Chapter 6: Interest Rate Questions

Kern Corporation's 5-year bonds yield 6.60% and 5-year T-bonds yield 3.40%. The real risk free rate is r* = 2.5%, the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern's bonds is LP = 1.3%, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds?

0.50%

Suppose the interest rate on a 1-year T-bond is 5.00% and that on a 2-year T-bond is 7.90%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now? Round the intermediate calculations to 4 decimal places and final answer to 2 decimal places.

10.88%

The real risk-free rate is 3.05%, inflation is expected to be 5.95% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, i.e., if averaging is required, use the arithmetic average, what is the equilibrium rate of return on a 1-year Treasury bond?

9.00%

Which of the following would be most likely to lead to a higher level of interest rates in the economy?

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

Which of the following statements is CORRECT? a) If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. b) The actual shape of the yield curve depends only on expectations about future inflation. c) Downward sloping yield curves are inconsistent with the pure expectations theory. d) Yield curves must be either upward or downward sloping - they cannot first rise and then decline. e) If the yield curve is upward sloping, the maturity risk premium must be positive and the inflation rate must be zero.

If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future.

Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that

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

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) Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. c) Liquidity premiums are generally higher on Treasury than on corporate bonds. d) The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping. e) If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.

Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT? a) The interest rate today on a 3-year bond should be approximately 8%. b) The interest rate today on a 3-year bond should be approximately 7%. c) The interest rate today on a 2-year bond should be approximately 7%. d) The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. e) The interest rate today on a 2-year bond should be approximately 6%

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

If the pure expectations theory holds, which of the following statements is CORRECT? a) The yield curve for Treasury securities cannot be downward sloping. b) The maturity risk premium would be zero. c) If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end up with more money if he or she bought 2-year bonds. d) The yield curve for both Treasury and corporate bonds should be flat. e) The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping.

The maturity risk premium would be zero

If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT? a) An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future. b) The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope. c) The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat. d) A 5-year T-bond would always yield less than a 10-year T-bond. e) If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.

The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.

Which of the following statements is CORRECT? a) The yield on a 3-year corporate bond should always exceed the yield on a 2-year b) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond c) 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. d) d) The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. e) e) The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5- year AAA-rated corporate bond.

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

Because the maturity risk premium is normally positive, the yield curve is normally upward sloping. (t/f)

true

If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve. (t/f)

true

If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. (t/f)

true

One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in a given security. The higher the risk, the higher the security's required return, other things held constant. (t/f)

true

One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for consumption. The higher the time preference, the lower the cost of money, other things held constant. (t/f)

true