Corporate Finance Quiz 4

False

Long-term bonds are more vulnerable to reinvestment rate risk than short-term bonds.

False

Long-term interest rates are always higher than short-term interest rates.

default risk premium (DRP)

The difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability; it is the compensation for the risk that a corporation will not meet its debt obligations.

Production opportunity

The return available within an economy from investment in productive (cash- generating) assets.

True

The term structure is defined as the relationship between interest rates and maturities of similar securities.

c

If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other things held constant, what will this tend to do to short-term security prices and interest rates? a. Prices and interest rates will both rise. b. Prices will rise and interest rates will decline. c. Prices will decline and interest rates will rise. d. Prices and interest rates will both decline. e. There will be no changes in either prices or interest rates.

True

If the liquidity preference theory of the term structure is correct, we would expect the size of the maturity risk premium to increase with maturity. Thus, we might observe an upward sloping yield curve, even if future short-term rates are expected to decrease.

False

All else equal, the maturity risk premium tends to decline when interest rate volatility increases.

liquidity premium (LP)

A premium added to the rate on a security if the security cannot be converted to cash on short notice at a price that is close to its original cost.

c

Assume that the expectations theory of term structure holds. If the rate on a two-year Treasury bond is 10% and the rate on a three-year Treasury bond is 8%, what is the expected rate on a one-year Treasury bond in year three? a. 8% b. 7% c. 6% d. 5% e. 4%

d

Given the following data, find the expected rate of inflation during the next year. r* = real risk-free rate = 3%. Maturity risk premium on 10-year T-bonds = 2%. It is zero on 1-year bonds, and a linear relationship exists. Default risk premium on 10-year, A-rated bonds = 1.5%. Liquidity premium = 0%, and the going interest rate on 1-year T-bonds = 9.5%. a. 3.5% b. 4.5% c. 5.5% d. 6.5% e. 7.5%

b

If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond? a. The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity premiums. b. The yield on the 10-year bond is less than the yield on a 1-year bond. c. It is impossible to tell without knowing the coupon rates of the bonds. d. The yields on the two bonds are equal. e. It is impossible to tell without knowing the relative risks of the two bonds.

False

Inflations rate are always lower than short-term interest rates.

maturity risk premium (MRP)

It accounts for the fact that longer-term bonds experience greater price reactions to interest rate changes than do short-term bonds.

inflation premium (IP)

It describes the relationship between yields and maturities of securities.

market segmentation theory

It states that every borrower and lender has a preferred maturity and that the slope of the yield curve depends on the supply of and the demand for funds in the long-term market relative to the short- term market.

expectations theory

It states that the shape of the yield curve depends on investors' expectations about future inflation rates. More specifically, the yield curve should be upward sloping when investors expect inflation, and thus interest rates, to increase, and vice versa.

liquidity preference theory

It states that, all else being equal, lenders prefer to make short- term loans rather than long-term loans; hence they will lend short- term funds at lower rates than they lend long-term funds.

False

The difference between the nominal risk-free rate and the real risk-free rate is that the real risk-free includes inflation and the nominal risk-free rate does not include inflation.

True

The dollar return earned on a debt investment is comprised of the interest payments received and the change in value of the debt instrument in the financial markets.

True

The liquidity premium reflects the fact that some investments are more easily converted into cash on a short notice at fair market value than other securities.

True

The nominal interest rate is defined as being equal to the real risk-free rate, plus an inflation premium, plus a default risk premium, plus a liquidity premium, plus a maturity risk premium.

nominal risk-free rate

The rate of interest on a security that is free of all risk; it is measured by the T-bill rate or the T-bond rate and includes an inflation premium.

real risk-free rate of interest

The rate of interest that would exist on default- free U.S. Treasury securities if no inflation were expected.

e

What is the yield on a one-year corporate bond with a $1,000 face value that pays a 10% annual interest if it was purchased for $900 and held until maturity? a. 12.0% b. 12.6% c. 17.0% d. 17.9% e. 22.2%

a

Which of the following is not one of the fundamental factors that affect the cost of money? a. Liquidity premium b. Time preferences for consumption c. Production opportunities d. Risk e. Inflation

d

Which of the following statements is correct? a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. b. The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve normally is upward sloping. c. According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to slope downward. d. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds e. If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

d

Which of the following statements is most correct? a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds. b. Reinvestment rate risk is lower, other things held constant, on 30-day T-bills than on 30-year T-bonds. c. According to the market segmentation theory of the term structure of interest rates, we should normally expect the yield curve to have an upward slope. d. If the maturity risk premium were zero and the rate of inflation were expected to increase in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope. e. The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield curve is normally upward sloping.

c

Which of the following statements is most correct? Other things held constant, a. the "expectations theory" would generally lead to an upward sloping yield curve. b. the "market segmentation theory" would generally lead to an upward sloping yield curve. c. the "liquidity preference theory" would generally lead to an upward sloping yield curve. d. the yield curve under "normal" conditions should be horizontal (i.e., flat.) e. a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.

c

You read in The Wall Street Journal that 30-day T-bills currently are yielding 7 percent. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums: Inflation premium=5%, Liquidity premium=1%, Maturity risk premium=2%, Default risk premium=2% Based on these data, the real risk-free rate of return is a. 0% b. 1% c. 2% d. 3% e. 4%