Ch 6 Interest Rates

If the inflation rate is expected to remain constant at the current level in the future, say 3%, which of the following best describes the shape of the yield curve? Consider all factors that affect the yield curve, not just inflation.

Because of the existence of a positive maturity risk premium, and even though the inflation rate is expected to remain constant, the shape of the Treasury yield curve would be upward sloping

The default risk premium is an important contributor in determining what happens to which of the following?

Market Interest Rates

Quantitative easing came about because which policy was not working properly?

Monetary Policy

Nominal

The rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate or the T-bond rate; rRF includes an inflation premium

The interest rate on 3-year Treasury securities is currently 6%. The interest rate on 4-year Treasury securities is currently 7%. Assume that the pure expectations theory is correct. To the closest whole percent, what is a reasonable forecast of the rate on 1-year Treasury securities 3 years from now?

10%

Assume that the real risk-free rate is r* = 2.5% and the average expected inflation rate is 3% for each future year. The DRP and LP for Bond X are 1% each, and the applicable MRP is 1.5%. What is Bond X's interest rate?

9% ---------- r* 2.5% Inflation Premium 3.0% Default Risk Premium 1.0% Liquidity Premium 1.0% Maturity Risk Premium 1.5% Bond X interest rate 9.0%

If inflation during the last 12 months was 3% and the interest rate during that period was 5%, what was the real rate of interest?

= 2% 5% - 3% for inflation = 2%

liquidity premium (LP)

A premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its "fair market value."

inflation premium (IP)

A premium equal to expected inflation that investors add to the real risk-free rate of return.

Which of the following is likely to lead to lower interest rates on U.S. securities?

A slowdown occurs in the U.S. economy, which reduces corporate borrowing.

What does an inverted yield curve usually signal?

Current or Future Recession

What are the two items whose sum is the cost of equity?

Dividends and capital gains

Which of the following factors would tend to be consistent with a downward-sloping yield curve?

Expected inflation is expected to decline in future years.

Nominal interest rate shows you a more accurate rate of return than the real interest rate.

False

The yield curve for corporate bonds tends to have a shape similar to that for Treasury securities, but interest rates on corporate bonds are at lower levels because corporate yields include smaller default risk and liquidity premiums than do Treasury yields. True or false?

False

An increase in either risk or inflation would likely lead to which of the following results?

Higher interest rates.

The term structure of interest rates shows:

How securities that are similar in every other way but have different maturities have different yields.

The goal of quantitative easing is to:

Increase liquidity in financial markets.

Real Interest Rate

Nominal Interest Rate - Inflation

Which of the following statements is true regarding real and nominal interest rates?

Real interest rates are nominal interest rates minus inflation

An inverted yield curve occurs whe

Short term bonds pay higher yields than longer term bonds.

According to the Pure Expectations Theory, an upward sloping yield curve signals markets believe what?

Short term interest rates will be higher in the future than what they are today.

Which of the following is most likely to occur during a recession?

The demand for funds declines, leading to lower interest rates.

default risk premium (DRP)

The difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability

According to the Pure Expectations Theory, long term yields are determined by:

The expected yield on short term bonds in the future.

You observe that the Treasury yield curve has been upward sloping in recent weeks, and that its slope has steadily increased. Which of the following could explain the increase in the slope of the yield curve?

The market's forecast of expected inflation has increased in recent weeks.

interest rate risk

The risk of capital losses to which investors are exposed because of changing interest rates.

foreign trade deficit

The situation that exists when a country imports more than it exports.

A positive maturity risk premium has the effect of raising interest rates on long-term bonds relative to those of short-term bonds. True or false?

True

An upward-sloping yield curve is often referred to as a "normal" yield curve, whereas a downward-sloping yield curve is often referred to as an inverted or "abnormal" yield curve. True or false?

True

The greater the default risk, the higher the default risk premium.

True

The optimal financial policy often depends on the nature of the firm's assets. For example, a firm with highly liquid assets would be more likely to use a greater percentage of short-term debt than a firm whose assets are illiquid. True or false?

True

Can the real interest rate ever be negative?

Yes, example. If the Nominal interest rate if at 5% and the rate of inflation is at 6% the real interest rate would be -1% :(

The term structure of interest rates is shown graphically with the:

Yield Curve