Brunstein Quiz 1 HW Problems

Bonds with a maturity that is as short as the holding period have ______ interest-rate risk.

no

If the expected path of one−year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that today's interest rate on the five−year bond is a. 4 percent. b. 5 percent. c. 6 percent. d. 7 percent.

c. 6 percent.

15. According to the expectations theory of the term structure, the interest rate on a long −term bond will equal the________ of the short−term interest rates that people expect to occur over the life of the long−term bond. a. multiple b. sum c. average d. difference

c. average

Everything else held constant, an increase in expected inflation, lowers the expected return on ________ compared to________ assets. a. real estate; financial b. real estate; real c. bonds; real d. bonds; financial

c. bonds; real

If the demand for bonds shifts to the left, the price of bonds a. decreases, and interest rates fall. b. increases, and interest rates rise. c. decreases, and interest rates rise. d. increases, and interest rates fall.

c. decreases, and interest rates rise.

Holding everything else constant, if interest rates are expected to increase, the demand for bonds ________ and the demand curve shifts ________. a. increases; right b. decreases; right c. decreases; left d. increases; left

c. decreases; left

When the prices of rare coins become volatile, the ________ curve for bonds shifts to the ________, everything else held constant. a. supply; left b. demand; left c. demand; right d. supply; right

c. demand; right

A rise in the price level causes the demand for money to ________ and the interest rate to ________, everything else held constant. a. decrease; increase b. decrease; decrease c. increase; increase d. increase; decrease

c. increase; increase

Everything else held constant, when bonds become less widely traded, and as a consequence the market becomes less liquid, the demand curve for bonds shifts to the ________ and the interest rate ________. a. right; falls b. left; falls c. left; rises d. right; rises

c. left; rises

Everything else held constant, when stock prices become ________ volatile, the demand curve for bonds shifts to the________ and the interest rate ________. a. more; right; rises b. less; left; falls c. more; right; falls d. less; left; does not change

c. more; right; falls

When the wealth of individuals decreases a. the price of bonds increases while the interest rates decrease.the price of bonds increases while the interest rates decrease. b. both the price of bonds and interest rates decrease c. the price of bonds decreases while the interest rates increase. d. both the price of bonds and interest rates increase.

c. the price of bonds decreases while the interest rates increase.

Everything else held constant, when the government has higher budget deficits a. the demand curve for bonds shifts to the left and the interest rate falls. b. the demand curve for bonds shifts to the left and the interest rate rises. c. the supply curve for bonds shifts to the right and the interest rate rises. d. the supply curve for bonds shifts to the right and the interest rate falls.

c. the supply curve for bonds shifts to the right and the interest rate rises.

If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve? The yield curve would become

flatter

If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would

increase

If the supply of bonds shifts to the left the price of bonds ______ and the interest rate __________

increases decreases

Compared to bonds with longer maturity, bonds with shorter maturity respond _____ dramatically to changes in interest rates.

less

This same $125 received in one year would be worth ___ to you today if the interest rate rose to 15%.

less

How much is $125 to be received in exactly one year worth to you today if the interest rate is 10%?

$113.64

Calculate the present value of an $1,100 discount bond with 7 years to maturity if the yield to maturity is 5%. What is the present value?

$781.75

Given the nominal interest rate of 14% and the expected inflation of 15%, then the value of the real interest rate is____

1%

Moral Hazard 1. A situation where the borrower might engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back. 2. Investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. 3. Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. 4. A situation where one party often does not know enough about the other party to make accurate decisions. 5. A process of borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders.

1. A situation where the borrower might engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back.

Adverse Selection 1. A situation where the borrower might engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back. 2. Investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. 3. Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. 4. A situation where one party often does not know enough about the other party to make accurate decisions. 5. A process of borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders.

3. Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected.

What is the yield to maturity (YTM) on a simple loan for $1,500 that requires a repayment of $6,000 in five years' time? The yield to maturity is

32.0%

Asymmetric Information 1. A situation where the borrower might engage in activities that are undesirable from the lender's point of view, because they make it less likely that the loan will be paid back. 2. Investing in a collection (portfolio) of assets whose returns do not always move together, with the result that overall risk is lower than for individual assets. 3. Occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan and are thus most likely to be selected. 4. A situation where one party often does not know enough about the other party to make accurate decisions. 5. A process of borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders.

