Question 1

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 2

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 will typically have lower interest rates since they are considered less risky and easier to sell in the market. Bonds with lower liquidity may have higher interest rates to compensate investors for the added risk and potential difficulty in selling them.

Question 3

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 value present consumption more than future consumption and will demand a higher rate of return to be compensated for delaying gratification and saving. Conversely, investors with a lower time preference for consumption value future consumption more and require a lower rate of return to forego current consumption for future gain.

Question 4

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 5

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 long-term interest rate is the expected average of short-term interest rates over the same period. Therefore, if interest rates are expected to remain constant over the next 6 years, the six-year bond and the combination of a 3-year bond and another 3-year bond three years from now should offer the same rate of return.

Question 6

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 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

When financial institutions are required to make long-term, fixed interest rate mortgages, they face the risk of interest rate changes that could cause losses. Therefore, they prefer a normal yield curve, where long-term interest rates are higher than short-term interest rates, as it would allow them to earn a higher spread between their borrowing and lending rates. In contrast, an inverted curve, where short-term interest rates are higher than long-term interest rates, would lead to reduced profitability and may even cause losses. The restriction to deposits that can be withdrawn on demand only adds to this preference for a normal yield curve, as it creates a liquidity risk that would be aggravated in the case of an inverted curve.

Question 8

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 reduces the availability of funds for borrowing, which leads to an increase in demand for loans and subsequently, an increase in short-term interest rates. Long-term interest rates, however, are influenced by other factors such as inflation expectations and the perceived risk of default, which may not be affected by the Fed's monetary policy changes. Therefore, the increase in short-term interest rates is likely to be greater than the increase in long-term rates.

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 is because investors are willing to pay more to invest in firms that have high profitability and growth potential, as these firms have a higher chance of generating returns on investment. As more capital flows into these firms, it can lead to increased productivity and growth, while less efficient firms may struggle to attract funding and may be left behind.

Question 10

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

Accepted Answer

The definition of term structure involves the relationship between interest rates and maturities of comparable securities.

Question 11

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

Accepted Answer

An inverted yield curve occurs when long-term interest rates are lower than short-term rates, indicating potential economic downturns.

Question 12

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 real rate of interest is the nominal rate minus inflation, while the nominal rate includes the risk-free rate plus a risk premium.

Question 13

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 liquidity preference theory suggests that investors demand a premium for longer-term investments due to increased risk, leading to an upward-sloping yield curve, not based on preferred maturities.

Question 14

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 to satisfy both criteria is a AAA bond with a shorter time to maturity. The shorter time to maturity reduces interest rate risk and the AAA rating reduces default risk. Choice D is the only option that meets both of these criteria.

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

This statement is true. The nominal rate of interest includes both the nominal risk-free rate of return (the rate of return on an investment with no risk) and the expected inflation rate.

Question 16

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 because in high business activity periods, there is often more demand for short-term borrowing for investment and expansion, leading to lower short-term interest rates. This can result in a flattening or downward slope of the yield curve, as longer-term interest rates do not decrease at the same rate as shorter-term rates. Humps in the curve could occur if there are specific factors affecting certain maturities, such as government policy.

Question 17

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 18

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 19

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

Accepted Answer

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

Question 20

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 will allow the firm to lock in a lower interest rate for a longer period of time, which will be beneficial if interest rates rise during the economic boom. Short-term debt would need to be refinanced more frequently, which could result in higher interest rates if rates have increased.

Quiz 5: The Cost of Money Interest Rates