Question 1

In the textbook, the nominal interest rate is defined as being equal to the real risk-free rate, plus an inflation premium, plus a default risk premium, plus a liquidity premium, plus a maturity risk premium.

Accepted Answer

This is the correct definition of the nominal interest rate according to the textbook.

Question 2

Long-term interest rates reflect expectations about future inflation.Inflation has varied significantly from year to year in the past, and as a result, long-term rates can be expected to fluctuate more than short-term rates.

Accepted Answer

Long-term interest rates do reflect expectations about future inflation, but they also incorporate premiums for the risk of holding longer-term securities. These rates are generally less volatile than short-term rates because they average out expected future short-term rates, including fluctuations due to varying inflation expectations over time.

Question 3

Assume that the current interest rate on a 1-year bond is 8 percent, the current rate on a 2-year bond is 10 percent, and the current rate on a 3-year bond is 12 percent.If the expectations theory of the term structure is correct, what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average.)

Accepted Answer

The answer of Assume that the current interest rate on...

Question 4

If the Federal Reserve tightens the money supply, other things held constant, short-term interest rates will be pushed upward, and this increase probably will be greater than the increase in rates in the long-term market.

Accepted Answer

When the Federal Reserve tightens the money supply, they sell government securities to banks and the public, reducing the amount of money in circulation. This causes short-term interest rates to increase as banks have less money to lend overnight to each other. However, the long-term interest rates are influenced more by market factors such as inflation expectations and economic growth prospects, and may not be affected as much by the Fed's actions.

Question 5

Assume that the real risk-free rate, r*, is 4 percent, and that inflation is expected to be 9% in Year 1, 6% in Year 2, and 4% thereafter.Assume also that all Treasury bonds are highly liquid and free of default risk.If 2-year and 5-year Treasury bonds both yield 12%, what is the difference in the maturity risk premiums (MRPs) on the two bonds, i.e., what is MRP₅ − MRP₂?

Accepted Answer

The Fisher equation states that the nominal interest rate (i) is the sum of the real risk-free rate (r*) and the expected inflation rate (π), adjusted for the maturity risk premium (MRP) when dealing with Treasury bonds longer than one year. The equation can be represented as: i = r* + π + MRP.Given:- Real risk-free rate (r*) = 4%- Inflation Year 1 = 9%, Year 2 = 6%, Year 3 and beyond = 4%- 2-year and 5-year Treasury bonds yield = 12%First, calculate the expected inflation rates for the 2-year and 5-year periods using the given inflation rates. For the 2-year bond, the average expected inflation rate is (9% + 6%) / 2 = 7.5%. For the 5-year bond, the average expected inflation rate is (9% + 6% + 4% + 4% + 4%) / 5 = 5.4%.Using the Fisher equation, we can solve for the MRP of each bond by rearranging the equation to MRP = i - r* - π.For the 2-year bond:MRP_2 = 12% - 4% - 7.5% = 0.5%For the 5-year bond:MRP_5 = 12% - 4% - 5.4% = 2.6%The difference in the MRPs is:MRP_5 - MRP_2 = 2.6% - 0.5% = 2.1%Therefore, the difference in the maturity risk premiums on the two bonds is 2.1%.

Question 6

The real risk-free rate of interest is 3 percent.Inflation is expected to be 4 percent this coming year, jump to 5 percent next year, and run at 6 percent the year after (Year 3).According to the expectations theory, what should be the interest rate on 3-year, risk-free securities today?

Accepted Answer

The expectations theory suggests that the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. To calculate the expected interest rate for a 3-year security, we add the real risk-free rate to the expected inflation rates for each year, then average them. The calculation is as follows: Year 1: 3% (real risk-free rate) + 4% (inflation) = 7% Year 2: 3% + 5% = 8% Year 3: 3% + 6% = 9% The average of these rates is (7% + 8% + 9%) / 3 = 8%.

Question 7

You are given the following data:  Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant.Given these conditions, the nominal risk-free rate for T-bills is ____, and the rate on long-term Treasury bonds is ____.

Accepted Answer

The answer of You are given the following data: ...

Question 8

Which of the following is not one of the fundamental factors that affect the cost of money?

Accepted Answer

The fundamental factors that affect the cost of money are production opportunities, time preferences for consumption, risk, and inflation. Exchange rates, while important in international finance, do not directly affect the cost of money.

Question 9

The fundamental factors that affect the cost of money include

Accepted Answer

All of the above factors affect the cost of money. Production opportunities and time preference for consumption affect the return on investment and therefore the cost of borrowing money. Inflation affects the purchasing power of the money lent and the expected return on investment. Risk affects the likelihood of default and therefore the cost of borrowing money.

