Midterm 2 practice exam

Refer to the diagram to the right. What is the risk premiumLOADING... on​ 10-year corporate Baa bonds in​ 2002?

4.75% (7.75-3)

If 1−year interest rates for the next five years are expected to be​ 4, 2,​ 5, 4, and 5​ percent, and the 5−year term premium is 1​ percent, than the 5−year bond rate will be

5 percent.

Compute the price of a share of stock that pays a ​$5.00 per year dividend and that you expect to be able to sell in one year for ​$50​, assuming you require a 5​% return.

52.38

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

6 percent.

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

default risk.

Suppose that a stock paid a dividend of $5 this year and that your required return on equity investments is 8​%. Using the Gordon growth​ model, if you expect the dividends to grow at 4​%, you will be willing to pay for the stock the amount Using the Gordon growth model of stock price​ determination, if a share of stock will pay a $3dividend next year​, dividends are expected to grow 3​%, and people require an 8​% return on equity​ investments, then the price of the stock is According to the Gordon growth model of stock price​ determination, at what price should a stock sell for if the required return on equity investments is​ 12%, the stock will pay a dividend of​ $1.80 next​ year, and dividends are expected to grow at a constant rate of​ 3%?

130 60 20

If​ 1-year interest rates for the next three years are expected to be​ 1, 1, and 1​ percent, and the​ 3-year term premium is 1​ percent, then the​ 3-year bond rate will be

2 percent.

Will a U.S. Treasury bill have a risk premium that is higher​ than, lower​ than, or the same as that of a similar security​ (in terms of maturity and​ liquidity) issued by the government of​ Colombia?

A U.S. Treasury bill will have a lower risk premium since U.S. government issued securities are usually considered to be default free.

Risk premiums on corporate bonds are usually anticyclical​; that​ is, they decrease during business cycle expansions and increase during recessions. Why is this​ so? Part 2

As the economy enters an​ expansion, there is greater likelihood that borrowers will be able to service their debt.

Periodic payments of net earnings to shareholders are known as

dividends.

John values ABC stock at​ $10 per share. Susan values it at​ $15 per​ share, and Bill values it at​ $20 per share. In a​ free-market auction, the individual who ends up buying the item is Which of the following is true regarding the pricing of​ assets? If​ John, Jennifer,​ Arthur, and Lisa are the only prospective buyers of a​ stock, and they have the discount rates 11​%, 17​%, 7​% and 12​%, ​respectively, then the buyer who will be able to obtain the stock is

Bill other things being the same, the price is set by the buyers with the most amount of information regrading the stock Arthur

Which of the following long−term bonds has the highest interest​ rate?

Corporate Baa bonds

Which of the following securities has the lowest interest​ rate?

U.S. Treasury bonds

Prior to​ 2008, mortgage lenders required a house inspection to assess its​ value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in​ 2008, mortgage lenders required a house​ inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that​ credit-rating agencies played in the global financial​ crisis?

Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.

Suppose the interest rates on​ one-, five-, and​ ten-year U.S. Treasury bonds are currently​ 3%, 6%, and​ 6%, respectively. Investor A chooses to hold only​ one-year bonds, and Investor B is indifferent with regard to holding​ five- and​ ten-year bonds. Which theories best explain the behavior of Investors A and​ B?

Investor​ A's preferences are best explained by the segmented markets​ theory, while Investor​ B's preferences are more consistent with the expectations theory.

If junk bonds are​ "junk," then why would investors buy​ them?

Junk bonds can provide high yields.

What basic principle of finance can be applied to the valuation of any investment​ asset?

Present value

If monetary policy becomes more transparent about the future course of interest​ rates, how would that affect stock​ prices, if at​ all?

Stock prices will​ increase, as the risk and required return on the investment will be reduced.

During​ 2008, the difference in yield​ (the yield spread​) between​ 3-month AA-rated financial commercial paper and​ 3-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to​ zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden​ increase?

The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.

Expectations theory Preferred habitat Segmented markets

The interest rate on a​ long-term bond will equal an average of the​ short-term interest rates that people expect to occur over the life of the​ long-term bond. The interest rate on a​ long-term bond will equal an average of​ short-term interest rates expected to occur over the life of the​ long-term bond plus a liquidity premium​ (also referred to as a term​ premium) that responds to supply and demand conditions for that bond.. The interest rate for each bond with a different maturity is determined by the supply of and demand for that​ bond, with no effects from expected returns on other bonds with other maturities.

If a yield curve looks like the one shown in the figure to the​ right, what is the market predicting about the movement of future​ short-term interest​ rates? What might the yield curve indicate about the​ market's predictions for the inflation rate in the​ future?

