Question 1

Which of the following statements is most correct?

Accepted Answer

According to the Fisher equation, nominal interest rate = real interest rate + expected inflation rate. Rearranging the equation, we get the real interest rate = nominal interest rate - expected inflation rate. Using this formula, we can calculate the real risk-free rate r* as 2 percent (5 percent - 3 percent = 2 percent). Therefore, choice E is the most correct statement.

Question 2

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?

Accepted Answer

When the Federal Reserve sells $50 billion of short-term U.S. Treasury securities, it reduces the money supply in the market which leads to a decrease in demand for such securities. This drop in demand will cause the prices of securities to decline and interest rates to rise. Therefore, the correct choice is D- Prices will decline and interest rates will rise.

Question 3

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

Accepted Answer

An upward sloping (normal) yield curve typically implies that long-term interest rates are higher than short-term rates, reflecting expectations of future economic growth, potential inflation, or higher interest rates in the future. It does not necessarily imply any of the specific conditions listed in options A, B, C, or D.

Question 4

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?

Accepted Answer

The interest rate on a bond can be calculated using the formula: interest rate = r* + IP + MRP + DRP + LP, where r* is the real risk-free rate, IP is the inflation premium, MRP is the maturity risk premium, DRP is the default risk premium, and LP is the liquidity premium.For a 10-year Treasury bond:- r* = 2.0%- IP = Average inflation over 10 years. Given the inflation rates, the average would be (3% + 4% + 5% + 6%*7)/10 = 5.5% (since the first three years are 3%, 4%, and 5%, and then 6% thereafter for 7 years).- MRP = 0.1%(t - 1) = 0.1%(10 - 1) = 0.9%- DRP = 0% (since it's a Treasury bond, there's no default risk premium).- LP = 0% (liquidity premium is not applicable to Treasury bonds).Therefore, the interest rate for the 10-year Treasury bond = 2.0% + 5.5% + 0.9% = 8.4%.For a 10-year corporate bond:- r* = 2.0%- IP = 5.5% (same calculation as above).- MRP = 0.9% (same as above).- DRP = 0.05%(t - 1) = 0.05%(10 - 1) = 0.45%- LP = 1.0%Therefore, the interest rate for the 10-year corporate bond = 2.0% + 5.5% + 0.9% + 0.45% + 1.0% = 9.85%.The difference in interest rates between the 10-year corporate and Treasury bonds = 9.85% - 8.4% = 1.45%.

Question 5

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 AAA bond with 5 years to maturity is the best choice for your uncle because it has a lower default risk (due to its high credit rating) and a shorter maturity, which helps to reduce interest rate risk. The BBB bonds have a higher default risk, and the longer maturities of both the 10-year bonds increase interest rate risk. A perpetual bond has no maturity and therefore presents an even greater interest rate risk.

Question 6

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?

Accepted Answer

The expectations theory of the term structure of interest rates suggests that if the yield curve is downward sloping, investors expect future short-term interest rates to decrease. This is because the theory posits that long-term rates are an average of current and expected future short-term rates. If long-term rates are lower than current short-term rates (yield curve is downward sloping), it implies that investors are expecting future short-term rates to be lower than current rates.

Question 7

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?

Accepted Answer

To find the average expected rate of inflation over the 5-year period, add the rates for each year and divide by 5: (5% + 6% + 9% + 13% + 12%) / 5 = 45% / 5 = 9%.

Question 8

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?

Accepted Answer

When the yield curve is downward sloping, it indicates that short-term interest rates are higher than long-term interest rates. Therefore, the yield to maturity on a 10-year Treasury coupon bond will be less than the yield to maturity on a 1-year T-bond. This is because investors demand a higher return on shorter-term investments when interest rates are expected to decline in the future.

Question 9

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?

Accepted Answer

The average expected inflation rate over the 5-year period is calculated by adding the expected rates of inflation for each year and then dividing by the number of years. So, (4% + 7% + 10% + 8% + 6%) / 5 = 35% / 5 = 7%.