4. A situation where one party often does not know enough about the other party to make accurate decisions.

With the real interest rate equal to 44% and the expected inflation equal to 22%, then the value of the nominal interest rate is _____%

6%

As a bank, you make a loan to an individual seeking funds to open a coffee shop. When the loan is made, the borrower uses the funds to take a vacation to Greenland. This is an example of A. Moral hazard B. Adverse Selection C. Asset Transformation

A. Moral hazard

Before a loan is made, banks screen their loan applicants to avoid the problem of A. adverse selection B. moral hazard C. asset transformation D. risk sharing

A. adverse selection

Before a loan is made, banks screen their loan applicants to avoid the problem of A. adverse selection B. asset transformation C. moral hazard D. risk sharing

A. adverse selection

Is it better for bondholders when the yield to maturity increases or decreases? Bondholders are better off when the yield to maturity: A. decreases, since this represents an increase in the price of the bond and a decrease in potential capital losses. B. increases, since this represents a decrease in the bond maturity and a decrease in potential capital losses. C. decreases, since this represents an increase in the coupon payment and an increase in potential capital gains. D. increases, since this represents a decrease in the price of the bond and an increase in potential capital gains.

A. decreases, since this represents an increase in the price of the bond and a decrease in potential capital losses.

Financial intermediaries have a role to play in matching savers and borrowers for all of the following reasons except: A. information symmetries B. economies of scale C. risk sharing D. minimizing transaction costs

A. information symmetries

The ________ interest rate more accurately reflects the true cost of borrowing. A. real B. discount C. nominal D. market

A. real

If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond would you prefer to have been holding? A. A bond with twenty years to maturity B. A bond with one year to maturity C. A bond with five years to maturity D. A bond with ten years to maturity

B. A bond with one year to maturity

Why are financial markets important to the health of the economy? A. They eliminate the need for financial intermediaries B. They channel funds from savers to investors C. They identify and shut down inefficient firms D. They allow consumers to time their purchases better

B. They channel funds from savers to investors

When lenders have inferior knowledge relative to borrowers about the potential returns and risks associated with an investment project, it gives rise to the problem known as A. transaction costs. B. asymmetric information C. asset transformation D. financial intermediation

B. asymmetric information

When the ________ interest rate is low, there are greater incentives to ________ and fewer incentives to ________. A. real; lend; borrow B. real; borrow; lend C. nominal; lend; borrow D. market; lend; borrow

B. real; borrow; lend

Retired persons often have much of their wealth placed in savings accounts and other interest-bearing investments, and complain whenever interest rates are low. Which of the following, if true, would be a valid complaint? A. There has not been significant growth of nominal interest rates for the last 5 years. B. Nominal interest rates decrease, while there is a slight increase in real interest rates. C. Expected inflation is falling at a slower rate than nominal interest rates. D. Expected inflation is falling at the same rate as nominal interest rates.

C. Expected inflation is falling at a slower rate than nominal interest rates.

One of the factors contributing to the financial crisis of 2007-2009 was the widespread issuance of subprime mortgages. How does this demonstrate adverse selection? A. Lenders consciously loaned money to the riskiest homeowners with the highest interest rates to increase their profits. B. Financial intermediaries provided funds to potential homeowners under strict conditions. C. Lenders loaned money to a pool of potential homeowners with the highest credit risk and lowest net wealth. D. Potential homeowners borrowed funds for high-yield, high-risk investments instead of mortgages

C. Lenders loaned money to a pool of potential homeowners with the highest credit risk and lowest net wealth.

How do financial intermediaries benefit by providing risk-sharing services? A. They are able to turn safe assets into high-risk, high-return investments B. A collection of riskier assets is always more profitable for a bank or intermediary C. They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold D. Customers pay a fee to financial intermediaries for being able to invest in safer assets

C. They are able to earn a profit on the spread between the returns they earn on risky assets and the payments they make on the assets they have sold

True or False: With a discount bond, the return on a bond is equal to the rate of capital gain . A. True: A discount bond pays fixed interest payments every year so the return is equal to the rate of capital gain. B. False: Bond returns can never equal the rate of capital gain; there must be a capital loss or gain indicated. C. True: A discount bond has no coupon payments so the return on the bond is equal to the rate of capital gain. D. There is no way to determine this without the knowing the coupon amount and interest rate.

