Deck 6: Interest Rates

Question 1

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) weather conditions.

Answer 1

False

Question 2

One of the four most fundamental factors that affect the cost of money as discussed in the text is the current state of the weather. If the weather is dark and stormy, the cost of money will be higher than if it is bright and sunny, other things held constant.

Answer 2

False

Question 3

One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for consumption. The higher the time preference, the lower the cost of money, other things held constant.

Answer 3

False

Question 4

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward-sloping yield curve.

Question 5

If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

Question 6

One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security. The higher the risk, the higher the security's required return, other things held constant.

Question 7

The "yield curve" shows the relationship between bonds' maturities and their yields.

Question 8

If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill.

Question 9

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) the skill level of the economy's labor force.

Question 10

Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong.

Question 11

The risk that interest rates will decline, and that decline will lead to a decline in the income provided by a bond portfolio as interest and maturity payments are reinvested, is called "reinvestment rate risk."

Question 12

Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

Question 13

Since yield curves are based on a real risk-free rate plus the expected rate of inflation, at any given time there can be only one yield curve, and it applies to both corporate and Treasury securities.

Question 14

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

Question 15

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk."

Question 16

If the pure expectations theory is correct, a downward-sloping yield curve indicates that interest rates are expected to decline in the future.

Question 17

During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

Question 18

An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal."

Question 19

If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*.

Question 20

The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.

Question 21

Which of the following statements is CORRECT?

A) The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.
B) The most likely explanation for an inverted yield curve is that investors expect inflation to increase.
C) The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.
D) If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.
E) Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

Question 22

Which of the following would be most likely to lead to a higher level of interest rates in the economy?

A) Households start saving a larger percentage of their income.
B) Corporations step up their expansion plans and thus increase their demand for capital.
C) The level of inflation begins to decline.
D) The economy moves from a boom to a recession.
E) The Federal Reserve decides to try to stimulate the economy.

Question 23

Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, we could be sure that

A) Long-term interest rates are more volatile than short-term rates.
B) Inflation is expected to decline in the future.
C) The economy is not in a recession.
D) Long-term bonds are a better buy than short-term bonds.
E) Maturity risk premiums could help to explain the yield curve's upward slope.

Question 24

A bond trader observes the following information: • The Treasury yield curve is downward sloping. • Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. • Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields. On the basis of this information, which of the following statements is most CORRECT?

A) A 10-year corporate bond must have a higher yield than a 5-year Treasury bond.
B) A 10-year Treasury bond must have a higher yield than a 10-year corporate bond.
C) A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.
D) The corporate yield curve must be flat.
E) Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping.

Question 25

One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

Question 26

The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?

A) The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
B) The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
C) The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
D) The conditions in the problem cannot all be true--they are internally inconsistent.
E) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

Question 27

Which of the following statements is CORRECT?

A) If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.
B) If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat.
C) If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.
D) If the expectations theory holds, the Treasury bond yield curve will never be downward sloping.
E) Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.

Question 28

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

A) The yield on a 10-year bond would be less than that on a 1-year bill.
B) The yield on a 10-year bond would have to be higher than that on a 1 year bill because of the maturity risk premium.
C) It is impossible to tell without knowing the coupon rates of the bonds.
D) The yields on the two securities would be equal.
E) It is impossible to tell without knowing the relative risks of the two securities.

Question 29

Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

Question 30

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

Question 31

In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t − 1)%, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT?

A) The yield on 2-year Treasury securities must exceed the yield on 5 year Treasury securities.
B) The yield on 5-year Treasury securities must exceed the yield on 10 year corporate bonds.
C) The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds.
D) The yield curve must be "humped."
E) The yield curve must be upward sloping.

Question 32

Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that

A) Inflation is expected to decline in the future.
B) The economy is not in a recession.
C) Long-term bonds are a better buy than short-term bonds.
D) Maturity risk premiums could help to explain the yield curve's upward slope.
E) Long-term interest rates are more volatile than short-term rates.

Question 33

Which of the following factors would be most likely to lead to an increase in nominal interest rates?

A) Households reduce their consumption and increase their savings.
B) A new technology like the Internet has just been introduced, and it increases investment opportunities.
C) There is a decrease in expected inflation.
D) The economy falls into a recession.
E) The Federal Reserve decides to try to stimulate the economy.

Question 34

Which of the following statements is CORRECT?

A) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
B) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.
C) The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.
D) If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.
E) The real risk-free rate should increase if people expect inflation to increase.

Question 35

Which of the following statements is CORRECT?

A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10 year Treasury bond.
B) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
C) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.
D) The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond.
E) The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

Question 36

Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?

A) If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
B) If the pure expectations theory holds, the corporate yield curve must be downward sloping.
C) If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
D) If inflation is expected to decline, there can be no maturity risk premium.
E) The expectations theory cannot hold if inflation is decreasing.

