Question 1

Risk-free rate of interest is equal to the sum of the real rate of interest plus an inflation premium.

Accepted Answer

The risk-free rate of interest is typically defined as the rate of return that an investor expects from an absolutely risk-free investment, such as a U.S. Treasury bond. This rate of return is comprised of two components: the real rate of interest (i.e., the return an investor would earn in the absence of any inflation or risk) and an inflation premium (i.e., the compensation an investor demands for the expected loss of purchasing power due to inflation). Therefore, the statement "risk-free rate of interest is equal to the sum of the real rate of interest plus an inflation premium" is true.

Question 2

A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs than long-term borrowing costs.

Accepted Answer

A normal yield curve is upward-sloping, indicating lower short-term borrowing costs than long-term borrowing costs. This is because lenders typically demand higher compensation for taking on the risk of lending money over a longer period of time.

Question 3

The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by demander.

Accepted Answer

The nominal rate of interest refers to the actual rate of interest charged by the lender and paid by the borrower, without adjusting for inflation or other factors. It is different from the real rate of interest, which takes into account inflation and reflects the true purchasing power of the interest earned or paid.

Question 4

A nominal rate of interest is equal to the sum of the real rate of interest plus the risk free rate of interest.

Accepted Answer

A nominal rate of interest is equal to the sum of the real rate of interest plus the expected inflation rate, not the risk-free rate of interest.

Question 5

In theory, the rate of return on U.S. Treasury bills should always exceed the rate of inflation as measured by the consumer price index.

Accepted Answer

U.S. Treasury bills are considered one of the safest investments and typically offer low yields. However, they are also backed by the full faith and credit of the U.S. government, which means that default is highly unlikely. In theory, the rate of return on these bills should always exceed the rate of inflation as measured by the consumer price index, as investors demand compensation for the erosion of purchasing power caused by inflation.

Question 6

The liquidity preference theory suggests that short-term interest rates should be lower than long-term interest rates.

Accepted Answer

According to the liquidity preference theory developed by John Maynard Keynes, individuals prefer to hold their wealth in liquid assets (such as cash or short-term securities) rather than in long-term investments. As a result, the demand for short-term securities increases, which drives down their yields and pushes short-term interest rates lower than long-term rates. This phenomenon is known as a "yield curve slope," where the yield curve is upward sloping, meaning that interest rates increase with the maturity of the debt. Therefore, the statement that short-term interest rates should be lower than long-term interest rates is true according to the liquidity preference theory.

Question 7

The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

Accepted Answer

The market segmentation theory proposes that the yield curve reflects the supply and demand for funds within different maturity segments, resulting in different yields for each segment. This theory suggests that investors have a preference for certain maturities, and they are willing to pay higher or lower prices to obtain the desired funds. As a result, the yield curve can be upward or downward sloping, depending on the relative supply and demand for each maturity segment.

Question 8

An interest rate or a required rate of return represents the cost of money.

Accepted Answer

An interest rate or a required rate of return is the compensation or reward for lending money, and represents the cost of money for the borrower.

Question 9

The nominal rate of interest on a bond is 7% and an inflation premium of 3%. This results in a real rate of interest of 4% on the bond.

Accepted Answer

The real rate of interest is not simply the nominal rate minus the inflation premium. It is calculated using the formula: real interest rate ≈ nominal interest rate - inflation rate. However, the exact real rate can be more accurately calculated using the Fisher equation, which would not necessarily result in exactly 4% in this scenario.

Question 10

Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term loans relative to their respective demand.

Accepted Answer

This is correct, as an upward-sloping yield curve occurs when short-term interest rates are lower than long-term interest rates due to higher inflation expectations, lender preferences for shorter maturity loans, and a greater supply of short-term loans relative to demand.

Question 11

A flat yield curve means that the rates do not vary much at different maturities.

Accepted Answer

A flat yield curve occurs when there is little difference between short-term and long-term interest rates, resulting in a horizontal line on a graph plotting yields against maturities. This means that rates do not vary much at different maturities.

Question 12

The liquidity preference theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.

Accepted Answer

The liquidity preference theory suggests that longer-term interest rates are generally higher than shorter-term rates because investors demand a premium for the increased risk of holding longer-term securities, not because of the supply and demand within each maturity segment.

Question 13

A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a normal yield curve.

Accepted Answer

A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a flat yield curve. A normal yield curve typically shows lower interest rates for short-term loans compared to higher rates for long-term loans, indicating an upward slope.

Question 14

A flat yield curve indicates generally cheaper long-term borrowing costs than short-term borrowing costs.

Accepted Answer

A flat yield curve typically indicates that short-term and long-term borrowing costs are relatively equal, which may not necessarily result in cheaper long-term borrowing costs compared to short-term borrowing costs. In contrast, a steep yield curve indicates higher long-term borrowing costs compared to short-term borrowing costs.

Question 15

Nominal rate of interest is equal to the sum of the real rate of interest plus an inflation premium plus a risk premium.

Accepted Answer

This is the formula for determining the nominal rate of interest, where it is equal to the real rate of interest (the rate adjusted for inflation) plus an inflation premium (to account for future inflation expectations) plus a risk premium (to account for the risk associated with the investment).

Question 16

The term structure of interest rates is a graphical presentation of the relationship between the maturity and rate of return.

Accepted Answer

The term structure of interest rates, also known as the yield curve, is a graphical representation of the relationship between the maturity and rate of return. It shows the different interest rates for bonds with different maturities, thereby indicating the expectations of investors about future interest rates and the economy in general.

Question 17

An inverted yield curve is a downward-sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.

Accepted Answer

An inverted yield curve is a phenomenon in which short-term interest rates are higher than long-term interest rates, resulting in a downward-sloping yield curve. This is a rare occurrence in financial markets and is often seen as a predictor of an economic recession.

Question 18

A real rate of interest is the compensation paid by the borrower of funds to the lender.

Accepted Answer

A real rate of interest specifically refers to the rate of interest an investor expects to receive after allowing for inflation. It is different from the nominal interest rate as it takes into account the erosion of purchasing power due to inflation.

Question 19

The expectations theory suggests that the shape of the yield curve reflects investors expectations about future interest rates.

Accepted Answer

The expectations theory is based on the premise that the yield curve reflects investors' expectations about future interest rates. The theory suggests that investors will demand higher rates for longer-term bonds if they expect interest rates to rise in the future, resulting in a steep yield curve. Conversely, if investors expect rates to remain stable, the yield curve will be flat or inverted.

Question 20

Longer the maturity of a Treasury security, the smaller the interest rate risk.

Accepted Answer

The statement is false. The longer the maturity of a Treasury security, the greater the interest rate risk. This is because longer-term securities are exposed to changes in interest rates over a longer period of time, which can result in significant changes to their market value. Shorter-term securities, on the other hand, are exposed to interest rate risk for a shorter period of time and are generally considered to be less risky.

Quiz 6: Interest Rates and Bond Valuation