Question 1

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."

Accepted Answer

Reinvestment rate risk refers to the risk of earning lower returns on reinvested principal and interest payments due to a decline in interest rates. This can lead to a decline in overall income provided by a bond portfolio.

Question 2

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

Accepted Answer

The maturity risk premium accounts for the additional compensation investors require for holding longer-term bonds, which is typically higher than short-term bonds. Therefore, a normal upward-sloping yield curve reflects this expectation of higher yields for longer-term bonds.

Question 3

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.

Accepted Answer

The statement is true.

Question 4

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.

Accepted Answer

The fourth factor listed (weather conditions) is not a fundamental factor that affects the cost of money. The correct fourth factor is inflation. Therefore, the statement is false.

Question 5

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.

Accepted Answer

The statement is false. While a positive maturity risk premium may contribute to an upward sloping yield curve, it is not the only factor. Other factors such as inflation expectations and short-term interest rates can also affect the shape of the yield curve. Additionally, there have been instances where the yield curve has been inverted, meaning that long-term rates are lower than short-term rates.

Question 6

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.

Accepted Answer

When demand for funds increases while supply remains constant, there will be an upward pressure on interest rates as borrowers compete for limited funds from lenders. As a result, the total amount of funds supplied and demanded may increase along with the higher interest rates.

Question 7

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.

Accepted Answer

If inflation is expected to be relatively high, then interest rates will tend to be relatively high, as investors will demand a higher rate of return to compensate for the loss of purchasing power caused by inflation.

Question 8

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

Accepted Answer

The answer of If the pure expectations theory is correct,...

Question 9

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

Accepted Answer

This is known as the Fisher effect, which states that the nominal interest rate is equal to the real interest rate plus the expected rate of inflation. If investors expect zero inflation, then the nominal rate will be equal to the real rate (r*).

Question 10

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.

Accepted Answer

This statement is false. The four most fundamental factors that affect the cost of money are inflation, economic growth, government monetary policy, and international factors such as exchange rates and global economic conditions. The state of weather has no direct impact on the cost of money.

Question 11

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.

Accepted Answer

The statement is actually reversed. The higher the time preference, the higher the cost of money, other things held constant. This is because individuals with a higher time preference value immediate consumption over saving, which reduces the supply of loanable funds and increases the cost of borrowing money.

Question 12

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

Accepted Answer

This is a commonly used terminology in the finance industry. A normal yield curve indicates that investors expect higher yields for longer-term bonds due to inflation and the time value of money. An abnormal yield curve, on the other hand, may indicate concerns about the economy and future interest rates.

Question 13

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 "interest rate price risk."

Accepted Answer

Interest rate risk is the risk of a decline in the prices of outstanding bonds due to an increase in interest rates.

Question 14

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.

Accepted Answer

The answer of If the Treasury yield curve were downward...

Question 15

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

Accepted Answer

This is because central banks will typically increase interest rates to combat inflation as higher interest rates make borrowing more expensive which can slow down spending and decrease demand, helping to decrease inflation. Conversely, when inflation is declining, central banks may decrease interest rates to stimulate economic growth and increase demand for goods and services.

Question 16

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.

Accepted Answer

This statement is true. The higher the risk associated with a security, the higher the required return investors demand to compensate for the higher level of risk. As a result, the cost of money for such securities increases.

Question 17

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.

Accepted Answer

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. The skill level of the economy's labor force is not typically considered a fundamental factor affecting the cost of money.

Question 18

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

Accepted Answer

The yield curve is a graph that shows the relationship between bond yields and their maturities. It plots the yield on the vertical axis and the maturity dates on the horizontal axis.

Question 19

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.

Accepted Answer

While the real risk-free rate and expected rate of inflation are factors in determining the shape of yield curves, there can actually be multiple yield curves at any given time, depending on factors such as maturity, credit risk, and market conditions. Yield curves for corporate and Treasury securities may also differ due to differences in credit risk and other factors.

Question 20

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.

Accepted Answer

An upward sloping yield curve occurs when long-term interest rates are higher than short-term interest rates. This often happens when investors expect inflation to increase, as higher inflation expectations lead to higher long-term interest rates to compensate for the loss of purchasing power over time.

Quiz 6: Bonds and Their Valuation