Question 1

You have just looked up the stock quotation for Premier Images, Inc. in the Wall Street Journal. The PE ratio is listed as 20. The dividend is shown as $1.00, and the stock just closed (last) at $42.00. What are the yield % and the earnings per share (EPS) for Premier Images, Inc.?

Accepted Answer

Yield % = (Dividend / Price) x 100
Yield % = (1.00 / 42.00) x 100
Yield % = 2.38% ≈ 2.4%

EPS = Price / PE ratio
EPS = 42.00 / 20
EPS = $2.10

Therefore, the correct answer is A. Yield = 2.4%; EPS = $2.10.

Question 2

The ____ theory states that the yield curve slopes upward or downward based on the predicted future interest rates.

Accepted Answer

The expectations theory of the yield curve predicts that the slope of the yield curve is determined by investors' expectations of future interest rates. This theory assumes that all types of bonds are perfect substitutes, and therefore investors are indifferent to the maturity of a bond when making investment decisions. As a result, the yield on long-term bonds should be equal to the average of short-term interest rates expected over the life of the long-term bond. If investors expect interest rates to rise in the future, then the yield curve will have an upward slope, reflecting the higher yields required on longer-term bonds to compensate investors for the expected increase in interest rates. Conversely, if investors expect interest rates to decline in the future, then the yield curve will have a downward slope, reflecting the lower yields required on longer-term bonds.

Question 3

The liquidity preference theory of interest rates suggests that:

Accepted Answer

The liquidity preference theory of interest rates suggests that lenders prefer shorter-term loans as they are more liquid and therefore less risky. This preference for liquidity leads to an upward sloping yield curve, where longer-term debt has a higher yield to compensate for the higher level of risk. Therefore, option C is the correct choice as it correctly reflects the theoretical relationship between liquidity preference and the shape of the yield curve. Options A and B are incorrect as they do not accurately reflect the liquidity preference theory.

Question 4

The market segmentation theory proposes that:

Accepted Answer

The market segmentation theory proposes that the debt market is represented by a series of supply/demand diagrams each representing a different term, and that these operate independently of one another. This explains why different bonds may have different interest rates even if they have similar credit risks.

Question 5

Which of the following is not associated with federal government debt?

Accepted Answer

The answer of Which of the following is not associated...

Question 6

Which of the following statements is/are TRUE?

Accepted Answer

Option A is true as a yield curve does plot interest rates against time to maturity.
Option B is true as a normal yield curve is upward sloping as it reflects a situation where long-term bonds have a higher yield than short-term bonds.
Option C is also true as average expected inflation is reflected in interest rates. When inflation is high, interest rates increase to compensate for the loss of purchasing power. Hence, option D is also true. Therefore, the correct answer is option E - all of the above statements are true.

Question 7

Given the following closing stock quote, what was the closing price two business days ago. $\begin{array}{|l|l|l|l|l|l|l|l|l|}
\hline \text { YTD } & 52 \text { Weeks } & & \text { YLD } & & \text { VOL } & & \text { NET } & \
\hline \% \text { CHG } & \text { Hi } & \text { Lo } & \text { STOCK (SYM) } & \% & \text { PE } & 100 \text { s } & \text { LAST } & \text { CHG } \
\hline 21 \% & 81 & 32 & \text { XYZ (XYZ) } & 2.5 \% & 22 & 25000 & 51 & +.50 \
\hline
\end{array}$

Accepted Answer

The closing price two business days ago was $50.50. The current closing price is $51, and the net change is +$0.50, indicating that the price increased by $0.50 from the previous day. Therefore, two business days ago, the price was $51 - $0.50 = $50.50.

Question 8

Which of the following theories can be used to explain the shape of both inverted and normal yield curves?

Accepted Answer

The answer of Which of the following theories can be...

Question 9

Use the following information to calculate the interest rate on an eight-year bond just issued by Becher Inc. Inflation: next two years = 2.5%
Year 3 and beyond = 4.5%
Pure Rate = 2.0%
Maturity Risk Premium = zero for a 1-year maturity, increasing by 0.1% each year thereafter
Default Risk Premium = 1.5%
Liquidity Risk Premium = 0.0% for treasuries; 0.5% for corporate bonds

Accepted Answer

To calculate the interest rate on an eight-year bond, we need to find the sum of all the premium rates and add them to the pure rate and inflation rates.

