Question 1

Treasury securities that mature in 6 years currently have an interest rate of 8.5%.Inflation is expected to be 5% each of the next three years and 6% each year after the third year.The maturity risk premium is estimated to be 0.1%(t − 1), where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero).The real risk-free rate is assumed to be constant over time.What is the real risk-free rate of interest?

Accepted Answer

E

Question 2

An inverted yield curve

Accepted Answer

An inverted yield curve occurs when short-term interest rates are higher than long-term rates, indicating investors' expectations of a future economic slowdown.

Question 3

Assume that the current yield curve is upward sloping, or normal.This implies that

Accepted Answer

An upward sloping (normal) yield curve typically implies that long-term interest rates are higher than short-term rates, reflecting expectations of future economic growth, potential inflation, or higher interest rates in the future. It does not necessarily imply any of the specific conditions listed in options A, B, C, or D.

Question 4

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

Accepted Answer

The liquidity preference theory suggests that investors prefer to hold short-term bonds due to their higher liquidity, and thus, the demand for short-term bonds is higher than for long-term bonds. This higher demand leads to higher prices and lower yields for short-term bonds, resulting in an upward sloping yield curve.

Question 5

If the Federal Reserve sells $50 billion of short-term U.S.Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates?

Accepted Answer

When the Federal Reserve sells short-term US Treasury securities to the public, it increases the supply of those securities. As the supply in the market increases, the demand for those bonds decreases, leading to a drop in bond prices. Interest rates and bond prices are inversely related, so as bond prices drop, the interest rates increase. Therefore, the correct answer is D. Prices will decline and interest rates will rise.

Question 6

Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7%, respectively.Assume that the pure expectations theory holds and that the market is in equilibrium.Which of the following statements is most correct?

Accepted Answer

The answer of Interest rates on 1-year, 2-year, and 3-year...

Question 7

Which of the following statements is most correct?

Accepted Answer

According to the expectations theory of the term structure of interest rates, the slope of the yield curve depends on investors' expectations of future interest rates. If the maturity risk premium were zero, this would mean that investors require the same return on short-term and long-term bonds, and therefore the yield curve would only depend on expectations of future interest rates. If inflation is expected to increase in the future, investors would demand a higher yield on long-term bonds to compensate for the loss of purchasing power, leading to an upward slope of the yield curve.

Question 8

If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are invalid, and we observe a downward sloping yield curve, which of the following is a true statement?

Accepted Answer

According to the expectations theory, an inverted yield curve indicates that investors expect short-term rates to decrease in the future. This is because long-term rates are a function of expected future short-term rates plus a premium, and if the premium is the same or smaller for longer maturities, then the expected short-term rates must be lower. The other answer choices contradict this theory. The maturity risk premium can be positive or negative depending on investor preferences and market conditions, and is not relevant to this question.

Question 9

Assume that r* = 2.0%; the maturity risk premium is found as MRP = 0.1%(t − 1) where t = years to maturity; the default risk premium for corporate bonds is found as DRP = 0.05%(t − 1); the liquidity premium is 1.0% for corporate bonds only; and inflation is expected to be 3%, 4%, and 5% during the next three years and then 6% thereafter.What is the difference in interest rates between 10-year corporate and Treasury bonds?

Accepted Answer

The interest rate on a bond can be calculated using the formula: interest rate = r* + IP + MRP + DRP + LP, where r* is the real risk-free rate, IP is the inflation premium, MRP is the maturity risk premium, DRP is the default risk premium, and LP is the liquidity premium.For a 10-year Treasury bond:- r* = 2.0%- IP = Average inflation over 10 years. Given the inflation rates, the average would be (3% + 4% + 5% + 6%*7)/10 = 5.5% (since the first three years are 3%, 4%, and 5%, and then 6% thereafter for 7 years).- MRP = 0.1%(t - 1) = 0.1%(10 - 1) = 0.9%- DRP = 0% (since it's a Treasury bond, there's no default risk premium).- LP = 0% (liquidity premium is not applicable to Treasury bonds).Therefore, the interest rate for the 10-year Treasury bond = 2.0% + 5.5% + 0.9% = 8.4%.For a 10-year corporate bond:- r* = 2.0%- IP = 5.5% (same calculation as above).- MRP = 0.9% (same as above).- DRP = 0.05%(t - 1) = 0.05%(10 - 1) = 0.45%- LP = 1.0%Therefore, the interest rate for the 10-year corporate bond = 2.0% + 5.5% + 0.9% + 0.45% + 1.0% = 9.85%.The difference in interest rates between the 10-year corporate and Treasury bonds = 9.85% - 8.4% = 1.45%.

