Question 1

Which of the following affect the interest rate used to discount future cash flows?
A) The degree of impatience or time preference on the part of surplus units
B) The returns that deficit units can earn on investment projects
C) The interaction of a and b
D) All of the above

Accepted Answer

All of the factors listed affect the interest rate used to discount future cash flows. The degree of impatience or time preference of surplus units influences their willingness to lend or invest at lower or higher rates. The returns that deficit units can earn on their investment projects determine how much they are willing to pay for financing. The interaction of these factors through supply and demand in financial markets ultimately determines the interest rate.

Question 2

A 10-year Treasury note with a 2.75 percent coupon is selling at 99. This means that
A) Its current yield is 2.75 percent
B) Its current yield is above 2.75 percent
C) Its current yield is below 2.75 percent
D) There is not enough information to make a determination

Accepted Answer

The current yield is calculated by dividing the annual coupon payments by the market price of the bond. Since the bond is selling at a discount (99 instead of 100), its current yield will be higher than its coupon rate of 2.75 percent.

Question 3

Interest rate (price) risk occurs when
A) The maturity of an instrument is less than the investor's holding period
B) The maturity of an instrument is greater than the investor's holding period
C) The maturity of an instrument is the same as the investor's holding period
D) The yield curve slopes upward

Accepted Answer

Interest rate (price) risk primarily occurs when the maturity of an instrument is greater than the investor's holding period, as changes in interest rates can affect the market value of the instrument, potentially leading to losses if the instrument is sold before maturity.

Question 4

A drop in interest rates
A) Affects the prices of short-term securities more than long-term securities
B) Affects the prices on short-term securities less than long-term securities
C) Affects the prices of short-term securities the same as long-term securities
D) Cannot affect prices of securities

Accepted Answer

A drop in interest rates affects the prices of long-term securities more than short-term securities because the present value of their longer-term cash flows increases more significantly. This is due to the inverse relationship between bond prices and interest rates, and the fact that longer-term bonds have more future payments that are discounted back to their present value at the new, lower interest rate.

Question 5

Which of the following cause a coupon security's duration to fall?
A) A shorter maturity
B) Higher interest rates
C) Higher bond prices
D) Both a and b

Accepted Answer

A shorter maturity reduces the time until cash flows are received, decreasing duration. Higher interest rates decrease a bond's price and its duration because the present value of future cash flows is discounted more heavily, leading to a quicker return of the principal. Higher bond prices, however, are associated with lower interest rates, which would increase duration, not decrease it.

Question 6

Under the Fisher effect
A) Lower inflation is associated with lower nominal interest rates
B) Lower inflation is associated with higher nominal interest rates
C) Higher inflation is associated with longer duration
D) All of the above

Accepted Answer

The Fisher effect posits that real interest rates are unaffected by inflation in the long run, meaning that higher inflation leads to higher nominal interest rates to maintain the real interest rate. Thus, lower inflation is associated with lower nominal interest rates.

Question 7

A zero-coupon security's duration
A) Is equal to its maturity
B) Does not vary with interest rates
C) Is longer than that of a comparable-maturity coupon security
D) All of the above

Accepted Answer

A zero-coupon security's duration is equal to its maturity because it pays no coupons and all its cash flow occurs at maturity. Its duration does not vary with interest rates for the same reason, and it is longer than that of a comparable-maturity coupon security because coupon securities pay interest before maturity, reducing their average maturity.

Question 8

The yield on a 10-year Treasury note is 2.74 percent and that on a 10-year TIPS note is 0.50 percent. Inflation compensation (mostly inflation expectations) is
A) 2.24 percent
B) -2.24 percent
C) 3.24 percent
D) Cannot tell from the above information

Accepted Answer

The inflation compensation, often referred to as the break-even inflation rate, is calculated by subtracting the yield on the TIPS note from the yield on the Treasury note. Therefore, 2.74% - 0.50% = 2.24%.

Question 9

An amortized financial instrument is one that
A) Enables the lender to acquire an equity position in the collateral
B) Finances only real estate transactions
C) Involves regular payments by the borrower that cover both interest and principal
D) Another term for a zero-coupon security

Accepted Answer

An amortized financial instrument involves regular payments that cover both the interest and the principal amount over the life of the loan, ensuring that the loan is fully paid off by the end of the term.

Question 10

In comparison with a 10-year Treasury coupon note, a 10-year Treasury zero-coupon security has
A) A shorter duration
B) A longer duration
C) The same duration
D) No value to investors

Accepted Answer

A 10-year Treasury zero-coupon security has a longer duration than a 10-year Treasury coupon note because it pays no interest until maturity, making its price more sensitive to changes in interest rates.

Question 11

The present value formula is used to
A) Determine the current price of an asset when the cash flows and discount rate are known
B) Determine the amount of regular fixed payments on a loan when the interest rate and loan amount are known
C) Determine the yield to maturity on a financial instrument when the current price and cash flows are known
D) All of the above

Accepted Answer

The present value formula is a fundamental financial principle used for various purposes, including determining the current price of an asset given its future cash flows and discount rate (A), calculating the fixed payments on a loan given the interest rate and loan amount (B), and finding the yield to maturity on a financial instrument when its current price and future cash flows are known (C).

Question 12

When the price of a bond increases
A) Its yield to maturity also increases
B) Its yield to maturity is unchanged
C) Its yield to maturity falls
D) A default has occurred

Accepted Answer

When the price of a bond increases, its yield to maturity falls because the yield to maturity is inversely related to the bond's price.

Quiz 4: The Pricing of Financial Assets

Which of the following affect the interest rate used to discount future cash flows?

A 10-year Treasury note with a 2.75 percent coupon is selling at 99. This means that

Interest rate (price) risk occurs when

A drop in interest rates

Which of the following cause a coupon security's duration to fall?

Under the Fisher effect

A zero-coupon security's duration

The yield on a 10-year Treasury note is 2.74 percent and that on a 10-year TIPS note is 0.50 percent. Inflation compensation (mostly inflation expectations) is

An amortized financial instrument is one that

In comparison with a 10-year Treasury coupon note, a 10-year Treasury zero-coupon security has

The present value formula is used to

When the price of a bond increases