Here is the breakdown of premium rates for an eight-year bond:

Maturity risk premium: 0.1% x 6 (years 2-7) = 0.6%
Default risk premium: 1.5%
Liquidity risk premium (for corporate bonds): 0.5%

The total premium rates sum up to 2.6%.

Next, we add the pure rate of 2.0% and inflation rates of 2.5% for two years and 4.5% for six years (years 3-8).

So, the interest rate on an eight-year bond issued by Becher Inc. would be:

2.6% + 2.0% + 2.5% + (6 years x 4.5%) = 8.7%

Therefore, the best choice is C) 8.7%.

Question 10

Assume the expected inflation rate is 5% for each of the next two years and 7% per year for the three years after. Calculate the inflation adjustment (INFL) for a 5-year loan.

Accepted Answer

The inflation adjustment (INFL) for a 5-year loan can be calculated as the average inflation rate over the period. For the first two years, the inflation rate is 5% each year, and for the next three years, it is 7% each year. The average inflation rate is calculated as: [(5% * 2) + (7% * 3)] / 5 = (10% + 21%) / 5 = 31% / 5 = 6.2%.

Question 11

If the yield curve is normal, what is the interest rate on a 20-year Treasury bond, compared to the interest rate on a 5-year Treasury bond?

Accepted Answer

In a normal yield curve, longer-term bonds typically have higher interest rates than shorter-term bonds. This means that the interest rate on a 20-year Treasury bond will be more than the interest rate on a 5-year Treasury bond.

Question 12

Economists forecast the following inflation rates for the next four years $\begin{array}{ll}
\text { Year } & \text { InflationRate } \
\hline 1 & 3 \% \
2 & 4 \% \
3 & 5 \% \
4 & 6 \%
\end{array}$ What inflation adjustment should be included in the interest rate on a four-year loan made today?

Accepted Answer

The average expected inflation rate over the four years is (3% + 4% + 5% + 6%) / 4 = 4.5%. This average rate should be included in the interest rate to account for inflation over the life of the loan.

Question 13

An inverted yield curve:

Accepted Answer

An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates, indicating investors' expectations for a downturn in the economy.

Question 14

The yield curve is:

Accepted Answer

Choice A is correct as an inverted yield curve occurs when short-term rates are higher than long-term rates.
Choice B is incorrect as a normal yield curve slopes upward to the right only in a graphical representation of the yield curve, not the definition of the yield curve.
Choice C is correct as the yield curve is a plot of interest rates versus term, also called the term structure of interest rates. 
Therefore, the best choice is D as it includes all of the correct answers.

Question 15

Economists forecast the following inflation rates for the next four years: $\begin{array}{ll}
\text { Year } & \text { InflationRate } \
\hline 1 & 3 \% \
2 & 4 \% \
3 & 5 \% \
4 & 6 \%
\end{array}$ What inflation adjustment should be included in the interest rate on a three-year loan made today?

Accepted Answer

The inflation adjustment should be based on the average expected inflation rate over the life of the loan, which is 4% for the three-year period.

Question 16

An investor desires to earn a real interest rate of 6%. If the expected rate of inflation is 5%, what nominal rate of interest would the investor set on a loan if all risk premiums are zero?

Accepted Answer

The answer of An investor desires to earn a real...

Question 17

What is the real rate of interest on a $50,000 loan if $62,000 repays the loan after one year, given a rate of inflation of 12%?

Accepted Answer

The answer of What is the real rate of interest...

Question 18

A 30 year corporate bond pays a higher interest rate than a 30 year federal government bond. This is due to a higher ____ premium on the corporate bond.

Accepted Answer

The higher interest rate on the corporate bond is due to the higher default risk associated with investing in a private corporation compared to the low risk of investing in the federal government.

Question 19

Assume that the pure interest rate is expected to be 3% for the foreseeable future, and inflation is expected to be 3%, 4% and 5% for each of the next three years and 6% thereafter. What is the base rate component for a 10-year bond?

Accepted Answer

The answer of Assume that the pure interest rate is...

Question 20

If a stock that has earnings per share of $1.50 is quoted in the Wall Street Journal as having a price-earnings ratio of 13, the closing price on that day must be:

Accepted Answer

The answer of If a stock that has earnings per...

Quiz 5: The Financial System, Corporate Governance, and Interest