Question 1

Your uncle would like to restrict his interest rate risk and his default risk,but he still would like to invest in corporate bonds.Which of the possible bonds listed below best satisfies your uncle's criteria?

Accepted Answer

The best choice for your uncle would be a bond with a high credit rating (AAA) and a shorter time to maturity (5 years). This will reduce his interest rate risk and default risk.

Question 2

The term structure is defined as the relationship between interest rates and maturities of similar securities.

Accepted Answer

The term structure refers to the relationship between interest rates and maturities of similar securities, so the statement is true.

Question 3

The yield curve is downward sloping,or inverted,if the long-term rates are higher than the short-term rates.

Accepted Answer

False

Question 4

The fact that a percentage of the interest income received by one corporation is excluded from taxable income has encouraged firms to use more debt financing relative to equity financing.

Accepted Answer

The statement refers to the tax treatment of interest and dividends. In reality, the tax code typically allows corporations to deduct interest expenses on debt from their taxable income, which can encourage the use of debt financing. However, the exclusion from taxable income usually pertains to dividends received from investments in other corporations, not interest income, and this mechanism aims to mitigate double taxation of income rather than encourage debt financing.

Question 5

The existence of an upward sloping yield curve proves that the liquidity preference theory is correct,because an upward sloping curve necessarily implies that firms must offer a maturity risk premium in order to induce investors to lend for longer periods.

Accepted Answer

An upward sloping yield curve can result from various factors, not just the liquidity preference theory. It can also reflect expectations of higher future interest rates or inflation, among other factors, not solely a maturity risk premium.

Question 6

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

Accepted Answer

The answer of The real rate of interest is composed...

Question 7

Suppose financial institutions,such as savings and loans,were required by law to make long-term,fixed interest rate mortgages,but,at the same time,were largely restricted,in terms of their capital sources,to deposits that could be withdrawn on demand.Under these conditions,these financial institutions should prefer a "normal" yield curve to an inverted curve.

Accepted Answer

With a normal yield curve, long-term interest rates are higher than short-term interest rates. This would allow the financial institutions to earn a higher interest income on their long-term mortgages while paying a lower interest rate on their short-term deposits. If the yield curve were inverted, short-term interest rates would be higher than long-term interest rates, which would increase the cost of funds for financial institutions and reduce their profitability. Therefore, financial institutions under these conditions should prefer a normal yield curve.

Question 8

Investors with a higher time preference for consumption will demand a lower rate of return to forego current consumption and save than investors with a lower time preference for consumption.

Accepted Answer

Investors with a higher time preference for consumption have a lower willingness to delay gratification, which means they are less willing to forego current consumption and save. Hence, they would require a higher rate of return to incentivize them to save. Conversely, investors with a lower time preference for consumption are more patient and willing to postpone consumption, which means they can be satisfied with a lower rate of return to save.

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 because firms with the most profitable investment opportunities are expected to provide higher returns to their investors, making their investments more attractive than those of less efficient firms or those whose products are not in demand. As a result, these firms are more likely to receive capital investment, which can help them expand and become more profitable over time.

Question 10

If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense,it would probably encourage companies to use more debt financing than they presently do,other things held constant.

Accepted Answer

The answer of If the tax laws stated that $0.50...

Question 11

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

Issuing long-term debt would be more beneficial in a booming economy as interest rates may be higher in the future. It would also provide stability and consistency in the firm's financing, as short-term debt would need to be constantly refinanced.

Question 12

Bonds with higher liquidity will demand 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 are more easily traded, meaning they are in high demand, which typically leads to lower interest rates, not higher. Bonds with low liquidity may demand higher interest rates because they are harder to trade, and investors require a greater return to compensate for the added risk.

Question 13

The two reasons most experts give for the existence of a positive maturity risk premium are (1)because investors are assumed to be risk averse,and (2)because investors prefer to lend long while firms prefer to borrow short.

Accepted Answer

The primary reasons for a positive maturity risk premium are (1) because investors are assumed to be risk averse, which is correct, but (2) it's actually because investors generally prefer shorter-term investments due to their lower risk, while firms may prefer to borrow for longer terms to lock in interest rates, leading to a demand for higher returns for longer maturities to compensate for the increased risk.

Question 14

Which of the following statements is most correct? Other things held constant.

Accepted Answer

The liquidity preference theory suggests that investors prefer more liquid assets, which leads to a higher demand for short-term bonds and a lower demand for long-term bonds. This results in a higher yield for long-term bonds and an upward sloping yield curve.

Question 15

The nominal rate of interest is defined as the sum of the nominal risk-free rate of return and the expected inflation rate.

Accepted Answer

r_Nom = r_RF + DRP + LP + MRP.

Question 16

An investor with a six-year investment horizon believes that interest rates are determined only by expectations about future interest rates,(i.e.,this investor believes in the expectations theory).This investor should expect to earn the same rate of return over the 6-year time horizon if he or she buys a 6-year bond or a 3-year bond now and another 3-year bond three years from now (ignore transaction costs).

Accepted Answer

According to the expectations theory, the yield on a long-term bond is equal to the average of the short-term interest rates expected to occur over the life of the long-term bond. Therefore, if an investor believes that future interest rates will remain constant, buying a 6-year bond or two 3-year bonds with the same maturity dates should result in the same rate of return.

Question 17

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 18

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

Accepted Answer

This is true. During peak business activity, demand for credit and borrowing is high, which can limit the supply of available funds and increase short-term interest rates. This can lead to a flat or downward sloping yield curve, indicating that long-term interest rates are not much higher than short-term interest rates. The possibility of humps in the yield curve also exists as different parts of the curve can be affected differently by changes in interest rates or expectations for inflation.

Question 19

The liquidity preference theory states that each borrower and lender has a preferred maturity and that the slope of the yield curve depends on supply and demand for funds in the long-term market relative to the short-term market.

Accepted Answer

The answer of The liquidity preference theory states that each...

Question 20

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 Federal Reserve tightens the money supply, it becomes difficult for banks to lend money. As a result, short-term interest rates increase to obtain funds from the central bank. Long-term interest rates, on the other hand, are influenced by different factors such as inflation expectations and are usually less sensitive to short-term policy changes. Therefore, short-term interest rates will be pushed upward, and this increase is likely to be greater than the increase in the long-term market.

Quiz 5: The Cost of Money