C. True: A discount bond has no coupon payments so the return on the bond is equal to the rate of capital gain.

A financial adviser has just given you the following advice: "Long-term bonds are a great investment because their interest rate is over 20%." Is the financial adviser necessarily right? A. No. When making an investment decision, you should take the yield to maturity into account, not the interest rate. B. Yes. If the interest rate remains unchanged until maturity, the price of the bond will be more than its face value. C. Yes. The higher the annual interest rate, the higher the annual income on bonds. D. No. If interest rates rise sharply in the future, long-term bonds may suffer a sharp fall in price, causing their return to be quite low.

D. No. If interest rates rise sharply in the future, long-term bonds may suffer a sharp fall in price, causing their return to be quite low.

When lenders have inferior knowledge relative to borrowers about the potential returns and risks associated with an investment project, it gives rise to the problem known as A. asset transformation B. transaction costs C. financial crisis D. asymmetric information

D. asymmetric information

Financial markets improve economic welfare because: A. they allow consumers to time their purchases better B. they channel funds from savers to investors C. they eliminate the need for financial intermediaries D. both A and B are correct E. all of the above are correct

D. both A and B are correct

The interest rate on a consol equals the... A. price times the coupon payment. B. coupon payment plus the price. C. price divided by the coupon payment. D. coupon payment divided by the price.

D. coupon payment divided by the price.

If you expect the inflation rate to be 15 percent next year and a one −year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is A. 7 percent. B. 22 percent. C. −15 percent. D. −8 percent.

D. −8 percent.

10. Suppose you observe a change in the relationship between short-term and long-term bonds. Specifically, you note that although interest rates on both short-term and long-term bond are rising together, as expected, the rate on long-term bonds is not rising by as much as has been observed in the past. Assuming the liquidity premium theory of term structure, you conclude that the liquidity premium is _______ As a result, the yield curve becomes ________

Decreasing Flatter

A lender prefers a ______ real interest rate while a borrower prefers a ______ real interest rate

Higher; lower

________ in the money supply creates excess ________ money, causing interest rates to ________, everything else held constant. a. A decrease; demand for; rise b. An increase; demand for; fall c. A decrease; supply of; fall d. An increase; supply of; rise

a. A decrease; demand for; rise

What will happen to interest rates if the public suddenly expects a large increase in stock prices? a. Interest rates will fall because the expected increase in stock prices raises the liquidity of stocks relative to bonds and so the demand for bonds decreases. b. Interest rates will rise because the expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds decreases c. Interest rates will fall because the expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds decreases d. Interest rates will rise because the expected increase in stock prices raises the liquidity of stocks relative to bonds and so the demand for bonds decreases

a. Interest rates will fall because the expected increase in stock prices raises the liquidity of stocks relative to bonds and so the demand for bonds decreases.

What would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market? a. Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand, which would lower the risk premium b. Lower brokerage commissions for corporate bonds would only reduce the cost of buying and selling the bonds, which would have no impact on the risk premium c. Lower brokerage commissions for corporate bonds would make them more desirable to hold and thus increase demand; consequently, this would raise interest rates and thus raise the risk premium d. None of the above

a. Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand, which would lower the risk premium

The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is a. default risk. b. liquidity risk. c. interest rate risk. d. inflation risk.

a. default risk.