The market is predicting that future​ short-term interest rates will increase The​ market's predictions indicate that inflation will be higher in the future.

If a yield curve looks like the one shown in the diagram to the​ right, what is the market predicting about the movement of future​ short-term interest​ rates? What might the yield curve indicate about the​ market's predictions for the inflation rate in the​ future?

The market is predicting that​ short-term interest rates will increase in the near term, then decrease in the long term The​ market's predictions indicate that inflation will increase in the near term, then decrease in the long term

Consider tight money policy and its effects on stock prices via the simplified Gordon growth model equation ​Which of the following accurately describes the effects of tight money policy on stock​ prices, according to this​ model? ​Again, consider the effect of tight money policy on stock prices. Which of the following accurately describes the effects of tight money policy on stock​ prices, according to this​ model?

The return on bonds and the required return on an equity investment (ke​) would​ rise, while the price of stock (P0​) would fall. The economy would slow​ down, causing an increase in the denominator of the simplified Gordon growth model and a decrease in the price of stock ​(P0​).

In 2010 and​ 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market​ graphs, determine how default would affect the risk premium between U.S. Treasury debt and Greek debt with comparable maturity. In the case of​ default, what would happen to the risk premium between U.S. Treasury debt and comparable maturity Greek​ debt?

The risk premium would​ increase, which corresponds to segment B on the graphs above

In the fall of​ 2008, AIG, the largest insurance company in the world at the​ time, was at risk of defaulting due to the severity of the global financial crisis. As a​ result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this​ affect, if at​ all, the yield and risk premium on AIG corporate​ debt?

The yield and risk premium will fall since demand for AIG corporate debt will increase.

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

Following a policy meeting on March​ 19, 2009, the Federal Reserve made an announcement that it would purchase up to​ $300 billion of​ longer-term Treasury securities over the following six months. What effect might this policy have on the yield​ curve?

The yield curve would shift​ down, but mostly on​ medium- and​ long-term maturities.

Which of the following bonds are considered to be default−risk ​free?

U.S. Treasury bonds

Just before the collapse of the subprime mortgage market in​ 2007, the most important​ credit-rating agencies rated​ mortgage-backed securities with Aaa and AAA ratings. Explain how it was possible that a few months into​ 2008, the same securities had the lowest possible ratings. Should we always trust​ credit-rating agencies?

When housing prices began to fall and subprime mortgages began to​ default, many​ AAA-rated products had to be downgraded over and over again. No. Sometimes there are conflicts of interests in​ credit-rating agencies.

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

You would raise your predictions of future interest rates.

Suppose that you are asked to forecast future stock prices of ABC​ Corporation, so you proceed to collect all available information. The day you announce your​ forecast, competitors of ABC Corporation announce a brand new plan to merge and reshape the structure of the industry. Would your forecast still be considered​ optimal? ​(Select all that​ apply.)

Your forecast is considered​ optimal, but for a short period of time. Your forecast is still considered to be​ optimal, since it was made with all available information at the time.

Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a​ bubble? Explain how it can do this using the Gordon growth model.

a bubble is created that when investors belive they have valid information that the growth of a dividnet will be very high and so g is hisg leading to making the bottom of the function small and dividnet outcome high. The government can come in and rise its interest rates that leads to the rising of the rquired rate of return and a decrease in teh expected dividens. If investors lower the required rate of return this bubble can be created to and with lowering interest rates the gocernemtn can increase the required rate of return.

If you have a very low tolerance for​ risk, which of the following bonds would you be least likely to hold in your​ portfolio?

a corporate bond with a rating of Baa

If the yield curve is flat for short maturities and then slopes downward for longer​ maturities, the liquidity premium theory​ (assuming a mild preference for shorter−term bonds) indicates that the market is predicting.

a decline in short−term interest rates in the near future and an even steeper decline further out in the future.

When the yield curve is flat or downward−​sloping, it suggest that the economy is more likely to enter

a recession.

A plot of the yields on bonds with different terms to maturity but the same​ risk, liquidity, and tax considerations is known as

a yield curve.

A key assumption in the segmented markets theory is that bonds of different maturities

are not substitutes at all.

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.

average

When short−term interest rates are expected to fall sharply in the​ future, the yield curve will

be inverted.

If the yield curve has a mild upward​ slope, the liquidity premium theory​ (assuming a mild preference for shorter−term ​bonds) indicates that the market is predicting

constant short−term interest rates in the near future and further out in the future.

According to the liquidity premium theory of the term​ structure, a flat yield curve indicates that short−term interest rates are expected to

decline moderately in the future.

According to the liquidity premium theory of the term​ structure, a downward sloping yield curve indicates that short−term interest rates are expected to

decline sharply in the future.

