Chapter 6 Finance

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

True

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*. T or F?

True

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 zero. Given this information, which of the following statements is CORRECT? a. The yield curve for U.S. Treasury securities will be upward sloping. b. A 5-year corporate bond must have a lower yield than a 5-year Treasury security. c. A 5-year corporate bond must have a lower yield than a 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.

A

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? a. The yield on a 10-year bond would be less than that on a 1-year bill. b. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium. c. It is impossible to tell without knowing the coupon rates of the bonds. d. The yields on the two securities would be equal. e. It is impossible to tell without knowing the relative risks of the two securities.

A

Keys Corporation's 5-year bonds yield 6.20% 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 liquidity premium for Keys' bonds is LP = 0.5% 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 default risk premium (DRP) on Keys' bonds? a. 1.17% b. 1.30% c. 1.43% d. 1.57% e. 1.73%

B

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. 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? a. 1.08% b. 1.20% c. 1.32% d. 1.45% e. 1.60%

B

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, 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. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. 5.08% b. 5.35% c. 5.62% d. 5.90% e. 6.19%

B

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond? a. 5.51% b. 5.80% c. 6.09% d. 6.39% e. 6.71%

B

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

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 2.15%. 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. a. 1.81% b. 1.90% c. 2.00% d. 2.10% e. 2.21%

C

Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT? a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. b. The interest rate today on a 2-year bond should be approximately 6%. c. The interest rate today on a 2-year bond should be approximately 7%. d. The interest rate today on a 3-year bond should be approximately 7%. e. The interest rate today on a 3-year bond should be approximately 8%.

D

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now? a. 7.36% b. 7.75% c. 8.16% d. 8.59% e. 9.04%

E

Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. b. The real risk-free rate is higher for corporate than for Treasury bonds. c. Most evidence suggests that the maturity risk premium is zero. d. Liquidity premiums are higher for Treasury than for corporate bonds. e. 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.

E

Which of the following statements is CORRECT? a. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. b. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. c. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. e. The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.

A

Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, we could be sure that a. Long-term interest rates are more volatile than short-term rates. b. Inflation is expected to decline in the future. c. The economy is not in a recession. d. Long-term bonds are a better buy than short-term bonds. e. Maturity risk premiums could help to explain the yield curve's upward slope.

E

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. T or F?

False

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. T or F?

True

One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security. The higher the risk, the higher the security's required return, other things held constant. T or F?

True

The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak. T or F?

True

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. T or F?

True