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Exam 6: Interest Rates

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Question 21

True/False

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

A) True
B) False

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Question 22

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

A) The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
B) The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
C) The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
D) The conditions in the problem 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 B)
G) All of the above

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Question 23

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If the pure expectations theory holds, which of the following statements is CORRECT?

If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?

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?

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?

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?

One of the four most fundamental factors that affect the cost of money as discussed in the text is the current state of the weather. If the weather is dark and stormy, the cost of money will be higher than if it is bright and sunny, other things held constant.

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.

Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The default risk premium for Kop's bonds is DRP = 0.40%, the liquidity premium on Kop's bonds is LP = 1.70% versus zero on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*?

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT?

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?

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

Which of the following statements is CORRECT?

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?

Which of the following statements is CORRECT?

The "yield curve" shows the relationship between bonds' maturities and their yields.

Since yield curves are based on a real risk-free rate plus the expected rate of inflation, at any given time there can be only one yield curve, and it applies to both corporate and Treasury securities.

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

Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.20% per year to maturity applies, i.e., MRP = 0.20%(t) , where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 1.35% applies to A-rated corporate bonds. What is the difference in the yields on a 5-year A-rated corporate bond and on a 10-year Treasury bond? Here we assume that the pure expectations theory is NOT valid, and disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.