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Because the maturity risk premium is normally positive, the yield curve is normally upward sloping.

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 E)
G) B) and D)

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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 yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
C) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.
D) The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond.
E) 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.

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

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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) C) and E)
G) B) and D)

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Which of the following statements is CORRECT?


A) The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.
B) The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.
C) The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.
D) If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.
E) The real risk-free rate should increase if people expect inflation to increase.

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

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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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Koy Corporation's 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% 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 Koy's bonds?


A) 5.94%
B) 6.60%
C) 7.26%
D) 7.99%
E) 8.78%

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

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

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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 D)
G) B) and E)

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C

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) All of the above
G) None of the above

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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:


A) Tax effects.
B) Default and liquidity risk differences.
C) Maturity risk differences.
D) Inflation differences.
E) Real risk-free rate differences.

F) None of the above
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 D)
G) B) and E)

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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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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?


A) 5.90%
B) 6.21%
C) 6.52%
D) 6.85%
E) 7.19%

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

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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?


A) The yield on 2-year Treasury securities must exceed the yield on 5 year Treasury securities.
B) The yield on 5-year Treasury securities must exceed the yield on 10 year corporate bonds.
C) The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds.
D) The yield curve must be "humped."
E) The yield curve must be upward sloping.

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

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E

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?


A) 5.51%
B) 5.80%
C) 6.09%
D) 6.39%
E) 6.71%

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

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B

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

Correct Answer

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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) All of the above
G) B) and D)

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If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase.

A) True
B) False

Correct Answer

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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.

A) True
B) False

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