Chapter 6 Exam Review

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. 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. a. 5.70% b. 5.14% c. 6.28% d. 5.42% e. 5.99%

a. 5.70% Yield= 3.50% + 2.20%

Which of the following factors would be most likely to lead to an increase in nominal interest rates? a.Households reduce their consumption and increase their savings b. a new tech like the internet has just been introduced, and it increases investment opportunities c. there is a decrease in expected inflation d. the economy falls into a recession e. the Federal Reserve decides to try to stimulate the economy

b. a new tech like the internet has just been introduced, and it increases investment opportunities If the new tech was so efficient that it takes an underdeveloped economy from a subsistence level, where savings are necessarily low and rates high, to where a level where people could afford to save, this might cause interest rates to decline

Niendorf Corporation's 5-year bonds yield 8.00%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf's bonds is DRP = 1.20% 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 Niendorf's bonds? a. 1.31% b. 1.46% C. 1.62% D. 1.80% e. 2.00%

e. 2.00% MRP in both bonds, not needed = .40% IP in both bonds, not needed = 1.65% r* in both bonds, not needed = 2.75% rnie = 8.00% rT-bond = 4.80% DRP included in Corp. only = 1.20%

Assume the following: the real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter. The maturity risk premium is 0. Given this info which of the following statements is CORRECT? a. The yield curve or US treasury securities will be upward sloping. b. A 5-year corporate bond must have a lower yield than 5-year treasury security c. A 5-year corporate bond must have a lower yield than 7-year treasury security d. the real risk-free rate cannot be constant if inflation is not expected to remain constant e. this problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

e. this problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

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

false, if the rate of inflation is expected to decline sharply in the future, this could offset the positive MRP and result in a downward-sloping yield curve.

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

true