Finance ch 8

______________ is the tendency of prices, aided by union-corporation contracts, to rise during economic expansions and resist declines during recessions.

Administrative inflation

Investment grade bonds have ratings of ________ or higher.

Baa

______________ occurs when prices are raised to cover rising production costs, such as wages.

Cost-push inflation

______________ occurs when there is an excessive demand for goods and services as a result of large increases in the money supply

Demand-pull inflation

An economy with a large share of young people will have more total savings than one with more late middle- aged people. (T/F)

False

Business will increase current long-term borrowing if they forecast a decrease in interest rates in the near future. (T/F)

False

Interest rates generally fall during periods of economic expansion and rise during economic contraction. (T/F)

False

Interest rates in the United States are only influenced by domestic factors. (T/F)

False

The maturity risk premium is the added return expected by lenders because of the expectation of inflation. (T/F)

False

The shorter the maturity of a fixed-rate debt instrument, the greater the reduction in its value to a given interest rate increase. (T/F)

False

The Treasury's major influence through its borrowing to finance federal deficits is on the supply rather than demand for loanable funds. (T/F)

False; Treasury borrowing is demanding loanable funds

The risk-free rate of interest is found by combining the real rate of interest and the rate paid on U.S. Treasury debt. (T/F)

False; combine real rate and inflation premium, risk-free rate in United States is represented by U.S. Treasury debt instruments

The most important holders of Treasury bills are corporations and individuals. (T/F)

False; commercial banks

Holding demand constant, an increase in the supply of loanable funds will result in an increase in interest rates. (T/F)

False; decreased supply curve → increased interest rate

Cost-push inflation during economic expansions when demand for goods and services is greater than supply. (T/F)

False; demand-pull

Holding supply constant, an increase in the demand for loanable funds will result in a decrease in interest rates. (T/F)

False; increased demand curve → increased interest rate

The expectations theory contends that the shape of the yield curve reflects investor expectations about future GDP growth rates. (T/F)

False; inflation rates not GDP growth rates

The maturity risk premium is the compensation that investors demand for holding securities that cannot easily be converted to cash without major price discounts. (T/F)

False; liquidity premium

The interest rate that is observed in the marketplace is called a real interest rate. (T/F)

False; nominal interest rate

Treasury bonds are issued with an original maturity in excess of one year. (T/F)

False; ten

Securities that may be bought and sold through customary market channels are called

Marketable government securities

38. Which of the following statements is correct? a. A downward sloping yield curve implies that Treasury securities with long-term maturities have lower interest rates relative to similar quality securities with short-term maturities. b. Commercial paper is a primary source of short-term borrowing used by the U.S. government. c. A decline in interest rates for long-term Treasury securities indicates an increase in investor long-run inflation expectations. d. The establishment of the Federal Reserve System has caused the yield curve to always be upward sloping.

a. A downward sloping yield curve implies that Treasury securities with long-term maturities have lower interest rates relative to similar quality securities with short-term maturities.

The default risk premium at a certain point in time may be expressed by comparing the interest rates on: a. a Treasury bill and a Treasury bond b. a Treasury bond and a long-term high quality bond of a large corporation c. a Treasury bond and the commercial paper rate d. a junk bond and a comparable maturity U.S. Treasury security

b. a Treasury bond and a long-term high quality bond of a large corporation

Multiple Answer Question: Select ALL of the following that are true of Treasury bills: a. are issued usually for maturities ranging from one to ten years b. are issued with maturities of up to one year c. typically have original maturities in excess of ten years d. are issued on a discount basis e. are callable f. mature at par g. issued at specified interest rates

b. are issued with maturities of up to one year d. are issued on a discount basis f. mature at par

The basic sources of loanable funds are: a. short-term funds and currency b. current savings and the creation of new funds through the expansion of deposits by depository institutions c. contractual savings and commercial bank credit d. bank loans and the creation of new funds through the contraction of credit by depository institutions

b. current savings and the creation of new funds through the expansion of deposits by depository institutions

Which of the following is not considered to be a basic theory used to explain the term structure of interest rates? a. expectations theory b. demand-pull theory c. liquidity preference theory d. market segmentation theory

b. demand-pull theory

Treasury bills are: a. issued on a premium basis and pay a fixed annual interest rate. b. issued on a discount basis and mature at par. c. issued on a premium basis and mature at par. d. issued on a discount basis and pay a fixed annual interest rate. e. none of the above

b. issued on a discount basis and mature at par.