Question 37

Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by:

A) Tax effects.
B) Default and liquidity risk differences.
C) Maturity risk differences.
D) Inflation differences.
E) Real risk-free rate differences.

Question 38

Which of the following statements is CORRECT?

A) If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.
B) If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.
C) Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.
D) If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
E) The yield curve can never be downward sloping.

Question 39

Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information, which of the following statements is CORRECT?

A) The yield curve for U.S. Treasury securities will be upward sloping.
B) A 5-year corporate bond must have a lower yield than a 5-year Treasury security.
C) A 5-year corporate bond must have a lower yield than a 7-year Treasury security.
D) The real risk-free rate cannot be constant if inflation is not expected to remain constant.
E) This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

Question 40

Which of the following statements is CORRECT, other things held constant?

A) If companies have fewer good investment opportunities, interest rates are likely to increase.
B) If individuals increase their savings rate, interest rates are likely to increase.
C) If expected inflation increases, interest rates are likely to increase.
D) Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities.
E) Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

Question 41

The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT?

A) Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond.
B) Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.
C) Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds.
D) The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
E) The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Question 42

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 5.14%
B) 5.42%
C) 5.70%
D) 5.99%
E) 6.28%

Question 43

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?

A) 5.51%
B) 5.80%
C) 6.09%
D) 6.39%
E) 6.71%

Question 44

Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT?

A) The yield curve should be downward sloping, with the rate on a 1-year bond at 6%.
B) The interest rate today on a 2-year bond should be approximately 6%.
C) The interest rate today on a 2-year bond should be approximately 7%.
D) The interest rate today on a 3-year bond should be approximately 7%.
E) The interest rate today on a 3-year bond should be approximately 8%.

Question 45

Which of the following statements is CORRECT?

A) Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve.
B) If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.
C) The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.
D) Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted.
E) The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.

Question 46

Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things held constant, what would be the most likely effect on short-term securities' prices and interest rates?

A) Prices and interest rates would both rise.
B) Prices would rise and interest rates would decline.
C) Prices and interest rates would both decline.
D) Prices would decline and interest rates would rise.
E) There is no reason to expect a change in either prices or interest rates.
Multiple Choice: Problems
Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the

Question 47

Which of the following statements is CORRECT?

A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10 year Treasury bond.
B) The real risk-free rate is higher for corporate than for Treasury bonds.
C) Most evidence suggests that the maturity risk premium is zero.
D) Liquidity premiums are higher for Treasury than for corporate bonds.
E) The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

Question 48

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT?

A) In equilibrium, long-term rates must be equal to short-term rates.
B) An upward-sloping yield curve implies that future short-term rates are expected to decline.
C) The maturity risk premium is assumed to be zero.
D) Inflation is expected to be zero.
E) Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

Question 49

If the pure expectations theory holds, which of the following statements is CORRECT?

A) The yield curve for both Treasury and corporate bonds should be flat.
B) The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping.
C) The yield curve for Treasury securities cannot be downward sloping.
D) The maturity risk premium would be zero.
E) If 2-year bonds yield more than 1-year bonds, an investor with a 2 year time horizon would almost certainly end up with more money if he or she bought 2-year bonds.

Question 50

Which of the following statements is CORRECT?

A) Downward-sloping yield curves are inconsistent with the expectations theory.
B) The actual shape of the yield curve depends only on expectations about future inflation.
C) If the pure expectations theory is correct, a downward-sloping yield curve indicates that interest rates are expected to decline in the future.
D) If the yield curve is upward sloping, the maturity risk premium must be positive and the inflation rate must be zero.
E) Yield curves must be either upward or downward sloping--they cannot first rise and then decline.

Question 51

Which of the following statements is CORRECT?

A) The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
B) Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
C) The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping.
D) If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
E) Liquidity premiums are generally higher on Treasury than on corporate bonds.

Question 52

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 3.80%
B) 3.99%
C) 4.19%
D) 4.40%
E) 4.62%

Question 53

Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT?

A) If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds.
B) If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds.
C) If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal.
D) If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds.
E) If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.

Question 54

Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 4.10%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 5.38%
B) 5.66%
C) 5.96%
D) 6.27%
E) 6.60%

Question 55

Assuming the pure expectations theory is correct, which of the following statements is CORRECT?

A) If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise.
B) If both 2-year and 3-year Treasury rates are 7%, then 5-year rates must also be 7%.
C) If 1-year rates are 6% and 2-year rates are 7%, then the market expects 1-year rates to be 6.5% in one year.
D) Reinvestment rate risk is higher on long-term bonds, and interest rate (price) risk is higher on short-term bonds.
E) Interest rate (price) risk and reinvestment rate risk are relevant to investors in corporate bonds, but these concepts do not apply to Treasury bonds.

