finance conceptual chapter 6

Inflation Premium (IP)

Avg. annual expected inflation over life of security included in all

How would the yield curve facing BB-rated company compare with yield curve for US treasury securities

BB curve is above the AAA curve which is above the treasury securities curve

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

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

If interest rates on 20-year Treasury and corporate bonds are as follows: T-bond= 6.27% AAA=9.72% A=10.34% BBB=11.42% Then differences in these rates were probably caused primarily by: -Inflation differences. -Real risk-free rate differences. -Maturity risk differences. -Tax effects. -Default and liquidity risk differences.

Default and liquidity risk differences.

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: -Tax effects. -Default risk differences. -Maturity risk differences. -Inflation differences. -Both default risk differences and inflation differences.

Default risk differences.

True or False: 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

Which of the following statements about interest rates is CORRECT, all other things held constant? -If companies increase their savings rate, interest rates are likely to increase. -If individuals have fewer good investment opportunities, interest rates are likely to increase. -Interest rates on long-term bonds are more volatile than rates on short-term debt securities such as T-bills. -If expected inflation increases, interest rates are likely to increase. -Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities.

If expected inflation increases, interest rates are likely to increase.

Government issued treasury bonds are....

greater than 10 yrs)

High quality bond will be _________ risky

less

Treasury Bills are....

less than 1 yr

Treasury notes are...

1-10 yrs

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. On the basis of this information, which of the following statements is most CORRECT? -The corporate yield curve must be flat. -Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping. -A 5-year corporate bond must have a higher yield than a 10-year Treasury bond. -A 10-year corporate bond must have a higher yield than a 5-year Treasury bond. -A 10-year Treasury bond must have a higher yield than a 10-year corporate bond.

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

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

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

How would the yield curve facing AAA-rated company compare with yield curve for US treasury securities

AAA curve would be above the treasury securities curve

Default Risk premium (DRP)

An additional return required to compensate for the chance that a company will not make principal/interest payments on debt Not included in treasuries.

Which of the following statements about the yield curve is CORRECT? -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. -If the expectations theory holds, the Treasury bond yield curve will never be downward sloping. -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. -If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. -If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat.

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.

Which of the following statements about bond markets is CORRECT? -The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. -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. -The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. -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 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.

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 Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope. -The conditions in the problem cannot all be true—they are internally inconsistent. -The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond. -The yield on a 2-year T-bond must exceed that of a 5-year T-bond. -The yield on a 5-year Treasury bond must exceed that of a 2-year Treasury bond.

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

True or False: 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

True or False: 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

True or False: 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

Nominal risk-free rate (Rrf)

actual purchasing power with inflation. what we observe on a treasury security Rrf = r* +IP

Maturity risk premium (MRP)

additional return for investing in a long-term security not included in short-term treasuries/corp

Liquidity Premium (LP)

additional return to compensate for lack of an active secondary market not included in long term treasuries

Real Risk free-rate of interest (r*)

the return on a security that has no risk. No inflation ex: govt issues treasury bond (>10 yrs), treasury bills (<1 yr), and treasury notes (1-10 yrs)