The loanable funds theory used to explain the level of interest rates holds that interest rates are a function of the supply of: a. loanable funds and the demand for money b. loanable funds and the demand for loanable funds c. money and the demand for loanable funds d. money and the demand for money

b. loanable funds and the demand for loanable funds

Which of the following is not considered to be a basic theory used to explain the term structure of interest rates? a. expectations theory b. loanable funds theory c. liquidity preference theory d. market segmentation theory e. all of the above are theories used to explain the term structure of interest rates.

b. loanable funds theory

Which of the following is not true of Treasury bonds? a. long-lived b. noncallable c. stated interest rate d. all the above are false

b. noncallable

8. Multiple Answer Question: Select ALL of the following theories that are commonly used to explain the term structure of interest rates: a. the default risk theory b. the expectations theory c. the market segmentation theory d. the liquidity preference theory e. the demand-pull theory f. the cost-push theory

b. the expectations theory c. the market segmentation theory d. the liquidity preference theory

Multiple Answer Question: Select ALL of the following statements that are correct. a. The liquidity preference theory holds that interest rates are determined by the supply of and demand for loanable funds. b. The mutual funds theory and the liquidity preference theory are compatible with each other. c. Marketable U.S. government securities are mainly sold through dealers and have interest payments that are federally taxable. d. The market segmentation theory holds that securities of different maturities are perfect substitutes for each other.

c. Marketable U.S. government securities are mainly sold through dealers and have interest payments that are federally taxable.

Which of the following statements is correct? a. Marketable government securities are those securities that cannot be transferred to other persons or institutions and can be redeemed only by being turned in to the U.S. government b. Nonmarketable government securities are those securities that can be transferred to other persons or institutions and can be redeemed only by being turned in to the U.S. government c. Nonmarketable government securities are those securities that cannot be transferred to other persons or institutions and can be redeemed only by being turned in to the U.S. government d. none of the above

c. Nonmarketable government securities are those securities that cannot be transferred to other persons or institutions and can be redeemed only by being turned in to the U.S. government

Sources of loanable funds do not include: a. current savings b. the expansion of deposits by depository institutions c. federal deficits d. all the above are sources of loanable funds

c. federal deficits

Junk bonds a. are high grade corporate bonds. b. are high grade government bonds. c. have a substantial probability of default. d. are investment grade bonds

c. have a substantial probability of default

Assuming no adjustment on the part of borrowers, an unanticipated increase in inflation should: a. increase the demand for loanable funds b. decrease the interest rate on loans c. increase the interest rate on loans d. have no effect on the interest rate on loans

c. increase the interest rate on loans r = RR + IP + DRP + MRP + LP, ↑ inflation ↑ → ↑IP → ↑ r

Long-run inflation expectations in the capital markets can be estimated by: a. subtracting the real return and maturity risk premium components from the rate on short-term Treasury bills b. adding the real return and maturity risk premium components to interest rates on long-term corporate bonds c. subtracting the real return and maturity risk premium components from the rate on long-term Treasury securities d. adding the real return and maturity risk premium components to interest rates on short-term corporate securities

c. subtracting the real return and maturity risk premium components from the rate on long-term Treasury securities r = RR + IP + DRP + MRP + LP, for Treasury securities DRP & LP are 0

If the nominal interest rate for is 8% and the risk-free rate is 3%, the expected inflation rate must be

cannot be determined without additional information (need to know RR to be able to calculate IP)

A basic source of loanable funds is

current savings that flow through financial institutions (expansions of deposits by depository institutions)

Which statement about inflation is incorrect? a. Demand-pull inflation traditionally exists during periods of economic expansion when an increase in the money supply causes the demand for goods and services to exceed the available supply of such goods and services. b. Cost-push inflation occurs when prices are raised to cover rising production costs, such as wages c. Speculative inflation is caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices d. Administrative inflation occurs when the Fed lowers the prime rate. e. None of the four (a, b, c, and d) are correct f. All four (a, b, c, and d) are correct

d. Administrative inflation occurs when the Fed lowers the prime rate

Which of the following statements is false? a. A major determinant in the long run of the volume of savings is the level of taxes. b. The money market involves obtaining and trading of credit and debt instruments with maturity of one year or less. c. Bond risk premiums follow changes in investor optimism/pessimism about expected economic activity. d. High short-term Treasury interest rates and a downward sloping yield curve is generally perceived as being conductive to future economic expansion.

d. High short-term Treasury interest rates and a downward sloping yield curve is generally perceived as being conductive to future economic expansion.