Question 10

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%.

Accepted Answer

The answer of Given the following data,find the expected rate...

Question 11

Which of the following statements is correct?

Accepted Answer

The yield curve for a company with the largest default risk premium (DRP) and liquidity premium (LP) would indeed be higher than others, as these premiums add to the yield required by investors.

Question 12

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?

Accepted Answer

According to the pure expectations theory, the interest rates on longer-term securities are determined by the market's expectations of future short-term rates. Since the 2-year and 3-year rates are higher than the 1-year rate, it implies that the market expects interest rates to rise over the next two years.

Question 13

Which of the following statements is most correct?

Accepted Answer

The maturity risk premium compensates investors for the uncertainty associated with holding longer-term bonds, but if it were zero, the yield curve would only reflect expected future interest rates and inflation rates. If the rate of inflation were expected to increase in the future, this would lead to higher expected future nominal interest rates, which would cause the yield curve to have an upward slope. Therefore, choice E is the most correct statement among the options given.

Question 14

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?

Accepted Answer

According to the expectations theory, the interest rate on a 2-year bond is the average of the current 1-year rate and the expected 1-year rate one year from now. Thus, (12% + x)/2 = 10.5%, solving for x gives x = 9.0%.

Question 15

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

Accepted Answer

The liquidity preference theory states that long-term interest rates are normally higher than short-term interest rates. This is because investors require a higher rate of return on their investments in long-term bonds to compensate for the higher risk of tying up their money for a longer period. Therefore, this theory generally leads to an upward sloping yield curve.

Question 16

In a recent year,interest rates on long-term government and corporate bonds were as follows:
T-bond= 7.72%
A= 9.64%
AAA= 8.72%
BBB= 10.18%
The differences in rates among these issues were caused primarily by

Accepted Answer

The differences in rates among these issues were primarily caused by default risk differences. T-bonds are backed by the US government, which is considered to have a low risk of default. A-rated and AAA-rated corporate bonds are issued by companies with a lower risk of default compared to BBB-rated bonds, which have a higher risk of default. Inflation and tax effects may also influence interest rates, but they are not the primary factors in this case.

Question 17

Which of the following statements is correct?

Accepted Answer

Reinvestment rate risk is indeed lower for long-term bonds compared to short-term bonds because the principal and interest payments from long-term bonds are locked in for a longer period, reducing the frequency of reinvesting at potentially lower rates.

Question 18

An inverted yield curve

Accepted Answer

An inverted yield curve occurs when short-term interest rates are higher than long-term rates, indicating investors' expectations of a future economic slowdown.

Question 19

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?

Accepted Answer

The nominal interest rate is the sum of the real risk-free rate, expected inflation, and the maturity risk premium. Given the nominal rate is 8.5%, expected inflation averages 5.5% over 6 years, and the maturity risk premium is 0.5%, the real risk-free rate is 2.5%.

Question 20

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?

Accepted Answer

The difference in interest rates between 10-year AT&T bonds and 10-year Treasury bonds can be calculated by considering the default risk premium (DRP), the liquidity premium (LP), and the maturity risk premium (MRP) for AT&T bonds, since Treasury bonds do not have DRP or LP and both types of bonds would have the same MRP. For a 10-year bond, the DRP = 0.07%(10 - 1) = 0.63%, the LP = 0.50%, and the MRP does not contribute to the difference since it affects both types of bonds equally. Therefore, the total difference = DRP + LP = 0.63% + 0.50% = 1.13%.

Quiz 5: The Cost of Money Interest Rates

Which of the following statements is most correct?

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?

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

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?

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?

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?

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?

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?

Which of the following statements is correct?

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?

Which of the following statements is most correct?

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

In a recent year,interest rates on long-term government and corporate bonds were as follows: T-bond= 7.72% A= 9.64% AAA= 8.72% BBB= 10.18% The differences in rates among these issues were caused primarily by

Which of the following statements is correct?

An inverted yield curve