Finc 409 Chapter 8
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 *federal government borrowing is done by the Treasury
Treasury notes are intermediate-term Federal debt obligations.
T 1-10 years
The liquidity premium is the compensation that investors demand for holding securities that cannot easily be converted to cash without major price discounts
T
The loanable funds theory states that interest rates are a function of the supply of and demand for loanable funds
T
The market segmentation theory holds that securities of different maturities are not perfect substitutes for each other
T
The maturity risk premium is the compensation expected by investors due to interest rate risk on debt instruments with longer maturity.
T
The nominal interest rate may include a default risk premium.
T
The risk free rate of interest is the interest rate on a debt instrument with no default, maturity, or liquidity risks.
T
The risk-free rate of interest is equal to the real rate of interest plus a premium for inflation
T
The term structure of interest rates indicates the relation between interest rates and the maturity of comparable quality debt instruments
T
There are two basic sources of loanable funds: current savings and the expansion of deposits of depository institutions
T
There is an inverse relation between debt instrument prices and nominal interest rates in the marketplace
T
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
Holding supply constant, a decrease in the demand for loanable funds will result in a decrease in interest rates
T *draw decreased demand curve means decreased interest rate
The maturity risk premium is the compensation that investors demand for holding securities that cannot easily be converted to cash without major price discounts.
F *liquidity premium
The interest rate that is observed in the marketplace is called a real interest rate
F *nominal interest rate
Treasury bonds are issued with an original maturity in excess of one year
F *ten
Interest rates generally fall during periods of economic expansion and rise during economic contraction
F p174-176
Interest rates in the United States are only influenced by domestic factors
F p179
The maturity risk premium is the added return expected by lenders because of the expectation of inflation
F p179-180
The risk-free rate of interest is found by combining the real rate of interest and the rate paid on U.S. Treasury debt.
F p180 *combine real rate and inflation premium, risk-free rate in US is represented by US Treasury debt instruments
The interest rate is the basic price that equates the demand for and supply of loanable funds in the financial markets
T
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
1. The basic price that equates the demand for and supply of loanable funds in the financial markets is the __________: a. interest rate b. yield curve c. term structure d. cash price e. none of the above
A
14. A basic source of loanable funds is: a. current savings that flow through financial institutions b. future savings and investment by the Federal Reserve c. current and future savings d. investment by the Federal Reserve and expansion of deposits by insurance companies
A
22. An increase in the demand for loanable funds, holding supply constant, will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
A
25. A decrease in the supply for loanable funds, holding demand constant, will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
A
29. A decrease in the supply for loanable funds accompanied by an increase in demand will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
A
3. As interest rates fall, the prices of existing bonds will: a. rise b. stay the same c. fall d. either a or b, depending on the state of the economy e. none of the above
A
36. 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? a. downward sloping b. flat or level c. upward sloping d. U shaped
A
38. Which of the following statements is most 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. Treasury bills 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
4. The liquidity preference theory holds that interest rates are determined by the: a. investor preference for short-term securties b. investor preference for higher-yielding long-term securities. c. "flow" of funds over time d. "flow" of bank credit over time
A
40. 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
41. Compensation for those financial debt instruments that cannot be easily converted to cash at prices close to estimated fair market values is termed: a. liquidity premium b. market risk premium c. maturity premium d. none of the above
A
43. Which of the following is not true of Treasury bills? a. long-lived b. sold at a discount c. mature at par d. all the above are false
A
5. In an inflationary period, interest rates have a tendency to: a. rise b. fall c. stay the same d. act erratically
A
52. Which one of the following is not a marketable government security? a. Treasury stock b. Treasury bill c. Treasury note d. Treasury bond
A
53. 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
8. Three theories commonly used to explain the term structure of interest rates include all of the following EXCEPT a. the default risk theory b. the expectations theory c. the market segmentation theory d. the liquidity preference theory
A
9. As the economy begins moving out of a recessionary period, the yield curve is generally: a. upward sloping b. flattened out c. downward sloping d. discontinuous
A
48. When investors expect higher inflation rates they will require __________ nominal interest rates so that a real rate of return will remain after the inflation. a. higher b. lower c. the same d. there is no connection between inflation expectations and nominal interest rates
A *r = RR + IP + DRP + MRP + LP
11. A maturity 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 bill and a long-term (corporate bond corporate bond also includes default risk premium( c. a Treasury bill and a Federal Reserve note (Federal Reserve note is fiat money) d. a risky stock and a comparable maturity U.S. Treasury security (stocks have no maturity date) e. none of the above
A *r = RR + IP + DRP + MRP + LP, for Treasury securities 0 = DRP = LP
12. 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 credit 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
23. A decrease in the demand for loanable funds, holding supply constant, will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
B
24. An increase in the supply for loanable funds, holding demand constant, will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
B
28. An increase in the supply for loanable funds accompanied by a decrease in demand will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
B
33. When referring to a "downward sloping" yield curve: a. as maturities shorten, interest rates decline b. as maturities shorten, interest rates rise c. as maturities lengthen, interest rates remain the same d. as maturities lengthen, interest rates rise
B
44. 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
50. 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
6. 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
B
7. 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
47. 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%? a. 4% b. 2% c. 5% d. 13%
B *r = RR + IP + DRP + MRP + LP → 15% = RR + 5% + 3% + 4% + 1% →RR = 15% - 13% = 2%
20. 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? a. 4% b. 7% c. 2% d. 1%
B *r = RR + IP + DRP = 4% + 2% + 1% = 7%
30. The major factor that determines the volume of savings, corporate as well as individual, is the: a. volume of spending b. level of national income c. amount of private pension plans d. amount of life insurance policies
B *there are other factors
