price. Here, the coupon payment is $120 (12% of $1,000), and the gain from the price difference is $50 ($1,000 - $950). So, the yield is ($120 + $50) / $950 = $170 / $950 = 17.9%.

Question 18

You are given the following data:
R* = real risk-free rate
= 4%Constant inflation premium
= 7%Maturity risk premium
= 1%Default risk premium for AAA bonds
= 3%Liquidity premium for long-term T-bonds
= 2%Assume that a highly liquid market does not exist for long-term T-bonds,and the expected rate of inflation is a constant.Given these conditions,the nominal risk-free rate for T-bills is ____,and the rate on long-term Treasury bonds is ____.

Accepted Answer

Nominal risk-free rate for T-bills = R* + Inflation premium = 4% + 7% = 11%

Rate on long-term Treasury bonds = Nominal risk-free rate + Maturity risk premium + Default risk premium + Liquidity premium = 11% + 1% + 3% + 2% = 14%

Question 19

As the demand for funds increase,the demand curve will shift to the ____ resulting in ____ market clearing interest rate.

Accepted Answer

As the demand for funds increases, the demand curve shifts to the right, indicating a higher quantity of funds demanded at each interest rate. This leads to an increase in the market-clearing interest rate.

Question 20

Assume that the expectations theory of term structure holds.If the rate on a two-year Treasury bond is 8% and the rate on a three-year Treasury bond is 7%,what is the expected rate on a one-year Treasury bond in year three?

Accepted Answer

The answer of Assume that the expectations theory of term...

Quiz 5: The Cost of Money Interest Rates