In the market for money, an interest rate below equilibrium results in an excess ________ money and the interest rate will ________. a. demand for; rise b. supply of; fall c. supply of; rise d. demand for; fall

a. demand for; rise

When the interest rate on a bond is above the equilibrium interest rate, in the bond market there is excess ________ and the interest rate will ________. a. demand; fall b. demand; rise c. supply; rise d. supply; fall

a. demand; fall

A business cycle expansion increases income, causing money demand to ________ and interest rates to ________, everything else held constant. a. increase; increase b. decrease; decrease c. increase; decrease d. decrease; increase

a. increase; increase

A decrease in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant. a. increase; reduce b. increase; increase c. reduce; increase d. reduce; reduce

a. increase; reduce

In the bond market, the bond demanders are the ________ and the bond suppliers are the ________. a. lenders; borrowers b. lenders; advancers c. borrowers; lenders d. borrowers; advancers

a. lenders; borrowers

When yield curves are downward sloping, a. short−term interest rates are above long−term interest rates. b. short−term interest rates are about the same as long−term interest rates. c. long−term interest rates are above short−term interest rates. d. medium−term interest rates are above both short−term and long−term interest rates.

a. short−term interest rates are above long−term interest rates.

According to the liquidity premium theory of the term structure a. the interest rate on long−term bonds will equal an average of short−term interest rates that people expect to occur over the life of the long−term bonds plus a term premium. b. the interest rate for each maturity bond is determined by supply and demand for that maturity bond. c. because of the positive term premium, the yield curve will not be observed to be downward sloping. d. because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time.

a. the interest rate on long−term bonds will equal an average of short−term interest rates that people expect to occur over the life of the long−term bonds plus a term premium.

What effect would reducing income tax rates have on the interest rates of municipal bonds? a. Interest rates would fall because the reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds. b. Interest rates would rise because the reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds. c. Interest rates would rise because Treasury securities are now less valuable and more people will want to hold municipal bonds. d. Interest rates would fall because Treasury securities are now less valuable and more people will want to hold municipal bonds.

b. Interest rates would rise because the reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds.

Would interest rates of Treasury securities be affected by the tax rate change? a. Yes, because municipal bonds are less risky than Treasury securities, the demand for Treasury securities will decrease. b. Yes, because the reduction in the tax-exempt privilege in municipal bonds would raise the relative value of Treasury securities, making Treasury securities more desirable. c. Yes, because the increase in interest rates would increase the desire to hold more municipal bonds and less Treasury securities. d. No, there would be no impact on the market for Treasury securities.

b. Yes, because the reduction in the tax-exempt privilege in municipal bonds would raise the relative value of Treasury securities, making Treasury securities more desirable.

When the yield curve is flat or downward−sloping, it suggest that the economy is more likely to enter a. a period of increasing output. b. a recession. c. a boom time. d. an expansion.

b. a recession.

A lower level of income causes the demand for money to ________ and the interest rate to ________, everything else held constant. a. increase; increase b. decrease; decrease c. decrease; increase d. increase; decrease

b. decrease; decrease

Along the supply curve for bonds, an increase in the price of bonds a. decreases the interest rate and decreases the quantity of bonds supplied. b. decreases the interest rate and increases the quantity of bonds supplied. c. increases the interest rate and decreases the quantity of bonds supplied. d. increases the interest rate and increases the quantity of bonds supplied.

b. decreases the interest rate and increases the quantity of bonds supplied.

The following three characteristics of a bond are collectively embedded in the risk structure of interest rates except a. liquidity b. difference in maturity c. income tax treatment d. risk of default

b. difference in maturity

If there is an excess supply of money a. individuals sell bonds, causing the interest rate to rise. b. individuals buy bonds, causing interest rates to fall. c. individuals sell bonds, causing the interest rate to fall. d. individuals buy bonds, causing interest rates to rise.

b. individuals buy bonds, causing interest rates to fall.

The demand curve for bonds has the usual downward slope, indicating that at ________ prices of the bond, everything else equal, the ________ is higher. a. higher; quantity demanded b. lower; quantity demanded c .lower; demand d. higher; demand

b. lower; quantity demanded

In the bond market, the market equilibrium shows the market−clearing ________ and market−clearing ________. a. price; deposit b. price; interest rate c. interest rate; premium d. interest rate; deposit

b. price; interest rate

During business cycle expansions when income and wealth are rising, the demand for bonds ________ and the demand curve shifts to the ________, everything else held constant. a. falls; right b. rises; right c. falls; left d. rises; left

b. rises; right

If there is an excess demand for money, individuals ________ bonds, causing interest rates to ________. a. sell; fall b. sell; rise c. buy; fall d. buy; rise

b. sell; rise

When yield curves are flat, a. short−term interest rates are above long−term interest rates. b. short−term interest rates are about the same as long−term interest rates. c. long−term interest rates are above short−term interest rates. d. medium−term interest rates are above both short−term and long−term interest rates.

b. short−term interest rates are about the same as long−term interest rates.