13. 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
16. 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. none of the above
C
2. As interest rates rise, the prices of existing bonds will: a. rise b. stay the same c. fall d. either a or b, depending on the state of the economy
C
31. If the money supply and total demand increase faster than output, prices will: a. fall b. stay the same c. rise d. reflect lower inflation
C
34. The yield curve or the term structure of interest rates is typically downward sloping when: a. short-term Treasury interest rates are lower than long-term Treasury interest rates b. short-term and long-term Treasury interest rates are the same c. long-term Treasury interest rates are lower than short-term Treasury interest rates d. long-term Treasure interest rates are higher than short-term Treasury interest rates
C
35. Assume that these current yields exist: long-term Treasury bonds yield 9 percent, five-year Treasury securities yield 8.5 percent, and one-year Treasury bills yield 8 percent. What type of yield curve is depicted? a. downward sloping b. flat or level c. upward sloping d. U shaped
C
46. Which of the following is NOT 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
C
55. Changes in the money supply or in the amount of metal in the money unit have influenced prices: a. only during wars b. only during our gold-standard period c. since the earliest records of civilization d. only in modern industrialized societies
C
15. 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 * r = RR + IP + DRP + MRP + LP, for Treasury securities DRP & LP are 0
21. 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? a. 8% b. 7% c. 6% d. 5%
C *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%
37. Which of the following statements is most correct? a. The liquidity preference theory holds that interest rates are determined by the supply of and demand for loanable funds. b. The loanable funds theory and the liquidity preference theory are incompatible with each other because one is right and the other is wrong. c. Marketable U.S. 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 *supply and demand curves can reflect liquidity preferences of buyers & sellers
10. 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 bill and a long-term corporate bond c. a Treasury bill and the commercial paper rate d. a risky security and a comparable maturity U.S. Treasury security
D
17. 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
18. Which of the following factors directly impact the level of interest rates? a. risk b. marketability c. maturity d. all of the above
D
19. Which of the following may accumulate savings? a. individuals b. corporations c. sometimes governmental units d. all the above may have savings
D
32. When referring to an "upward sloping" yield curve, interest rates: a. are flat across all maturities b. decrease as maturity increases c. increase as maturity decreases d. increase as maturity increases
D
39. 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. (affects disposable income) b. The money market involves obtaining and trading of credit and debt instruments with maturity of one year or less. (definition of money market) c. Bond risk premiums follow changes in investor optimism/pessimism about expected economic activity. d. A high interest rate level but downward sloping yield curve is generally perceived as being conductive to future economic expansion. (this usually occurs when economic activity peaks)
D
45 . 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
49. The average maturity of the marketable debt in the United States: a. is of little importance, unlike that of private corporations b. has been constant for the last two decades c. remains unchanged unless new obligations are issued d. decreases day by day unless new obligations are issued to offset such decreases
D
51. The risk-free interest rate is composed of: a. an inflation premium and a default risk premium b. a default risk premium and a maturity risk premium c. a real rate of interest and a liquidity premium d. a real rate of interest and an inflation premium
D
54. By September of 2011 the federal debt was owned primarily by: a. foreign and international investors b. commercial banks c. insurance companies d. the sum of all private investors
D
26. A decrease in the supply for loanable funds accompanied by a decrease in demand will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
D *end result depends on the magnitudes of the shifts
27. An increase in the supply for loanable funds accompanied by an increase in demand will cause interest rates to: a. increase b. decrease c. stay the same d. not enough information to tell
D *end result depends on the magnitudes of the shifts
42. If the nominal interest rate for Treasury bonds is 8% and the risk-free rate is 3%, the expected inflation rate must be: a. 3% b. 5% c. 11% d. cannot be determined without additional information
D *nominal interest r = RR + IP + DRP + MRP + LP and risk-free rate = RR + IP = 3% for Treasury bonds DRP and LP are 0, MRP > 0 → 8% = RR + IP + MRP = 3% + MRP → MRP = 5% but you need to know RR to be able to calculate IP
An economy with a large share of young people will have more total savings than one with more late middleaged people
F
Business will increase current long-term borrowing if they forecast a decrease in interest rates in the near future
F
The /shorter/ the maturity of a fixed-rate debt instrument, the /greater/ the reduction in its value to a given interest rate increase
F
The Treasury's major influence through its borrowing to finance federal deficits is on the supply rather than demand for loanable funds.
F *Treasury borrowing is demanding loanable funds
The most important holders of Treasury bills are corporations and individuals
F *commercial banks
Holding demand constant, an increase in the supply of loanable funds will result in an increase in interest rates
F *decreased supply curve means increased interest rate
Cost-push inflation during economic expansions when demand for goods and services is greater than supply
F *demand-pull
Holding supply constant, an increase in the demand for loanable funds will result in a decrease in interest rates.
F *increased demand curve means increased interest rate
The expectations theory contends that the shape of the yield curve reflects investor expectations about future GDP growth rates
F *inflation rates not GDP growth rates
The default risk premium is the compensation that investors demand for holding securities that cannot easily be converted to cash without major price discounts.
F *liquidity premium
A "shock" may be defined as an unanticipated change that will cause the demand for, or supply of loanable funds to change
T
Administrative inflation is the tendency of prices, aided by union-corporation contracts, to rise during economic expansion and to resist declines during recessions.
T
Cost-push inflation occurs when prices are raised to cover rising production costs, such as wages
T
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
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
Holding demand constant, a decrease in the supply of loanable funds will result in an increase in interest rates
T
If the Fed changes discount policies it may affect the supply of loanable funds
T
Inflation is an increase in the price of goods or services that is not offset by an increase in quality
T
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
Speculative inflation is caused by the expectation that prices will continue to rise, resulting in increased buying to avoid even higher future prices
T
Tax deferral on investments may increase the volume of savings
T
The demand for loanable funds comes from all sectors of the economy
T