FIN311 Chapter 6

Kay Corporation's 5-year bonds yield 5.90% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds?

0.20%

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.65%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

1.10%

Crockett Corporation's 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.45%. The real risk-free rate is r* = 2.80%, the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds, the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What inflation premium (IP) is built into 5-year bond yields?

1.25%

​Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.50% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

1.90

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 2.00% per year. What is the real risk-free rate of return, r*? The cross-product term should be considered , i.e., if averaging is required, use the geometric average. (Round your final answer to 2 decimal places.)

4.90%

Which of the following factors would be most likely to lead to an increase in nominal interest rates?

A new technology like the Internet has just been introduced, and it increases investment opportunities.

Which of the following statements is CORRECT?

Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve.

Which of the following statements is CORRECT, other things held constant?

If expected inflation increases, interest rates are likely to increase

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?

Prices would decline and interest rates would rise

Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong.

false

One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

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

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

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

false

Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

true

During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

true

One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

true

The "yield curve" shows the relationship between bonds' maturities and their yields.

true

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk."

true

5-year Treasury bonds yield 4.4%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*?

2.10%

Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.20% per year to maturity applies, i.e., MRP = 0.20%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.70% applies to A-rated corporate bonds. What is the difference in the yields on a 5-year A-rated corporate bond and on a 10-year Treasury bond? Here we assume that the pure expectations theory is NOT valid, and disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

2.20

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 1.80%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

2.35%

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 4.10%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places.

2.42

Suppose the rate of return on a 10-year T-bond is 6.90%, the expected average rate of inflation over the next 10 years is 2.0%, the MRP on a 10-year T-bond is 0.9%, no MRP is required on a TIPS, and no liquidity premium is required on any Treasury security. Given this information, what should the yield be on a 10-year TIPS? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

4.00%

The real risk-free rate is 3.05%, inflation is expected to be 3.60% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, i.e., if averaging is required, use the arithmetic average, what is the equilibrium rate of return on a 1-year Treasury bond?

6.65%

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 2.50%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

7.10%

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 4.80%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

8.30%

Assuming the pure expectations theory is correct, which of the following statements is CORRECT?

If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise.

Which of the following statements is CORRECT?

If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.

Which of the following statements is CORRECT?

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.

Which of the following statements is CORRECT?

If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future.

If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?

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

The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT?

The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT?

The maturity risk is assumed to be zero

If the pure expectations theory holds, which of the following statements is CORRECT?

The maturity risk premium would be zero

Which of the following statements is CORRECT?

The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT?

The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.

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?

The yield curve must be upward 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?

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

Which of the following statements is CORRECT?

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.