If the price of bonds is above the equilibrium price, there occurs an excess a. supply of bonds, the price of bonds will rise, and the interest rate will fall. b. supply of bonds, the price of bonds will fall, and the interest rate will rise. c. demand for bonds, the price of bonds will rise, and the interest rate will fall. d. demand for bonds, the price of bonds will fall, and the interest rate will rise.

b. supply of bonds comma the price of bonds will fall comma and the interest rate will rise.

9. Which of the following statements is true? a. The differences in bond interest rates reflect differences in default risk only. b. The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds. c. The corporate bond market is the most liquid bond market. d. A liquid asset is one that can be quickly and cheaply converted into cash.

d. A liquid asset is one that can be quickly and cheaply converted into cash.

What effect will a sudden increase in the volatility of gold prices have on interest rates? a. Interest rates will increase because bonds will become relatively more risky, which decreases the demand for bonds b. Interest rates will increase because bonds will become relatively less risky, which increases the demand for bonds c. Interest rates will decrease because bonds will become relatively more risky, which decreases the demand for bonds d. Interest rates will decrease because bonds will become relatively less risky, which increases the demand for bonds

d. Interest rates will decrease because bonds will become relatively less risky, which increases the demand for bonds

How might a sudden increase in people's expectations of future real estate prices affect interest rates? a. Interest rates would decrease because real estate would have a relatively lower rate of return compared to bonds, which would cause the demand for bonds to increase. b. Interest rates would increase because real estate would have a relatively lower rate of return compared to bonds, which would cause the demand for bonds to increase. c. Interest rates would decrease because real estate would have a relatively higher rate of return compared to bonds, which would cause the demand for bonds to decrease. d. Interest rates would increase because real estate would have a relatively higher rate of return compared to bonds, which would cause the demand for bonds to decrease.

d. Interest rates would increase because real estate would have a relatively higher rate of return compared to bonds, which would cause the demand for bonds to decrease.

The reduction of brokerage commissions for trading common stocks that occurred in 1975 caused the demand for bonds to ________ and the demand curve to shift to the ________. a. fall; right b. rise; right c. rise; left d. fall, left

d. fall, left

According to the liquidity premium theory of the term structure a. interest rates on bonds of different maturities do not move together over time. b. bonds of different maturities are not substitutes. c. yield curves should never slope downward. d. if yield curves are downward sloping, then short−term interest rates are expected to fall by so much that, even when the positive term premium is added, long−term rates fall below short−term rates.

d. if yield curves are downward sloping, then short−term interest rates are expected to fall by so much that, even when the positive term premium is added, long−term rates fall below short−term rates.

If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on corporate bonds will ________ and the expected return on these bonds will ________, everything else held constant. a. decrease; decrease b. increase; increase c. decrease; increase d. increase; decrease

d. increase; decrease

The supply curve for bonds has the usual upward slope, indicating that as the price ________, ceteris paribus, the________ increases. a. falls; quantity supplied b. rises; supply c. falls; supply d. rises; quantity supplied

d. rises; quantity supplied

In a business cycle expansion, the ________ of bonds increases and the ________ curve shifts to the ________ as business investments are expected to be more profitable. a. demand; demand; right b. demand; demand; left c. supply; supply; left d. supply; supply; right

d. supply; supply; right

What will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future? Interest rates on corporate bonds will

decrease

The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him. As a result of the president's announcement, people's expectations of inflation will _______ which causes the demand for bonds to shift to the ___________ However, the lower expected inflation rate causes the cost of borrowing to __________ so the supply of bonds will __________ which causes the supply curve for bonds to shift to the ________The impact of this change in bond demand and supply will cause equilibrium interest rates to _________.

fall right rise decrease left decrease

If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future? You would _____ your predictions of future interest rates.

raise

The _______ is the spread between the interest rates on bonds with default risk and those of the default-free bonds when both types of bonds have the same maturity.

risk premium