Finance chapter 6 conceptual questions

Which of the following statements about bond markets is CORRECT? a. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year, AAA-rated corporate bond. b. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. c. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. d. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. e. The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = −0.1%(t), where t is the years to maturity.

c

Which of the following statements about the yield curve is CORRECT? a. If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. b. If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat. c. If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. d. Yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds because long-term bonds are riskier than short-term bonds. e. If the expectations theory holds, the Treasury bond yield curve will never be downward sloping.

c

If the U.S. Treasury were to issue $50 billion of short-term securities and sell them to the public, what would be the most likely effect on short-term securities' prices and interest rates? Assume that other factors are held constant. a. Interest rates and prices would both rise. b. Interest rates and prices would both decline. c. Prices would decline and interest rates would rise. d. Interest rates would decline and prices would rise. e. There is no reason to expect a change in either prices or interest rates.

c.

two main ways companies raise capital

debt and equity

The prices of long-term bonds ________ whenever interest rates rise.

decline

the difference between the interest rate on a US treasury bond and a corporate bond of equal maturity and marketability

default risk premium

If the government spends more than it takes in as taxes, it runs a ____________ , which must be covered by additional borrowing or by printing money. If the government borrows money, this _________ the demand for funds and ____________ interest rates. If the government prints money, the result will be _________ inflation, which will __________ interest rates. So, the larger the federal ___________ , other things held constant, the __________ the level of interest rates.

deficit, increases, increases, increased, increase, deficit, higher

Which of the following situations would be most likely to lead to an increase in interest rates in the economy? a. The level of inflation begins to decline. b. The economy moves from a boom to a recession. c. The Federal Reserve decides to try to stimulate the economy. d. Households start saving a larger percentage of their income. e. Corporations step up their expansion plans and thus increase their demand for capital.

e.

borrower's risk, the use of funds borrowed, the collateral used to back the loan, and the length of time the funds are needed.

factors affecting prices of debt

T or F? Government policy doesn't influence the allocation of capital and the level of interest rates.

false

T or F? There is a price for each type of capital; however, the price remains constant due to foreign investment.

false

T or F? We should expect to see interest rates decline if the federal deficit increased sharply from one year to the next, the Federal Reserve kept the money supply constant, and all other things held constant.

false

production opportunities, time preferences for consumption, risk, and inflation.

four fundamental factors that affect the supply of, and demand for, invested capital

The ________ the bond's risk of default, the higher the market rate.

greater

___________ risk and _______ inflation lead to higher interest rates.

higher; higher

A(n)__________ yield curve occurs when interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities.

humped

To stimulate the economy, the Fed ____________ the money supply. The initial effect would be to cause short-term rates to decline; however, a __________ money supply might lead to an increase in expected future inflation, which would cause long-term rates to rise even as short-term rates fell. The reverse is true when the Fed ___________ the money supply.

increases, larger, tightens

the amount by which prices increase over time.

inflation

a premium equal to expected inflation that investors add to the real-risk free rate of return

inflation premium

Because interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called ____________ rate risk.

interest

The __________ is the price that lenders receive and borrowers pay for debt.

interest rate

While long-term bonds are heavily exposed to ________rate risk, short-term bills are heavily exposed to _____________ risk.

interest; reinvestment

The average default risk premium varies over time, and it tends to get ________ when the economy is weaker and borrowers are more likely to have a hard time paying off their debts.

larger

the yield spread between corporate and Treasury bonds is _________ the longer the maturity. This occurs because longer-term corporate bonds have __________ default and liquidity risk than shorter-term bonds, and both of these premiums are ________ in Treasury bonds.

larger; more; absent

Real assets are generally ________ liquid than financial assets, but different financial assets vary in their liquidity.

less

a premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its "fair market value"

liquidity premium

a _________ risk premium, which is higher the longer the term of the bond, is included in the required interest rate

maturity

a premium that reflects interest rate risk

maturity risk premium

Assets with higher trading volume are generally ____ liquid.

more

Because of their additional default and liquidity risk, corporate bonds yield ____________ Treasury bonds with the same maturity

more than

The interest rate on debt, r, is also equal to the _________ risk-free rate plus a default risk premium plus a liquidity premium plus a maturity risk premium.

nominal

A(n) ________ yield curve is upward sloping because investors charge higher rates on longer-term bonds, even when inflation is expected to remain constant.

normal

Federal Reserve policy, the federal budget deficit or surplus, international factors like the foreign trade balance and interest rates abroad, and the level of business activity.

primary macroeconomic factors

Although investing in short-term T-bills preserves one's ____________ , the interest income provided by short-term T-bills is ___________ stable than the interest income on long-term bonds.

principle; less

investment opportunities in cash-generating assets

production opportunities

The ___________ theory states that the shape of the yield curve depends on investors' expectations about future interest rates. The theory assumes that bond traders establish bond prices and interest rates strictly on the basis of expectations for future interest rates and that they are indifferent to maturity because they don't view long-term bonds as being riskier than short-term bonds

pure expectations

the rate of interest that would exist on default free US treasuries if no inflation was expected

real-risk free rate

During a______________ , the demand for money and the inflation rate tend to fall and the Fed tends to ____________ the money supply to stimulate the economy. As a result, there is a tendency for interest rates to decline during _____________

recession, increase, recessions

the chance that an investment will provide a low or negative return

risk

The firm's optimal financial policy depends on the nature of the firm's assets—the easier its assets can be sold, the more feasible it is for the firm to use ___________ -term debt.

short

The real risk-free rate of interest may be thought of as the interest rate on _________ U.S. Treasury securities in an inflation-free world

short term

it is logical for a firm to finance current assets with _________-term debt and to finance fixed assets with _____________-term debt.

short, long

the preferences for consumers for current consumption as opposed to saving for future consumption

time preferences for consumption

T or F? "Interest rate risk," also known as "price risk," is the risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds.

true

T or F? If management is sure that the economy is at the peak of a boom and is about to enter a recession, a firm that needs to borrow money should probably use short-term rather than long-term debt.

true

T or F? Of the many factors that affect the cost of money, one of the four most fundamental factors is the availability of production opportunities and their expected rates of return. A predictable correlation between production opportunities and interest rates is this: If opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

true

T or F? Suppose the Fed takes actions that lower expectations for inflation this year by 1 percentage point, but these same actions raise expectations for inflation in Years 2 and thereafter by 2 percentage points. Other things held constant, the yield curve becomes steeper.

true

T or F? The interest rate in each market is the point where the supply and demand curves for capital intersect.

true

T or F? The supply curve in each market is upward sloping, which indicates that investors are willing to supply more capital the higher the interest rate they receive on their capital.

true

T or F? When the U.S. economy is very strong, the Federal Reserve tends to take action to increase interest rates, but when the U.S. economy is weak, the Federal Reserve tends to decrease interest rates.

true

Producers' expected returns on their business investments set a(n)_______ limit on how much they can pay for savings, while consumers' time preferences for consumption establish how much consumption they are willing to delay, and, consequently, how much they will _______ at different interest rates

upper; save

If the demand for funds decline, which typically happens during a recession, interest rates _________

will decline

If the Federal Reserve tightens credit, which decreases the supply of funds, interest rates ________

will increase

Which of the following would be most likely to lead to increases in nominal interest rates? a. A new technology such as the Internet has just been introduced, and it increases investment opportunities. b. Households reduce their consumption and increase their savings. c. The economy falls into a recession. d. There is a decrease in expected inflation. e. The Federal Reserve decides to try to stimulate the economy by increasing investment opportunities.

a

A(n) _________ yield curve is downward sloping and indicates that investors expect inflation to decrease.

abmormal