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5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is no liquidity premium on these bonds. What is the real risk-free rate, r*?


A) 2.59%
B) 2.88%
C) 3.20%
D) 3.52%
E) 3.87%

F) A) and E)
G) A) and D)

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Keys Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys' bonds is LP = 0.5% 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 is the default risk premium (DRP) on Keys' bonds?


A) 1.17%
B) 1.30%
C) 1.43%
D) 1.57%
E) 1.73%

F) All of the above
G) A) and B)

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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.

A) True
B) False

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Which of the following statements is CORRECT?


A) If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.
B) If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.
C) Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.
D) If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
E) The yield curve can never be downward sloping.

F) A) and C)
G) None of the above

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Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money supply constant. Other things held constant, we would expect to see interest rates decline.

A) True
B) False

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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?


A) 1.90%
B) 2.09%
C) 2.30%
D) 2.53%
E) 2.78%

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

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Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information, which of the following statements is CORRECT?


A) The yield curve for U.S. Treasury securities will be upward sloping.
B) A 5-year corporate bond must have a lower yield than a 5-year Treasury security.
C) A 5-year corporate bond must have a lower yield than a 7-year Treasury security.
D) The real risk-free rate cannot be constant if inflation is not expected to remain constant.
E) This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

F) A) and E)
G) A) and C)

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Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things held constant, what would be the most likely effect on short-term securities' prices and interest rates?


A) Prices and interest rates would both rise.
B) Prices would rise and interest rates would decline.
C) Prices and interest rates would both decline.
D) Prices would decline and interest rates would rise.
E) There is no reason to expect a change in either prices or interest rates.

F) A) and E)
G) A) and B)

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


A) Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond.
B) Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.
C) Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds.
D) The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
E) The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

F) B) and E)
G) B) and D)

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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) 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.
D) 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.
E) Liquidity premiums are generally higher on Treasury than on corporate bonds.

F) A) and E)
G) B) and E)

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


A) Households reduce their consumption and increase their savings.
B) A new technology like the Internet has just been introduced, and it increases investment opportunities.
C) There is a decrease in expected inflation.
D) The economy falls into a recession.
E) The Federal Reserve decides to try to stimulate the economy.

F) A) and E)
G) A) and D)

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Which of the following statements is CORRECT?


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

F) A) and E)
G) A) and B)

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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) A 5-year T-bond would always yield less than a 10-year T-bond.
C) The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
D) The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope.
E) If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.

F) A) and B)
G) B) and D)

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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.


A) 1.81%
B) 1.90%
C) 2.00%
D) 2.10%
E) 2.21%

F) B) and D)
G) B) and C)

Correct Answer

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

A) True
B) False

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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?


A) 7.36%
B) 7.75%
C) 8.16%
D) 8.59%
E) 9.04%

F) B) and D)
G) A) and D)

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The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak.

A) True
B) False

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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? Include cross-product terms, i.e., if averaging is required, use the geometric average.


A) 5.21%
B) 5.49%
C) 5.78%
D) 6.07%
E) 6.37%

F) A) and E)
G) All of the above

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One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of production opportunities and their expected rates of return. If production opportunities are relatively good, then interest rates will tend to be relatively high, other things held constant.

A) True
B) False

Correct Answer

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Niendorf Corporation's 5-year bonds yield 8.00%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf's bonds is DRP = 1.20% 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 is the liquidity premium (LP) on Niendorf's bonds?


A) 1.31%
B) 1.46%
C) 1.62%
D) 1.80%
E) 2.00%

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

Correct Answer

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