Fin 361 Exam 4

True or False: The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.

True

True or False: Since yield curves are based on a real risk-free rate plus the expected rate of inflation, at any given time there can be only one yield curve, and it applies to both corporate and Treasury securities.

False

True or False:Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

False

True or False: If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*.

True

True or False: If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve.

True

Which of the following statements is CORRECT? a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. c. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. d. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. e. The yield curve can never be downward sloping.

a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.

Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant? a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping. b. If the pure expectations theory holds, the corporate yield curve must be downward sloping. c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping. d. If inflation is expected to decline, there can be no maturity risk premium. e. The expectations theory cannot hold if inflation is decreasing.

a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.

Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT? a. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities. b. The yield on any corporate bond must exceed the yields on all Treasury bonds. c. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds. d. The stated conditions cannot all be true - they are internally inconsistent. e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

a. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.

Which statement is correct? a. You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline. b. The time to maturity does not affect the change in the value of a bond in response to a given change in interest rates. c. You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from the current level, the zero coupon bond will experience the smaller percentage decline. d. The shorter the time to maturity, the greater the change in the value of a bond in response to a given change in interest rates, other things held constant. e. The longer the time to maturity, the smaller the change in the value of a bond in response to a given change in interest rates.

a. You hold two bonds, a 10-year, zero coupon, issue and a 10-year bond that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the market rate rises from its current level, the zero coupon bond will experience the larger percentage decline.

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 4.10%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Include crossproduct terms, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.) a. 6.58% b. 7.74% c. 9.37% d. 6.50% e. 7.90%

b. 7.74%

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. Corporations step up their expansion plans and thus increase their demand for capital.

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 4.00%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Include the crossproduct term, i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.) a. 8.88% b. 7.15% c. 7.22% d. 7.80% e. 8.95%

c. 7.22%

If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT? a. An upward-sloping yield curve would imply that interest rates are expected to be lower in the future. b. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now. c. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond. d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds. e. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.

Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things held constant, what would be the most likely effect on short-term securities' prices and interest rates? a. Prices and interest rates would both rise. b. Prices would rise and interest rates would decline. c. Prices and interest rates would both decline. d. Prices would decline and interest rates would rise. e. There is no reason to expect a change in either prices or interest rates.

d. Prices would decline and interest rates would rise.

In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t 1)%, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT? a. The yield on 2-year Treasury securities must exceed the yield on 5-year Treasury securities. b. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate bonds. c. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds. d. The yield curve must be "humped." e. The yield curve must be upward sloping.

e. The yield curve must be upward sloping.