Question 10

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 AAA rating indicates a low default risk, but the 5-year maturity will limit interest rate risk. The BBB ratings indicate a higher default risk, but the 10-year maturity and perpetual nature of options B and C will expose the investor to greater interest rate risk. Therefore, option D is the best choice as it balances both criteria.

Question 11

Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively.What is the average expected inflation rate over this 5-year period?

Accepted Answer

The average expected inflation rate over the 5-year period is calculated by adding the expected rates of inflation for each year and then dividing by the number of years. So, (4% + 7% + 10% + 8% + 6%) / 5 = 35% / 5 = 7%.

Question 12

Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero.If the annual rate of interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what rate of interest should you expect on a 1-year Treasury bond one year from now?

Accepted Answer

The answer of Assume that the expectations theory holds, and...

Question 13

Which of the following statements is correct?

Accepted Answer

Reinvestment rate risk is indeed lower for long-term bonds compared to short-term bonds because the principal and interest payments from long-term bonds are locked in for a longer period, reducing the frequency of reinvesting at potentially lower rates.

Question 14

In a recent year, interest rates on long-term government and corporate bonds were as follows:  The differences in rates among these issues were caused primarily by

Accepted Answer

The answer of In a recent year, interest rates on...

Question 15

Given the following data, find the expected rate of inflation during the next year. r* = real risk-free rate = 3%.
Maturity risk premium on 10-year T-bonds = 2%.It is zero on 1-year bonds, and a linear relationship exists.
Default risk premium on 10-year, A-rated bonds = 1.5%.
Liquidity premium = 0%.
Going interest rate on 1-year T-bonds = 8.5%.

Accepted Answer

The answer of Given the following data, find the expected...

Question 16

Which of the following statements is correct?

Accepted Answer

The answer of Which of the following statements is correct?
...

Question 17

Which of the following statements is most correct?

Accepted Answer

The real risk-free rate (r*) can be calculated by subtracting the expected rate of inflation from the nominal interest rate. So, r* = 5% - 3% = 2%. Maturity risk and liquidity premiums are assumed to be zero in this scenario.

Question 18

Assume that r* = 1.0%; the maturity risk premium is found as MRP = 0.2%(t − 1) where t = years to maturity; the default risk premium for AT&T bonds is found as DRP = 0.07%(t − 1); the liquidity premium is 0.50% for AT&T bonds but zero for Treasury bonds; and inflation is expected to be 7%, 6%, and 5% during the next three years and then 4% thereafter.What is the difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds?

Accepted Answer

The difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds can be calculated by considering the default risk premium (DRP), the liquidity premium (LP), and the maturity risk premium (MRP) for AT&T bonds, since Treasury bonds do not have DRP or LP and both types of bonds would have the same MRP. For a 10-year bond, the DRP = 0.07%(10 - 1) = 0.63%, the LP = 0.50%, and the MRP does not contribute to the difference since it affects both types of bonds equally. Therefore, the total difference = DRP + LP = 0.63% + 0.50% = 1.13%.

Question 19

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

Accepted Answer

An inverted yield curve indicates that short-term interest rates are higher than long-term rates. Therefore, the yield to maturity on a 10-year Treasury coupon bond is likely to be lower than that on a 1-year T-bond. This is because investors require less compensation for longer-term risks when they believe that short-term rates will remain high.

Question 20

Suppose that the annual expected rates of inflation over each of the next five years are 5 percent, 6 percent, 9 percent, 13 percent, and 12 percent, respectively.What is the average expected rate of inflation over the 5-year period?

Accepted Answer

The answer of Suppose that the annual expected rates of...

Quiz 5: The Cost of Money Interest Rates

An inverted yield curve

Assume that the current yield curve is upward sloping, or normal.This implies that

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

If the Federal Reserve sells $50 billion of short-term U.S.Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates?

Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7%, respectively.Assume that the pure expectations theory holds and that the market is in equilibrium.Which of the following statements is most correct?

Which of the following statements is most correct?

If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are invalid, and we observe a downward sloping yield curve, which of the following is a true statement?

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?

Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6 percent, respectively.What is the average expected inflation rate over this 5-year period?

Which of the following statements is correct?

In a recent year, interest rates on long-term government and corporate bonds were as follows: The differences in rates among these issues were caused primarily by

Which of the following statements is correct?

Which of the following statements is most correct?

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?

Suppose that the annual expected rates of inflation over each of the next five years are 5 percent, 6 percent, 9 percent, 13 percent, and 12 percent, respectively.What is the average expected rate of inflation over the 5-year period?