Deck 5: The Cost of Money Interest Rates

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?

A) 0.25%
B) 0.50%
C) 1.00%
D) 1.75%
E) 2.50%

Answer 1

2.50%

Question 2

An inverted yield curve

A) Exists when short-term rates exceed long-term rates.
B) Exists when long-term rates exceed short-term rates.
C) Represents the "normal term structure."
D) Signifies that investors can get higher returns by investing in bonds than by investing in stocks.
E) Signifies that investors can get higher returns on stocks than on bonds.

Answer 2

Exists when short-term rates exceed long-term rates.

Question 3

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

A) Short-term interest rates are more volatile than long-term rates.
B) Inflation is expected to subside in the future.
C) The economy is at the peak of a business cycle.
D) Long-term bonds are a better buy than short-term bonds.
E) None of the above statements is necessarily implied by the yield curve given.

Answer 3

None of the above statements is necessarily implied by the yield curve given.

Question 4

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

A) the "liquidity preference theory" would generally lead to an upward sloping yield curve.
B) the "market segmentation theory" would generally lead to an upward sloping yield curve.
C) the "expectations theory" would generally lead to an upward sloping yield curve.
D) the yield curve under "normal" conditions should be horizontal (i.e., flat.)
E) a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.

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?

A) Prices and interest rates will both rise.
B) Prices will rise and interest rates will decline.
C) Prices and interest rates will both decline.
D) Prices will decline and interest rates will rise.
E) There will be no changes in either prices or interest rates.

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?

A) The maturity risk premium is positive.
B) Interest rates are expected to rise over the next two years.
C) The market expects one-year rates to be 5.5% one year from today.
D) Answers a, b, and c are all correct.
E) Only answers b and c are correct.

Question 7

Which of the following statements is most 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 30-day T-bills than on 30-year T-bonds.
C) According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to have an upward slope.
D) The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve is normally upward sloping.
E) If the maturity risk premium were zero and the rate of inflation were expected to increase in the future, then the yield curve for U.S.Treasury securities would, other things held constant, have an upward slope.

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?

A) Investors expect short-term rates to be constant over time.
B) Investors expect short-term rates to increase in the future.
C) Investors expect short-term rates to decrease in the future.
D) It is impossible to say unless we know whether investors require a positive or negative maturity risk premium.
E) The maturity risk premium must be positive.

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?

A) 0.45%
B) 1.45%
C) 2.20%
D) 2.75%
E) 3.25%

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?

A) AAA bond with 10 years to maturity.
B) BBB perpetual bond.
C) BBB bond with 10 years to maturity.
D) AAA bond with 5 years to maturity.
E) BBB bond with 5 years to maturity.

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?

A) 6.5%
B) 7.5%
C) 8.0%
D) 6.0%
E) 7.0%

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?

A) 9.0%
B) 9.5%
C) 10.0%
D) 10.5%
E) 11.0%

Question 13

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) According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward.
D) The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping.
E) If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for U.S.Treasury securities would, other things held constant, have an upward slope.

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

A) Tax effects.
B) Default risk differences.
C) Maturity risk differences.
D) Inflation differences.
E) Answers b and d are both correct.

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%.

A) 3.5%
B) 4.5%
C) 5.5%
D) 6.5%
E) 7.5%

Question 16

Which of the following statements is correct?

A) If different markets existed for long-term and short-term bonds, but lenders and borrowers could move freely between markets, (1) the market segmentation theory could not really be an important determinant of the yield curve, and (2) maturity risk premiums could not be significant.
B) Because the default risk premium (DRP) and the liquidity premium (LP) are both essentially zero for U.S.Treasury securities, the Treasury yield curve is influenced more heavily by expected inflation than corporate bonds' yield curves, i.e., we can be sure that a given amount of expected inflation will have more effect on the slope of the Treasury yield curve than on the corporate yield curve.
C) According to the market segmentation theory, investors prefer to buy debt with short maturities.Therefore, the fundamental conclusion from this theory is that the yield curve normally should slope upwards.
D) It is theoretically possible for the yield curve to have a downward slope, and there have been times when such a slope existed.That situation was probably caused by investors' liquidity preferences, i.e., by the factors which underlie the liquidity preference theory.
E) Yield curves for government and corporate bonds can be constructed from data that exist in the marketplace.If the yield curves for several companies were plotted on a graph, along with the yield curve for U.S.Treasury securities, the company with the largest total of DRP plus LP would have the highest yield curve.

Question 17

Which of the following statements is most correct?

A) The more highly developed a nation's financial system is, the more likely funds are to flow from savers to borrowers by direct transfers as opposed to through financial intermediaries.
B) If people in the aggregate have a strong time preference for current consumption as opposed to future consumption, this factor will cause interest rates to be lower than if preferences were more toward future consumption.
C) If investors expect the rate of inflation to increase in the future, this would tend to cause the current short-term interest rate to be higher than current long-term rates.
D) The existence of maturity risk premiums is due to the fact that a change in interest rates has more effect on the prices of short-term than long-term bonds.
E) If a 1-year Treasury bond has a yield of 5 percent, if the expected rate of inflation during the coming year is 3 percent, and if the maturity risk and liquidity premiums on 1-year bonds are zero, then the real risk-free rate r* must be 2 percent.

