Ch. 6: Interest Rates

Assume that the real risk-free rate, r*, is 4% and that inflation is expected to be 7% in Year 1, 4% in Year 2, and 3% thereafter. Assume also that all Treasury bonds are highly liquid and free of default risk. If 2-year and 5-year Treasury bonds both yield 11%, what is the difference in the maturity risk premiums (MRPs) on the two bonds; that is, what is MRP5 - MRP2?

1.5%

A Treasury bond that matures in 20 years has a yield of 8%. A 20-year corporate bond has a yield of 11%. Assume that the liquidity premium on the corporate bond is 1.0%. What is the default risk premium on the corporate bond?

2%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 3-year Treasury securities? 5.7%

5.7%

The real risk-free rate of interest is 2%. Inflation is expected to be 3% the next 2 years and 5% during the next 3 years after that. Assume that the maturity risk premium is zero. What is the yield on 5-year Treasury securities?

6.2%

Bond market data show the following information: The Treasury yield curve is downward sloping. Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds. Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields.

A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

Which of the following situations would be most likely to lead to an increase in interest rates in the economy?

Corporations step up their expansion plans and thus increase their demand for capital.

Assume interest rates on 30-year government and corporate bonds were as follows: T-bond = 7.72%; AAA = 8.72%; A = 9.64%; BBB = 10.18%. The differences in rates among these issues are caused primarily by:

Default risk differences.

Of the many factors that affect the cost of money, one of the four most fundamental factors is the expected rate of inflation. A predictable correlation between inflation and interest rates is this: If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant.

False

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

Which of the following statements about interest rates is CORRECT, all other things held constant?

If expected inflation increases, interest rates are likely to increase

Imagine that you see a yield curve for a current corporate bond that is upward sloping. What can you determine from this information?

Maturity risk premiums could help to explain the yield curve's upward slope.

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.

Prices would decline and interest rates would rise.

Apply the pure expectations theory to the following: Assume that the real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future but that inflation is expected to increase steadily over the next 30 years, giving the Treasury yield curve an upward slope. You are considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity, both of which have the same default and liquidity risks. Again, assuming the pure expectations theory holds, which of these statements is CORRECT?

The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Assume that the rate on a 1-year bond is now 6%. Investors expect 1-year rates to be 7% one year from now and then 8% two years from now. If the pure expectations theory holds, so that the maturity risk premium equals zero, which of the following statements would be CORRECT?

The interest rate today on a 3-year bond should be approximately 7%.

Which of the following statements about bond markets is CORRECT?

The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

Suppose that a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, the real risk-free rate is expected to remain constant at 3% in the future, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?

The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond.

"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

A predictable correlation between the demand curve for funds and the supply curve is this: If the demand curve for funds increases but the supply curve remains constant, then the total amount of funds supplied and demanded increase and interest rates in general also increase.

True

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

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

Of the many factors that affect the cost of money, one of the four most fundamental factors is the risk inherent in a given security. A predictable correlation between risk and required return is this: The higher the risk, the higher the security's required return, other things held constant.

True

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

You have determined the following data for a given bond: Real risk-free rate (r*) = 3%; inflation premium = 8%; default risk premium = 2%; liquidity premium = 2%; and maturity risk premium = 1%. What is the nominal risk-free rate, rRF?

rRF = r* + IP = 3% + 8% = 11%.

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any T-bond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average

2%

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 6.00%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2-year bond. What is the yield on a 1-year T-bond expected to be one year from now?

6.20%

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond?

6.812%

Interest rates on 4-year Treasury securities are currently 6.5%, while 6-year Treasury securities yield 6.8%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? Use the geometric average to arrive at your answer.

7.4%

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

7.70%

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

9.04%

Which of the following would be most likely to lead to increases in nominal interest rates?

A new technology such as the Internet has just been introduced, and it increases investment opportunities.

Which of the following statements about the yield curve is CORRECT?

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.

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