Finance Exam #2

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?

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 default risk premium is an important contributor in determining what happens to ...?

Market Interest Rates

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

Real interest rates are nominal interest rates minus inflation

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

The demand for funds declines, leading to lower interest rates

Can the real interest rate ever be negative?

Yes

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

Yield Curve

If inflation during the last 12 months was 2% and the interest rate during that period was 5%, what was the real rate of interest?

3%

If inflation is expected to average 4% during the next year and the real rate is 3%, what should the current interest rate be?

7%

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.

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

An inverted yield curve occurs when:

Short term bonds pay higher yields than longer term bonds

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

Foreign bonds are issued by a foreign government or a foreign corporation. An additional risk exists when bonds are denominated in a currency other than that of the investor's home currency. True or false?

True

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

True

The interest paid on a municipal bond, otherwise known as a muni, is generally exempt from federal income taxes. Therefore, the coupon rate on these bonds is considerably lower than a corporate bond of equivalent risk. True or false?

True

An analyst evaluating securities has obtained the following information. The real rate of interest is 2% and is expected to remain constant for the next 3 years. Inflation is expected to be 3% next year, 3.5% the following year, and 4% the third year. The maturity risk premium is estimated to be 0.1 × (t - 1)%, where . The liquidity premium on relevant 3-year securities is 0.25% and the default risk premium on relevant 3-year securities is 0.6%. a.) What is the yield on a 1-year T-bill? b.) What is the yield on a 3-year T-bond?

a.) A Treasury security has no default risk premium or liquidity risk premium. Therefore, rT1 = r* + IP1 + MRP1 rT1 = 2% + 3% + 0.1(1-1)% rT1 = 5% b.) A Treasury security has no default risk premium or liquidity risk premium. Therefore, rT3 = r* + IP3 + MRP3 rT3 = 2% + [(3% + 3.5% + 4%)/3] + 0.1(3-1)% rT3 = 2% + 3.5% + 0.2% rT3 = 5.7% c.) Unlike Treasury securities, corporate bonds have both a default risk premium and a liquidity risk premium. rC3 = r* + IP3 + MRP3 + DRP + LP We can rewrite the equation: rC3 = rT3 + DRP + LP rC3 = 5.7% + 0.6% + 0.25% rC3 = 6.55%

The real risk-free rate of interest, r*, is 3%; and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The maturity risk premium is equal to 0.1 × (t - 1)%, where . The default risk premium for a BBB-rated bond is 1.3%. a.) What is the average expected inflation rate over the next 4 years? b.) What is the yield on a 4-year Treasury bond? c.) What is the yield on a 4-year BBB-rated corporate bond with a liquidity premium of 0.5%? d.) What is the yield on an 8-year Treasury bond? e.) What is the yield on an 8-year BBB-rated corporate bond with a liquidity premium of 0.5%? f.) If the yield on a 9-year Treasury bond is 7.3%, what does that imply about the expected inflation in 9 years?

a.) Average inflation over 4 years = (2% + 2% + 2% + 4%)/4 = 2.5% b.) T4 = r(RF) + MRP4 = r* + IP4 + MRP4 = 3% + 2.5% + (0.1)3% = 5.8% c.) C4,BBB = r* + IP4 + MRP4 + DRP + LP = 3% + 2.5% + 0.3% + 1.3% + 0.5% = 7.6% d.) T8 = r(RF) + MRP8 = r* + IP8 + MRP8 = 3% + 3.25% + (0.1)7% = 6.95% e.) C8,BBB = r* + IP8 + MRP8 + DRP + LP = 3% + 3.25% + (0.1)7% + 1.3% + 0.5% = 8.75% f.) T9 = r* + IP9 + MRP9 7.3% = 3% + IP9 + 0.8% IP9 = 3.5% 3.5% = (3 x 2% + 5 x 4% + X)/9 31.5% = 6% + 20% + X 5.5% = X X = Inflation in Year 9 = 5.5%

The yield on 1-year Treasury securities is 6%, 2-year securities yield 6.2%, 3-year securities yield 6.3%, and 4-year securities yield 6.5%. There is no maturity risk premium. Using expectations theory and geometric averages, forecast the yields on the following securities: a.) A 1-year security, 1 year from now b.) A 1-year security, 2 years from now c.) A 2-year security, 1 year from now d.) A 3-year security, 1 year from now

a.) T1 = 6%, T2 = 6.2%, T3 = 6.3%, T4 = 6.5%, MRP = 0 (1.062)^2 = (1.06)(1 + X) (1.062)^2/1.06 = 1 + X 6.4% = X b.) (1.063)^3 = (1.062)^2(1 + X) (1.063)^3/(1.062)^2 = 1 + X 1.065 = 1 + X 6.5% = X c.) (1.063)^3 = (1.06)(1 + X)^2 (1.063)^3/1.06 = (1 + X)^2 1.13317 = (1 + X)^2 (1.13317)^1/2 = 1 + X 6.45% = X d.) (1.065)^4 = (1.06)(1 + X)^3 (1.065)^4/1.06 = (1 + X)^3 1.213648 = (1 + X)^3 (1.213648)^1/3 = 1 + X 6.67% = X

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?

r = r* + IP + DRP + LP + MRP r = 2.5% + 3% + 1% + 1% + 1.5% r = 9%

Equation for Quoted, or Nominal, Interest Rate

r = r* + IP + DRP + LP + MRP OR r = r(rf) + DRP + LP + MRP