Which of the following factors affects the supply of loanable funds? a. the volume of savings b. expansion of deposits by banks c. attitudes about liquidity d. all the above

d. all of the above

Which of the following factors directly impact the level of interest rates? a. risk b. marketability c. maturity d. all of the above

d. all of the above

Which of the following may accumulate savings? a. individuals b. sometimes corporations c. sometimes governmental units d. all the above may have savings

d. all of the above may have savings

Which of the following costs serves to compensate the lender for not being able to quickly convert the loan to cash at a price close to the estimated market value of the loan? a. administrative costs of making the loan b. cost of paying for the risk involved c. cost to offset the likelihood of inflation d. liquidity premium

d. liquidity premium (similar to liquidity premium for bonds)

An increase in the supply for loanable funds accompanied by a decrease in demand will cause interest rates to

decrease

Holding demand constant, an increase in the supply of loanable funds will result in a(n) ___________ in interest rates.

decrease

Holding supply constant, a decrease in the demand of loanable funds will result in a(n) ___________ in interest rates

decrease

A decrease in the demand for loanable funds, holding supply constant, will cause interest rates to

decrease (photo in review)

An increase in the supply for loanable funds, holding demand constant, will cause interest rates to

decrease (photo in review)

The average maturity of the marketable debt in the United States

decreases day by day unless new obligations are issued to offset such decreases

The risk that a borrower will not pay interest and/or repay the principal on a loan or other debt instrument according to the agreed contractual terms is

default risk

Inflation caused by an excessive demand for goods and services as a result of large increases in the money supply

demand-pull inflation

What yield curve shape is depicted if intermediate-term Treasury securities yield 10 percent, short-term Treasuries yield 10.5 percent, and long-term Treasuries yield 9.5 percent?

downward sloping

The basic price that equates the demand for and supply of loanable funds in the financial markets is the __________

equilibrium interest rate

As interest rates rise, the prices of existing bonds will

fall

The default risk premium is the compensation that investors demand for holding securities that cannot easily be converted to cash without major price discounts. (T/F)

false; liquidity premium

When investors expect higher inflation rates they will require __________ nominal interest rates so that a real rate of return will remain after the inflation.

higher; r = RR + IP + DRP + MRP + LP

A decrease in the supply for loanable funds accompanied by an increase in demand will cause interest rates to

increase

Holding demand constant, a decrease in the supply of loanable funds will result in a(n) ___________ in interest rates.

increase

A decrease in the supply for loanable funds, holding demand constant, will cause interest rates to

increase (photo in review)

An increase in the demand for loanable funds, holding supply constant, will cause interest rates to

increase (photo in review)

When referring to an "upward sloping" yield curve, interest rates

increase as maturity increases

The liquidity preference theory holds that interest rates are determined by the

investor preference for short-term securities

The major factor that determines the volume of savings, corporate as well as individual, is the

level of national income

Compensation for those financial debt instruments that cannot be easily converted to cash at prices close to estimated fair market values is termed

liquidity premium

The yield curve or the term structure of interest rates is typically downward sloping when

long-term treasury interest rates are lower than short-term Treasury interest rates

An increase in the supply for loanable funds accompanied by an increase in demand will cause interest rates to

not enough information to tell end result depends on the magnitude of the shifts

A decrease in the supply for loanable funds accompanied by a decrease in demand will cause interest rates to

not enough information to tell end result depends on the magnitudes of the shifts

As interest rates fall, the prices of existing bonds will

rise

If the money supply increases faster than output, prices will

rise

In an inflationary period, interest rates have a tendency to

rise r = RR + IP + DRP + MRP + LP

Changes in the money supply or in the amount of metal in the money unit have influenced prices

since the earliest records of civilization

The relationship between interest rates or yields and the time to maturity for debt instruments of comparable quality is called

the term structure of interest rates

Since 2008 more than half of the federal debt has been owned by

total for private investors

As the economy begins moving out of a recessionary period, the yield curve is generally

upward sloping

Assume that these current yields exist: long-term Treasury bonds yield 9 percent, five-year Treasury notes yield 8.5 percent, and one-year Treasury bills yield 8 percent. What type of yield curve is depicted?

upward sloping

If the nominal rate of interest is 8%, the real rate of interest is 0.75%, the risk-free rate of interest is 2%, the default premium is 4%, the liquidity premium is 0.5%, and the maturity premium is 1.5%, then the inflation premium must be ______.