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?

A) 0.25%
B) 0.50%
C) 0.63%
D) 1.00%
E) 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?

A) The yield on the 10-year bond is less than the yield on a 1-year bond.
B) The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums.
C) It is impossible to tell without knowing the coupon rates of the bonds.
D) The yields on the two bonds are equal.
E) It is impossible to tell without knowing the relative risks of the two bonds.

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?

A) 6%
B) 7%
C) 8%
D) 9%
E) 10%

Question 21

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.

Question 22

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.

Question 23

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.)

A) 12.0%
B) 16.0%
C) 13.5%
D) 10.5%
E) 14.0%

Question 24

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.

Question 25

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?

A) 2.1%
B) 1.8%
C) 5.0%
D) 3.0%
E) 2.5%

Question 26

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?

A) 18%
B) 12%
C) 6%
D) 8%
E) 10%

Question 27

You are given the following data: 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 ____.

A) 4%; 14%
B) 4%; 15%
C) 11%; 14%
D) 11%; 15%
E) 11%; 17%

Question 28

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

A) Production opportunities
B) Time preferences for consumption
C) Exchange rates
D) Risk
E) Inflation

Question 29

The fundamental factors that affect the cost of money include

A) production opportunities
B) inflation
C) risk
D) time preference for consumption
E) all of the above

Question 30

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

A) inflation risk
B) maturity risk
C) liquidity risk
D) default risk

Question 31

During recessions the demand for funds typically ____.

A) increases
B) stays the same
C) decreases
D) doubles

Question 32

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

A) right; higher
B) left; higher
C) right; lower
D) left; lower

Question 33

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

A) one to two percent.
B) two to four percent.
C) four to seven percent
D) eight to twelve percent

Question 34

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?

A) 12.0%
B) 12.6%
C) 17.0%
D) 17.9%

Question 35

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: What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?

A) 5.0%; 2.0%
B) 4.5%; 1.5%
C) 3.0%; 1.8%
D) 5.6%; 2.6%
E) There is not enough information to answer this question.

Question 36

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: Based on these data, the real risk-free rate of return is

A) 0%
B) 1%
C) 2%
D) 3%
E) 4%

Question 37

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?

A) 7%
B) 8%
C) 9%
D) 17%
E) 18%

Question 38

Default risk premiums

A) are unrelated to the issuer of the security.
B) are higher for U.S.Treasury securities than for most corporate securities.
C) are higher for AAA bonds than for CCC bonds.
D) vary somewhat over time.

Question 39

Which of the following assets is the most liquid?

A) Stock
B) Treasury bills
C) Corporate bonds
D) Cash

Question 40

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?

A) 8%
B) 7%
C) 6%
D) 5%
E) 4%

Question 41

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.

Question 42

When the federal government runs a deficit the interest rates generally increases due to increased demand for funds.

Question 43

If the liquidity preference theory of the term structure is correct, we would expect the size of the maturity risk premium to increase with maturity.Thus, we might observe an upward sloping yield curve, even if future short-term rates are expected to decrease.

Question 44

The difference between the nominal risk-free rate and the real risk-free rate is that the real risk-free includes inflation and the nominal risk-free rate does not include inflation.

Question 45

The price of a bond bought at a discount cannot go down in the financial markets.

Question 46

Inflationary pressures are usually strongest during business booms.

Question 47

Suppose your firm must raise funds immediately, and it has decided to use debt financing to do so.If you believe that the economy is at the peak of a boom, but it is just about to enter a recession, your firm would probably be better off if it issued long-term debt rather than short-term debt.

Question 48

Investors with a high time preference for current consumption would be willing to pay a higher price for the same investment than investors with a low time preference for current consumption.

Question 49

The dollar return earned on a debt investment is comprised of the interest payments received and the change in value of the debt instrument in the financial markets.

Question 50

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.

Question 51

If the United States is running a deficit trade balance with Great Britain, we would expect the value of the British pound to depreciate against the U.S.dollar.

Question 52

The liquidity premium reflects the fact that some investments are more easily converted into cash on a short notice at fair market value than other securities.

Question 53

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).

Question 54

A downward sloping yield curve is considered normal.

Question 55

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

Question 56

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.

Question 57

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.

Question 58

The market segmentation theory of the term structure is, essentially, the expectations theory with the addition of maturity risk premiums.

Question 59

If the Fed increases the money supply interest rates will generally increase.

Question 60

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

Question 61

The return realized by investors comes only from the change in value of an asset over time

Question 62

All else equal, the maturity risk premium tends to decline when interest rate volatility increases.

Question 63

Expectations of high inflation lead to low interest rates and vice versa.

Question 64

Long-term bonds are more vulnerable to reinvestment rate risk than short-term bonds.

Question 65

Firms with the least profitable opportunities are willing and able to pay the most for capital.