Question 10

The ____ premium is compensation for possibility that the borrower will not be able to debt's interest and principal on time.

Accepted Answer

Default risk premium is the compensation paid to the lender or investor to compensate for the possibility that the borrower may default on the financial obligations. This risk arises when the borrower is unable to make timely payments of interest and principal due to financial distress or other reasons such as bankruptcy, insolvency, or economic recession. The default risk premium reflects the level of risk associated with the particular borrower or security and is typically higher for riskier investments or borrowers with a poor credit rating.

Question 11

During recessions the demand for funds typically ____.

Accepted Answer

During recessions, businesses and individuals tend to cut back on spending and investment, which leads to a decrease in the demand for funds.

Question 12

As the demand for funds increase, the demand curve will shift to the ____ resulting in ____ market clearing interest rate.

Accepted Answer

When the demand for funds increases, the demand curve will shift to the right, indicating that more funds are demanded at every interest rate. This results in a higher market clearing interest rate as borrowers are willing to pay more to access the additional funds available. Therefore, choice A is the best answer.

Question 13

Most experts think that in the United States the real risk-free rate fluctuates between

Accepted Answer

The real risk-free rate (RRFR) is the rate of return an investor can expect to earn from an investment without any risk. It is based on the rate of return of inflation-free investments such as the US Treasury bonds. The average rate of inflation in the US is about 2-3%, and historical data shows that the RRFR is about 2-4% above the inflation rate, making option B the most accurate choice. The RRFR can fluctuate based on various economic factors, but the range given in option C and D is too high and not supported by data. Option A is too narrow and does not consider potential fluctuations.

Question 14

What is the yield on a one-year corporate bond with a $1,000 face value that pays a 12% annual dividend if it was purchased for $950 and held until maturity?

Accepted Answer

The answer of What is the yield on a one-year...

Question 15

Assume investors demand a real rate of return equal to 3 percent and that there is no maturity risk premium associated with Treasury securities.According to the Wall Street Journal, the average nominal yields on risk-free Treasury securities with different maturities are:  What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?

Accepted Answer

The one-year nominal interest rate is given as 2.26%. To calculate the inflation premium that is expected in Year 4, we need to use the information provided in the table. The difference between the yield on a Treasury Inflation-Protected Security (TIPS) and the yield on a nominal Treasury security of the same maturity gives us the expected inflation rate. According to the table, the yield on a 4-year TIPS is 2.82% and the yield on a 4-year Treasury security is 6.42%. Therefore, the inflation premium is 6.42% - 2.82% = 3.6%. Since we know that investors demand a real rate of return of 3%, the expected nominal interest rate in Year 4 is 3% + 3.6% = 6.6%. Therefore, the answer is D, 5.6% and 2.6%.

Question 16

You read in The Wall Street Journal that 30-day T-bills currently are yielding 8 percent.Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:  Based on these data, the real risk-free rate of return is

Accepted Answer

The answer of You read in The Wall Street Journal...

Question 17

Assume that a 3-year Treasury note has no maturity premium, and that the real, risk-free rate of interest is 3 percent.If the T-note carries a yield to maturity of 13 percent, and if the expected average inflation rate over the next 2 years is 11 percent, what is the implied expected inflation rate during Year 3?

Accepted Answer

The answer of Assume that a 3-year Treasury note has...

Question 18

Default risk premiums

Accepted Answer

Default risk premiums vary somewhat over time. This is because investor perceptions of default risk can be influenced by a variety of factors, including economic conditions, industry trends, and changes to the issuer's financial position. Additionally, some issuers may have a higher perceived default risk than others, leading to varying default risk premiums across different securities. However, it is generally true that lower-rated securities, such as CCC bonds, have higher default risk premiums than higher-rated securities, such as AAA bonds. Finally, U.S. Treasury securities are generally considered to be the safest investments available, and therefore have very low default risk premiums or sometimes no default risk premiums at all.

Question 19

Which of the following assets is the most liquid?

Accepted Answer

Cash is considered the most liquid asset as it can be easily and quickly converted into other assets without any significant loss in value. Stocks, treasury bills, and corporate bonds may also be considered liquid but not as liquid as cash.

Question 20

Assume that the expectations theory of term structure holds.If the rate on a two-year Treasury bond is 8% and the rate on a three-year Treasury bond is 7%, what is the expected rate on a one-year Treasury bond in year three?

Accepted Answer

The answer of Assume that the expectations theory of term...

Quiz 5: The Cost of Money Interest Rates