Question 56

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 6.60%
B) 6.95%
C) 7.32%
D) 7.70%
E) 8.09%

Question 57

If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT?

A) An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future.
B) A 5-year T-bond would always yield less than a 10-year T-bond.
C) The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
D) The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope.
E) If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.

Question 58

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 5.08%
B) 5.35%
C) 5.62%
D) 5.90%
E) 6.19%

Question 59

If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?

A) An upward-sloping yield curve would imply that interest rates are expected to be lower in the future.
B) If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now.
C) The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond.
D) Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.
E) Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

Question 60

Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?

A) The yield on 10-year Treasury securities must exceed the yield on 7 year Treasury securities.
B) The yield on any corporate bond must exceed the yields on all Treasury bonds.
C) The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
D) The stated conditions cannot all be true--they are internally inconsistent.
E) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

Question 61

Niendorf Corporation's 5-year bonds yield 8.00%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf's bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf's bonds?

A) 1.31%
B) 1.46%
C) 1.62%
D) 1.80%
E) 2.00%

Question 62

Suppose the rate of return on a 10-year T-bond is 6.55%, the expected average rate of inflation over the next 10 years is 2.0%, the MRP on a 10-year T-bond is 0.9%, no MRP is required on a TIPS, and no liquidity premium is required on any Treasury security. Given this information, what should the yield be on a 10-year TIPS? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 2.97%
B) 3.13%
C) 3.29%
D) 3.47%
E) 3.65%

Question 63

If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?

A) 1.90%
B) 2.09%
C) 2.30%
D) 2.53%
E) 2.78%

Question 64

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?

A) 5.840%
B) 6.148%
C) 6.471%
D) 6.812%
E) 7.152%

Question 65

Crockett Corporation's 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 3.60%, the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds, the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What inflation premium (IP) is built into 5-year bond yields?

A) 0.68%
B) 0.75%
C) 0.83%
D) 0.91%
E) 1.00%

Question 66

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2 year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

A) 7.36%
B) 7.75%
C) 8.16%
D) 8.59%
E) 9.04%

Question 67

Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds?

A) 0.73%
B) 0.81%
C) 0.90%
D) 0.99%
E) 1.09%

Question 68

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Include cross-product terms, i.e., if averaging is required, use the geometric average.

A) 5.21%
B) 5.49%
C) 5.78%
D) 6.07%
E) 6.37%

Question 69

Koy Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Koy's bonds?

A) 5.94%
B) 6.60%
C) 7.26%
D) 7.99%
E) 8.78%

Question 70

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 1.81%
B) 1.90%
C) 2.00%
D) 2.10%
E) 2.21%

Question 71

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

A) 1.08%
B) 1.20%
C) 1.32%
D) 1.45%
E) 1.60%

Question 72

Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The default risk premium for Kop's bonds is DRP = 0.40%, the liquidity premium on Kop's bonds is LP = 1.70% versus zero on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*?

A) 2.04%
B) 2.14%
C) 2.26%
D) 2.38%
E) 2.50%

Question 73

Suppose 1-year Treasury bonds yield 4.00% while 2-year T-bonds yield 5.10%. Assuming the pure expectations theory is correct, and thus the maturity risk premium for T-bonds is zero, what is the yield on a 1-year T-bond expected to be one year from now?

A) 5.90%
B) 6.21%
C) 6.52%
D) 6.85%
E) 7.19%

Question 74

Kern Corporation's 5-year bonds yield 7.30% and 5-year T-bonds yield 4.10%. The real risk-free rate is r* = 2.5%, the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern's bonds is LP = 1.3%, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds?

A) 1.20%
B) 1.32%
C) 1.45%
D) 1.60%
E) 1.68%

Question 75

Keys Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys' bonds is LP = 0.5% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys' bonds?

A) 1.17%
B) 1.30%
C) 1.43%
D) 1.57%
E) 1.73%

Question 76

5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*?

A) 2.59%
B) 2.88%
C) 3.20%
D) 3.52%
E) 3.87%

Question 77

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Include the cross-product term, i.e., if averaging is required, use the geometric average.

A) 5.15%
B) 5.42%
C) 5.69%
D) 5.97%
E) 6.27%

Question 78

Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.90% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

A) 1.75%
B) 1.84%
C) 1.93%
D) 2.03%
E) 2.13%

Question 79

Kay Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds?

A) 0.36%
B) 0.41%
C) 0.45%
D) 0.50%
E) 0.55%

Question 80

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? The cross-product term should be considered , i.e., if averaging is required, use the geometric average.

A) 3.68%
B) 3.87%
C) 4.06%
D) 4.26%
E) 4.48%