Question 1

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

Accepted Answer

When the Fed increases the money supply, it is believed that interest rates will decrease as there is more money available for borrowing and lending. This increased supply of money makes it less expensive to borrow, leading to a decrease in interest rates.

Question 2

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.

Accepted Answer

The statement is true. The liquidity premium is the extra return offered by investments that are considered more liquid, meaning they can be bought or sold quickly without significantly affecting their market price. This extra return compensates investors for the reduced risk associated with these investments.

Question 3

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

Accepted Answer

When the federal government runs a deficit, it needs to borrow more money to finance its spending. This increases the demand for funds, which drives up interest rates.

Question 4

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

Accepted Answer

This is a correct definition of the term structure.

Question 5

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.

Accepted Answer

The nominal risk-free rate includes inflation expectations, whereas the real risk-free rate is adjusted to remove the effects of inflation, representing the true cost of borrowing without the influence of inflation.

Question 6

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.

Accepted Answer

If the United States is running a deficit trade balance with Great Britain, it means the United States is importing more goods and services from Great Britain than it is exporting to them. This results in an increase in demand for British pounds by American buyers to pay for those imports, which actually leads to an appreciation of the British pound against the U.S. dollar, not depreciation.

Question 7

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 would be a better option as a boom in the economy signals that interest rates are likely to rise. By issuing long-term debt, the firm can lock in lower interest rates for a longer period of time, which would be beneficial in the long run. Short-term debt would expose the firm to the risk of having to refinance at higher interest rates during the boom period.

Question 8

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.

Accepted Answer

The answer of Suppose your firm must raise funds immediately,and...

Question 9

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

Accepted Answer

The market segmentation theory and the expectations theory are distinct concepts. The market segmentation theory suggests that the bond market is segmented on the basis of maturity and that the interest rates for each segment are determined by the supply and demand for bonds within that segment. The expectations theory posits that the long-term interest rates are an average of current and future expected short-term interest rates, without explicitly accounting for maturity risk premiums.

Question 10

A downward sloping yield curve is considered normal.

Accepted Answer

A downward sloping yield curve, also known as an inverted yield curve, is considered abnormal as it indicates that long-term interest rates are lower than short-term interest rates, which is opposite from the usual relationship between the two. Typically, a normal yield curve has a upward slope where long-term interest rates are higher than short-term interest rates.

Question 11

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.

Accepted Answer

According to the liquidity preference theory, investors require a premium for investing in longer-term bonds due to the higher liquidity risk. Therefore, the maturity risk premium should increase with maturity, leading to an upward-sloping yield curve. This is true even if future short-term rates are expected to decrease, as the premium compensates for the additional risk, not just for the higher future rates.

Question 12

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.

Accepted Answer

Investors with a high time preference for current consumption prefer to spend their money now rather than invest it for future returns, meaning they would be less willing to pay a high price for investments compared to investors with a low time preference, who prioritize future gains over current consumption.

Question 13

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 yield curve reflects market expectations about future interest rates. If an investor believes in this theory, they would expect the yield on a 6-year bond to be equal to the average yield of a 3-year bond today and the expected yield on a 3-year bond in three years' time. Therefore, the investor should expect to earn the same rate of return over the 6-year time horizon whether they buy a 6-year bond or a 3-year bond now and another 3-year bond three years from now.

Question 14

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 15

Inflationary pressures are usually strongest during business booms.

Accepted Answer

During business booms, there is generally an increase in demand for goods and services, leading to higher prices and eventually inflationary pressures.

Question 16

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

A normal yield curve, with higher long-term interest rates, would provide financial institutions with higher returns on their fixed-rate mortgages, thus matching their long-term assets with their long-term liabilities. An inverted yield curve, with lower long-term interest rates, would result in lower returns for financial institutions on their mortgage loans, leading to a potential loss of profitability. Additionally, an inverted yield curve can signal economic uncertainty and potential future economic downturns, which can also negatively impact financial institutions.

Question 17

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.

Accepted Answer

The dollar return earned on a debt investment is indeed composed of both the interest payments received and the change in value of the debt instrument in the financial markets. However, it's essential to understand that the interest payments are fixed, while the value of the debt instrument can fluctuate, leading to different returns for the investor.

Question 18

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 19

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

Accepted Answer

The price of a bond bought at a discount can go down in the financial markets depending on various factors such as changes in interest rates, credit ratings, and economic conditions. When interest rates rise, the value of existing bonds decreases, causing prices to drop even further. So, the statement is false.

Question 20

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.

Quiz 5: The Cost of Money Interest Rates