If the dividend of a stock​ decreases, then according to the Gordon Growth​ Model, holding everything else​ constant, the price of the stock will

decrease

The​ ________ of the term structure of interest rates states that the interest rate on a long−term bond will equal the average of short−term interest rates that individuals expect to occur over the life of the long−term ​bond, and investors have no preference for short−term bonds relative to long−term bonds.

expectations theory

The U−shaped yield curve in the figure above indicates that short−term interest rates are expected to

fall sharply in the near−term and rise later on.

Forecasters' predictions of inflation are notoriously​ inaccurate, so their expectations of inflation cannot be rationalLOADING...​.' Is this statement​ true, false, or​ uncertain? Explain your answer.

false under the rational expectations theory it is says that all expectations are rational since they where made with the best possible information at the time and so they are rational

The typical shape for a yield curve is

gently upward sloping.

According to the liquidity premium theory of the term structure.

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 DuWop announces an increase in the annual​ dividend, ​Div, the price of a share of DuWop will If investors develop a greater aversion to risk or view DuWop stock as having greater​ risk, ​k, the share price will If investors expect an increase in the​ growth, g​, of earnings and dividends over the next 5​ years, the price of a share of DuWop wil

increase decrease increase

​A(n) ________ in the liquidity of corporate bonds will​ ________ the price of corporate bonds and​ ________ the yield on corporate​ bonds, all else equal.

increase; increase; decrease

The coronavirus pandemic

increased the Baa-Aaa spread.

According to the segmented markets theory of the term structure.

interest rates on bonds of different maturities do not move together over time.

According to the expectations theory of the term structure

interest rates on bonds of different maturities move together over time.

Bonds with relatively low risk of default are called​ ________ securities and have a rating of Baa​ (or BBB) and​ above; bonds with ratings below Baa​ (or BBB) have a higher default risk and are called​ ________.

investment​ grade; junk bonds

Given the market activity shown in the diagrams​ above, the risk premium Based on this​ information, it is more likely that the economy is entering

is decreasing. an expansion

Bonds with relatively high risk of default are called

junk bonds.

The​ ________ of the term structure states the​ following: the interest rate on a long−term bond will equal an average of short−term interest rates expected to occur over the life of the long−term bond plus a term premium that responds to supply and demand conditions for that bond.

liquidity premium theory

The preferred habitat theory of the term structure is closely related to the

liquidity premium theory of the term structure.

When yield curves are steeply upward​ sloping,

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

The Obama administration increased the tax on the top income tax bracket from​ 35% to​ 39%. Supply and demand analysis predicts the impact of this change was a​ ________ interest rate on municipal bonds and a​ ________ interest rate on Treasury bonds.

lower; higher

math

math

graph problem

no answer

math problem

no answer

If the expected path of 1−year interest rates over the next five years is 2​ percent, 4​ percent, 1​ percent, 4​ percent, and 3​ percent, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of

one year.

The value of any investment is found by computing the

present value of all future cash flows.

According to the Generalized Dividend​ Model, the final sales price of a stock depends on the following except the If a company called Advanced Technologies has yet to pay a dividend on its​ stock, the generalized dividend model predicts that the​ company's stock may still have value because

price of the stock in the last period. people expect Advanced Technologies to pay dividends in the future.

According to the liquidity premium theory of the term​ structure, a slightly upward sloping yield curve indicates that short−term interest rates are expected to

remain unchanged in the future.

According to the Gordon Growth​ Model, the price of stocks depend on the following except When your required return on an equity investment decreases​, then according to the Gordon Growth Model you will be willing to pay

return on Treasure bills more for the investment

According to the liquidity premium theory of the term​ structure, a steeply upward sloping yield curve indicates that short−term interest rates are expected to

rise in the future.

The mound−shaped yield curve in the figure above indicates that short−term interest rates are expected to

rise in the near−term and fall later on.

The spread between the interest rates on bonds with default risk and default−free bonds is called the

risk premium.

When yield curves are​ flat,

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

When yield curves are downward​ sloping,

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

The steeply upward sloping yield curve in the figure above indicates that

short−term interest rates are expected to rise in the future.

An inverted yield curve

slopes down

A​ ________ yield curve predicts a future increase in inflation.

steeply upward sloping

table

table

The spread between the interest rate on a​ one-year U.S. Treasury bond and a​ 20-year U.S. Treasury bond is known as the According to the expectations theory of the term structure of interest​ rates, if the​ one-year bond rate is 3​%, and the​ two-year bond rate is 4​%, next​ year's one-year rate is expected to be

term premium 5%

The additional incentive that the purchaser of a Treasury security requires to buy a long−term security rather than a short−term security is called the

term premium.