1.25% Risk-Free Rate = RR + IP 2% = 0.75% + IP IP = 1.25%

What is the real rate of interest if the nominal rate of interest is 15%, the IP is 5%, the DRP is 3%, the MRP is 4%, and the LP is 1%?

2% r = RR + IP + DRP + MRP + LP → 15% = RR + 5% + 3% + 4% + 1% → RR = 15% - 13% = 2%

If the nominal rate of interest is 10%, the real rate of interest is 3%, the default premium is 2%, the liquidity premium is 0.5%, and the maturity premium is 1.5%, then the inflation premium must be _______

3.0% r = RR + IP + DRP + MRP + LP → 10% = 3% + IP + 2% + 1.5% + 0.5% → IP = 10% - 7% = 3%

If you expect the inflation premium to be 2%, the default risk premium to be 1% and the real interest rate to be 4%, what interest would you expect to observe in the marketplace on short term Treasury securities?

6% DRP and LP on Treasury securities are 0%, and short term securities MRP are 0% → r = RR + IP + DRP + MRP + LP = 4% + 2% + 0% + 0% + 0% = 6%

If you expect the inflation premium to be 2%, the default risk premium to be 1% and the real interest rate to be 4%, what interest would you expect to observe in the marketplace under the simplest form of market interest rates?

7% r = RR + IP + DRP = 4% + 2% + 1% = 7%

Federal obligations usually issued for maturities up to one year are called

Treasury bills

Federal obligations usually issued for maturities in excess of ten years are called

Treasury bonds

Federal obligations usually issued for maturities of two to ten years are called

Treasury notes

A "shock" may be defined as an unanticipated change that will cause the demand for, or supply of loanable funds to change. (T/F)

True

Administrative inflation is the tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions. (T/F)

True

Cost-push inflation occurs when prices are raised to cover rising production costs, such as wages. (T/F)

True

Default risk is the risk that a borrower will not pay interest and/or repay the principal on a loan or other debt instrument according to the agreed contractual terms. (T/F)

True

Demand-pull inflation may be defined as an excessive demand for goods and services during periods of economic expansion as a result of large increases in the money supply. (T/F)

True

Holding demand constant, a decrease in the supply of loanable funds will result in an increase in interest rates. (T/F)

True

If the Fed changes discount policies it may affect the supply of loanable funds. (T/F)

True

Inflation is an increase in the price of goods or services that is not offset by an increase in quality. (T/F)

True

Interest rates will move from one equilibrium level to another if an unanticipated change occurs that causes the demand for loanable funds to change. (T/F)

True

Speculative inflation is caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices. (T/F)

True

Tax deferral on investments may increase the volume of savings. (T/F)

True

The demand for loanable funds comes from all sectors of the economy. (T/F)

True

The equilibrium interest rate is the basic price that equates the demand for and supply of loanable funds in the financial markets. (T/F)

True

The liquidity premium is compensation for those financial debt instruments that cannot be easily converted to cash at prices close to their estimated fair market values. (T/F)

True

The liquidity premium is the compensation that investors demand for holding securities that cannot easily be converted to cash without major price discounts. (T/F)

True

The loanable funds theory states that interest rates are a function of the supply of and demand for loanable funds. (T/F)

True

The market segmentation theory holds that securities of different maturities are not perfect substitutes for each other. (T/F)

True

The maturity risk premium is the compensation expected by investors due to interest rate risk on debt instruments with longer maturity. (T/F)

True

The nominal interest rate may include a default risk premium. (T/F)

True

The risk free rate of interest is the interest rate on a debt instrument with no default, maturity, or liquidity risks. (T/F)

True

The risk-free rate of interest is equal to the real rate of interest plus a premium for inflation. (T/F)

True

The term structure of interest rates indicates the relation between interest rates and the maturity of comparable quality debt instruments (T/F) .

