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Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t) , where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.90% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.


A) 1.75%
B) 1.84%
C) 1.93%
D) 2.03%
E) 2.13%

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

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Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t) , where t is the years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4-year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.


A) 6.60%
B) 6.95%
C) 7.32%
D) 7.70%
E) 8.09%

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

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The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.

A) True
B) False

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Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.


A) 3.80%
B) 3.99%
C) 4.19%
D) 4.40%
E) 4.62%

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

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Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 4.10%. What rate of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.


A) 5.38%
B) 5.66%
C) 5.96%
D) 6.27%
E) 6.60%

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

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


A) Long-term interest rates are more volatile than short-term rates.
B) Inflation is expected to decline in the future.
C) The economy is not in a recession.
D) Long-term bonds are a better buy than short-term bonds.
E) Maturity risk premiums could help to explain the yield curve's upward slope.

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

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Which of the following statements is CORRECT?


A) The yield on a 3-year Treasury bond cannot exceed the yield on a 10 year Treasury bond.
B) The real risk-free rate is higher for corporate than for Treasury bonds.
C) Most evidence suggests that the maturity risk premium is zero.
D) Liquidity premiums are higher for Treasury than for corporate bonds.
E) The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.

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

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If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?


A) An upward-sloping yield curve would imply that interest rates are expected to be lower in the future.
B) If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now.
C) The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond.
D) Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.
E) Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

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

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Suppose the rate of return on a 10-year T-bond is 6.55%, the expected average rate of inflation over the next 10 years is 2.0%, the MRP on a 10-year T-bond is 0.9%, no MRP is required on a TIPS, and no liquidity premium is required on any Treasury security. Given this information, what should the yield be on a 10-year TIPS? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.


A) 2.97%
B) 3.13%
C) 3.29%
D) 3.47%
E) 3.65%

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

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Kay 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 default risk premium for Kay's bonds is DRP = 1.30% 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 Kay's bonds?


A) 0.36%
B) 0.41%
C) 0.45%
D) 0.50%
E) 0.55%

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

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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) In equilibrium, long-term rates must be equal to short-term rates.
B) An upward-sloping yield curve implies that future short-term rates are expected to decline.
C) The maturity risk premium is assumed to be zero.
D) Inflation is expected to be zero.
E) Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

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

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Assuming the pure expectations theory is correct, which of the following statements is CORRECT?


A) If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise.
B) If both 2-year and 3-year Treasury rates are 7%, then 5-year rates must also be 7%.
C) If 1-year rates are 6% and 2-year rates are 7%, then the market expects 1-year rates to be 6.5% in one year.
D) Reinvestment rate risk is higher on long-term bonds, and interest rate (price) risk is higher on short-term bonds.
E) Interest rate (price) risk and reinvestment rate risk are relevant to investors in corporate bonds, but these concepts do not apply to Treasury bonds.

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

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Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? The cross-product term should be considered , i.e., if averaging is required, use the geometric average.


A) 3.68%
B) 3.87%
C) 4.06%
D) 4.26%
E) 4.48%

F) D) and E)
G) C) and D)

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Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.02% per year to maturity applies, i.e., MRP = 0.20%(t) , where t is the 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.


A) 0.77%
B) 0.81%
C) 0.85%
D) 0.89%
E) 0.94%

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

Correct Answer

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


A) The yield curve for both Treasury and corporate bonds should be flat.
B) The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping.
C) The yield curve for Treasury securities cannot be downward sloping.
D) The maturity risk premium would be zero.
E) 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.

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

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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.

A) True
B) False

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

A) True
B) False

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Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds?


A) 0.73%
B) 0.81%
C) 0.90%
D) 0.99%
E) 1.09%

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

Correct Answer

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


A) Inflation is expected to decline in the future.
B) The economy is not in a recession.
C) Long-term bonds are a better buy than short-term bonds.
D) Maturity risk premiums could help to explain the yield curve's upward slope.
E) Long-term interest rates are more volatile than short-term rates.

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

Correct Answer

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

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