Municipal bonds have default​ risk, yet their interest rates are usually lower than the rates on default−free Treasury bonds. This suggests that

the benefit from the tax−exempt status of municipal bonds exceeds their default risk.

The current​ one-year bond and​ two-year bond interest rates are both​ 4% and the​ one-year and​ two-year term premia are 0 and​ 1%, respectively. The liquidity premium theory of the term structure predicts that the expected​ one-year bond interest rate next year is

​2%.

Monetary policy affects stock prices through the following except Suppose that the Fed engages in an expansionary monetary​ policy, which reduces interest rates. Which of the following statements best describes the impact of this event on the stock​ market?

the changes in the price level. There will be an DECREASE in the required rate of return on​ equities, a increase in the growth rate on​ dividends, and stock prices will rise.

According to the segmented markets theory of the term structure

the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

Everything else held​ constant, if the tax−exempt status of municipal bonds were​ eliminated, then

the interest rate on municipal bonds would exceed the rate on Treasury bonds.

According to the liquidity premium theory of the term structure

the 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.

The risk structure of interest rates is

the relationship among interest rates of different bonds with the same maturity.

The segmented markets theory can explain

why yield curves usually tend to slope upward.

The spread between interest rates on low quality corporate bonds and U.S. government bonds

widened significantly during the Great Depression.

An inverted yield curve predicts that short−term interest rates

will fall in the future.

The current​ one-year bond and​ two-year bond interest rates are both​ 4% and the market expects the​ one-year bond interest rate to go down by​ 1% next year. This implies that the​ two-year term premium is

​0.5%.

Over the next three​ years, the expected path of​ 1-year interest rates is​ 4%, 1%, and​ 1%, and the current​ one-year, two-year, and​ three-year bond interest rates are​ 4%, 2%, and​ 4%, respectively. Then the​ three-year term premium is Part 2

​2%

Over the next three​ years, the expected path of​ one-year interest rates is​ 4%, 1%, and​ 1%. Today if you buy​ $1 of a​ one-year bond and when it matures you use the money you receive to buy another​ one-year bond, then your expected rate of return for this​ $1 investment is​ _______%. The expectations theory of the term structure implies that the current interest rate on a​ two-year bond must be​ _______%. Part 2

​5; 2.5

Everything else held​ constant, if the federal government were to guarantee today that it will pay creditors if a corporation goes bankrupt in the​ future, the interest rate on corporate bonds will​ ________ and the interest rate on Treasury securities will​ ________.

​decrease; increase

The Trump administration decreased the tax on​ high-income taxpayers from​ 39.6% to​ 37%. Supply and demand analysis predicts the impact of this change is a​ _______ interest rate on municipal bonds and a​ _______ interest rate on Treasury​ bonds, all else the same. Part 2

​higher; lower

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.

​increase; decrease

Consider the bull​ market, led in large part by the strong performance of tech​ stocks, that existed in the US in July 1997. On 17 July of that​ year, the Dow hit one in a long series of record highs at it exceeded 8000​ (8038.88, to be exact - to put that into​ perspective, consider that it stayed mostly in the 2000s during the preceding​ decade). A number of contributing factors have been​ credited, at least​ partially, for this strong​ performance: —Low interest rates —High dividends —High projected dividend growth We will consider each of these factors separately in the questions that follow. Consider the factor of low interest rates that existed during the bull market in July 1997. Which of the following accurately describes the role these low interest rates played in high stock​ prices? Now consider the factor of high dividends that existed during the bull market of July 1997. Which of the following accurately describes the role these high dividends played in high stock​ prices? ​Finally, consider the factor of high projected dividend growth that existed during the bull market of July 1997. Which of the following accurately describes the role this high projected dividend growth played in high stock​ prices?

​ke decreased, causing a decrease in the denominator of the Gordon growth model equation D0 was​ high, causing an increase in the numerator of the Gordon growth model equationg was ​high, causing an increase in the numerator and a decrease in the denominator of the Gordon growth model equation g was​ high, causing an increase in the numerator and a decrease in the denominator of the Gordon growth model equation

When the Treasury bond market becomes more​ liquid, other things​ equal, the demand curve for corporate bonds shifts to the​ ________ and the demand curve for Treasury bonds shifts to the​ ________.

​left; right

A bond with default risk will always have a​ ________ risk premium and an increase in its default risk will​ ________ the risk premium.

​positive; raise

An increase in the riskiness of corporate bonds will​ ________ the price of corporate bonds and​ ________ the price of Treasury​ bonds, everything else held constant.

​reduce; increase