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Exam 7: Interest Rates

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Question 21

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Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?

A) The yield on 10-year Treasury securities must exceed the yield on 7 year Treasury securities.
B) The yield on any corporate bond must exceed the yields on all Treasury bonds.
C) The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
D) The stated conditions cannot all be true--they are internally inconsistent.
E) The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

F) A) and C)
G) A) and B)

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Question 22

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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.

A) True
B) False

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Question 23

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Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong.

Suppose 1-year Treasury bonds yield 4.00% while 2-year T-bonds yield 5.10%. Assuming the pure expectations theory is correct, and thus the maturity risk premium for T-bonds is zero, what is the yield on a 1-year T-bond expected to be one year from now?

Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18% The differences in these rates were probably caused primarily by:

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

Crockett Corporation's 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.75%. The real risk-free rate is r* = 3.60%, the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds, the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T bonds, 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 inflation premium (IP) is built into 5-year bond yields?

If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill.

A bond trader observes 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?

Which of the following statements is CORRECT?

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.

During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

An upward-sloping yield curve is often call a "normal" yield curve, while a downward-sloping yield curve is called "abnormal."

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

If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*.

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?

The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, is called "interest rate risk," or "price risk."

In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t − 1) %, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT?