Ch. 6 (Exam 2)

If inflation during the last 12 months was 4% and the interest rate during that period was 5%, what was the real rate of interest?

1% Current rate of interest = current real rate of interest + inflation rate 5%= real rate of int+ 4%

The inflation in Country XYZ is expected to increase 2%. Assuming other things being equal, Country XYZ's interest rates will ______________ . A. Increase B. Decrease C. Stay the same

A. Increase-inflation increases, interest rates increase

If the Treasury yield curve is downward sloping, how would the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? A. The yield on a 10-year bond would be less than that on a 1-year bill. B. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium. C. It is impossible to tell without knowing the coupon rates of the bonds. D. The yields on the two securities would be equal. E. It is impossible to tell without knowing the relative risks of the two securities.

A. The yield on a 10-year bond would be less than that on a 1-year bill. Downward sloping==> long-term rates are lower than short-term rates.

Corporate yield curves are __________ than the treasury yield curves. The spread between corporate and Treasury yield curves ___________ as the corporate bond rating decreases. A. higher; increases. B. higher; decreases. C. lower; increases. D. lower; decrease

A. higher; increases

Assume that interest rates on 20-year Treasury and corporate bonds are 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: a. Tax effects. b. Default risk differences. c. Maturity risk differences. d. Inflation differences. e. Real risk-free rate differences.

B. Default risk differences . T-bonds have no default risk, AAA, A, and BBB are bond ratings, suggesting the likelihood of default. AAA is the highest rating. They are all of 20 year maturity, and so no MRP. Tax effects, Inflation premium, and real risk-free rate should be the same for all the bonds too.

Which of the following would be most likely to lead to a higher level of interest rates in the economy? A. Households start saving a larger percentage of their income. B. Corporations step up their expansion plans and thus increase their demand for capital. C. The level of inflation begins to decline. D. The economy moves from a boom to a recession. E. The Federal Reserve decides to try to stimulate the economy.

B. Increased demands for funds=higher interest rates

Assume that the real risk-free rate is r* = 1% and the average expected inflation rate is 3% for each future year. The default risk premium and liquidity premium for Bond X are each 1%, and the applicable maturity risk premium is 2%. Which of the following statement is correct? A. Bond X is more likely a Treasury bond than a corporate bond. B. Bond X is more likely to have a 3-month maturity than a 20-year maturity. C. Bond X is more likely to have a 20-year maturity than a 3-month maturity. D. both a and b are correct. E. both a and d are correct.

C. Bond X is more likely to have a 20-year maturity than a 3-month maturity.

Which of the following statements is CORRECT? A. If companies have fewer good investment opportunities, interest rates are likely to increase. B. If individuals increase their savings rate, interest rates are likely to increase. C. If expected inflation increases, interest rates are likely to increase. D. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities.

C. If expected inflation increases, interest rates are likely to increase.

Assume that interest rates on 20-year Treasury and corporate bonds are 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:

Default risk differences- T-bond: no default risk; AAA is the best credit rating rating a bond can get, followed by A and then BBB.

1.If companies have fewer good investment opportunities, interest rates are likely to increase.

False

1.If individuals increase their savings rate, interest rates are likely to increase.

False

1.Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities.

False

1.When the Federal Reserve decides to try to stimulate the economy, interest rates are likely to increase.

False

1.When the economy falls into a recession, interest rates are likely to increase.

False

T or F: The supply of fund is determined by production opportunities, while the demand of fund is determined by how willing people are to defer consumptions and save.

False- demand for fund is determined by production opportunities; supply of fund is determined by how willing people are to defer consumptions and save

Assume that the real risk-free rate is r* = 2% and the average expected inflation rate is 3% for each future year. The DRP and LP for Bond X are each 1%, and the applicable MRP is 2%. What is Bond X's interest rate? Is Bond X a Treasury bond or a corporate bond? Is Bond more likely to have a 3-month or 20-year maturity?

Nominal interest rate (r) = r* + IP + DRP + LP + MRP 2 + 3 + 1 + 1 + 2= 9% Corporate bond- it has default risk premium (DRP) 20yr maturity- it has maturity risk premium (MRP)

1.If expected inflation increases, interest rates are likely to increase.

True

1.When corporations step up their expansion plans, interest rates are likely to increase.

True

T or F: Interest rates usually fall during recessions.

True- During recession, we see companies downsize their operations, and stores and factories shut down. So the demand for funds goes down. When demand goes down, interest rates will go down.Another factor is that to stimulate economy, the fed often cut interest rate to stimulate economy, further lowering the interest rates.