True

There are two basic sources of loanable funds: current savings and the expansion of deposits of depository institutions. (T/F)

True

There is an inverse relation between debt instrument prices and nominal interest rates in the marketplace. (T/F)

True

Three theories commonly used to explain the term structure of interest rates are the expectations theory, the liquidity preference theory, and the market segmentation theory. (T/F)

True

Treasury notes are intermediate-term Federal debt obligations. (T/F)

True; 2-10 years

Holding supply constant, a decrease in the demand for loanable funds will result in a decrease in interest rates. (T/F)

True; draw decreased demand curve → decreased interest rate

While the Federal Reserve strongly influences the supply of funds, the Treasury's major influence is on the demand for funds, as it borrows heavily to finance federal deficits. (T/F)

True; federal government borrowing is done by the Treasury

A maturity risk premium at a certain point in time may be expressed by comparing the interest rates on

a Treasury bill and a Treasury bond

The risk-free interest rate is composed of

a real rate of interest and an inflation premium

______________ is caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices.

Speculative inflation

___________________ states that interest rates are a function of the supply and demand for loanable funds.

The loanable funds theory

Which of the following statements is correct? a. Advance refunding is one of the new debt-management techniques used to extend the average maturity of the marketable debt without disturbing the financial markets and occurs when the Treasury offers the owners of a given issue the opportunity to exchange their holdings well in advance of the holdings' regular maturity for new securities of longer maturity. b. Reverse refunding is one of the new debt-management techniques used to extend the average maturity of the marketable debt without disturbing the financial markets and occurs when the Treasury offers the owners of a given issue the opportunity to exchange their holdings well in advance of the holdings' regular maturity for new securities of longer maturity. c. Extended refunding is one of the new debt-management techniques used to extend the average maturity of the marketable debt without disturbing the financial markets and occurs when the Treasury offers the owners of a given issue the opportunity to exchange their holdings well in advance of the holdings' regular maturity for new securities of longer maturity. d. Laddered refunding is one of the new debt-management techniques used to extend the average maturity of the marketable debt without disturbing the financial markets and occurs when the Treasury offers the owners of a given issue the opportunity to exchange their holdings well in advance of the holdings' regular maturity for new securities of longer maturity. e. none of the above

a. Advance refunding is one of the new debt-management techniques used to extend the average maturity of the marketable debt without disturbing the financial markets and occurs when the Treasury offers the owners of a given issue the opportunity to exchange their holdings well in advance of the holdings' regular maturity for new securities of longer maturity.

Which of the following statements is correct? a. Income from the obligations of the federal government is exempt from all state and local taxes but is subject to federal and state inheritance, estate, or gift taxes. b. Income from the obligations of the federal government is exempt from all federal taxes but is subject to state and local income taxes, state inheritance, estate, or gift taxes. c. Income from the obligations of the federal government is exempt from all federal, state and local taxes but is subject to inheritance, estate, or gift taxes. d. none of the above

a. Income from the obligations of the federal government is exempt from all state and local taxes but is subject to federal and state inheritance, estate, or gift taxes.

Which one of the following is not a marketable government security? a. Treasury stock b. Treasury bill c. Treasury note d. Treasury bond

a. Treasury stock

Interest on obligations of the federal government: a. is not taxable by state or local government b. is not taxable by the federal government c. is taxable by both the federal and state governments d. except for Treasury notes is taxable by the federal government

a. is not taxable by state or local government

If interest rates increase because of a previously unanticipated inflation rate risk, the value of: a. long-lived fixed-rate debt instruments will decline more than short-lived fixed rate debt instruments b. long-lived fixed-rate debt instruments will decline less than short-lived fixed-rate debt instruments c. neither set of debt instruments will decline d. all other things being equal, both should decline equally

a. long-lived fixed-rate debt instruments will decline more than short-lived fixed rate debt instruments

Multiple Answer Question: Select ALL of the following that are a determinant of market interest rates: a. the inflation premium b. the maturity risk premium c. the volatility risk premium d. the real rate of interest e. the political premium

a. the inflation premium b. the maturity risk premium d. the real rate of interest

When referring to a "downward sloping" yield curve

as maturities shorten, interest rates rise