978-0134083285 Chapter 2 Part 4

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15) Which of the following represents the correct ordering of standard deviation of returns over the

period 1926 to 2014 (from highest to lowest standard deviation of returns)?

A) Treasury bills, long-term corporate bonds, long-term government bonds, common stocks

B) common stocks, long-term government bonds, long-term corporate bonds, Treasury bills

C) Treasury bills, long-term government bonds, long-term corporate bonds, common stocks

D) Treasury bills, long-term government bonds, common stocks, long-term corporate bonds

Keywords: Standard Deviation, Risk-Return Tradeoff

Learning Obj.: L.O. 2.3

AACSB: Analytical Thinking

16) During the period 1990 to 2014, the average yield on 3-month U.S. Treasury bills was 3.04%, the

average inflation rate was 2.64%, the average yield on 30-year Treasury bonds was 5.49%, and the

average return on 30-year Aaa-rated corporate bonds was 6.35%. The real risk-free short-term interest

rate is

A) 0.40%.

B) 2.13%.

C) 2.97%.

D) 4.76%.

Keywords: Real Risk-Free Interest Rate, Inflation Risk Premium

Learning Obj.: L.O. 2.3

AACSB: Analytical Thinking

17) Which of the following securities will likely have the highest liquidity premium?

A) U.S. Treasury bond maturing in 2027

B) Bbb-rated corporate bond maturing in 2020 actively traded on a major exchange

C) Aaa-rated corporate bond maturing in 2015 not actively traded

D) U.S. Treasury bill

Keywords: Liquidity Premium

Learning Obj.: L.O. 2.3

AACSB: Analytical Thinking

18) Which of the following securities will likely have the highest default risk premium?

A) U.S. Treasury bond maturing in 2027

B) Bbb-rated corporate bond maturing in 2020 actively traded on a major exchange

C) Aaa-rated corporate bond maturing in 2015 not actively traded

D) U.S. Treasury bill

Keywords: Default Risk Premium

Learning Obj.: L.O. 2.3

AACSB: Reflective Thinking

19) Suppose the following rates are averages for banks in your area: interest checking accounts pay 1%,

savings accounts pay 2%, and one-year certificates of deposit pay 3%. All accounts are federally insured

by the FDIC. The difference in rates can be explained mainly by

A) liquidity premiums.

B) default risk premiums.

C) maturity premiums.

D) inflation risk premiums.

Keywords: Liquidity Premium

Learning Obj.: L.O. 2.3

AACSB: Reflective Thinking

20) Which of the following statements is false?

A) Brokers purchase securities for their own account.

B) Most corporate bond trading takes place over the counter.

C) Broker-dealers stand ready to buy and sell specific securities at selected prices.

D) none of the above

Keywords: Brokers, Broker-Dealers, Securities

Learning Obj.: L.O. 2.3

AACSB: Analytical Thinking

21) Examine the securities below and identify the security with the highest liquidity premium, the highest

default risk premium, and the highest maturity premium.

a. 30-year U.S. Government Treasury bond maturing in 2025

b. 25-year Bbb-rated corporate bond maturing in 2030, actively traded on the New York Exchange

c. 10-year Aaa-rated corporate bond maturing in 2020, thinly traded on a regional exchange

d. 3-month U.S. Treasury bill

Keywords: Risk Premium, Liquidity Premium, Maturity Premium

Learning Obj.: L.O. 2.3

AACSB: Reflective Thinking

22) Distinguish between the concepts of the inflation premium and the default-risk premium.

Keywords: Risk Premium

Learning Obj.: L.O. 2.3

AACSB: Reflective Thinking

23) Distinguish between the concepts of the maturity-risk premium and the liquidity-risk premium.

Keywords: Risk Premium

Learning Obj.: L.O. 2.3

AACSB: Reflective Thinking

Learning Objective 2.4

1) The term structure of interest rates usually indicates that longer terms to maturity have higher

expected returns.

Keywords: Term Structure of Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

2) In response to the banking crisis and economic collapse of 2007 and 2008, the U.S. government moved

to increase interest rates in order to attract foreign capital seeking high returns in U.S. banks.

Keywords: Interest Rates, Term Structure

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

3) A liquidity-risk premium is the additional return required by investors in longer-term securities to

compensate them for the greater risk of price fluctuation on those securities caused by interest rate

changes.

Keywords: Nominal Rate of Interest, Inflation Premium, Real Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

4) A real interest rate is the interest rate on a fixed-income security that has no risk in an economic

environment of high inflation.

Keywords: Nominal Rate of Interest, Inflation Premium, Real Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

5) A liquidity-risk premium is the additional return required by investors for securities that cannot quickly

be converted into cash at a reasonably predictable price.

Keywords: Nominal Rate of Return, Liquidity Premium

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

6) Which of the following securities will likely have the highest maturity risk premium?

A) U.S. Treasury bond maturing in 2027

B) Bbb-rated corporate bond maturing in 2020 actively traded on a major exchange

C) Aaa-rated corporate bond maturing in 2015 not actively traded

D) U.S. Treasury bill

Keywords: Maturity Risk Premium

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

7) The one-year interest rate is 4%. The interest rate for a two-year security is 6%. According to the

unbiased expectations theory, the one-year interest rate one year from now must be equal to

A) 5.00%.

B) 8.00%.

C) 8.04%.

D) 10.00%.

Keywords: Term Structure of Interest Rates, Unbiased Expectations

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

8) The one-year interest rate is 4%. The interest rate for a two-year security is 6%. The one-year interest

rate one year from now is 8.34%. According to the liquidity preference theory, the risk premium for the

second one-year investment is

A) 0.50%.

B) 0.34%.

C) 0.30%.

D) 1.66%.

Keywords: Term Structure of Interest Rates, Liquidity Preference Theory

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

9) You are considering an investment in a U.S. Treasury bond but you are not sure what rate of interest it

should pay. Assume that the real risk-free rate of interest is 1.0%; inflation is expected to be 1.5%; the

maturity risk premium is 2.5%; and, the default risk premium for AAA rated corporate bonds is 3.5%.

What rate of interest should the U.S. Treasury bond pay?

A) 8.5%

B) 6.0%

C) 5.0%

D) 2.5%

Keywords: Nominal Interest Rate, Real Rate, Inflation Premium, Maturity Risk Premium, Default Risk Premium

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

10) You are considering an investment in a AAA-rated U.S. corporate bond but you are not sure what rate

of interest it should pay. Assume that the real risk-free rate of interest is 1.0%; inflation is expected to be

1.5%; the maturity risk premium is 2.5%; and, the default risk premium for AAA rated corporate bonds is

3.5%. What rate of interest should the U.S. corporate bond pay?

A) 8.5%

B) 6.0%

C) 5.0%

D) 2.5%

Keywords: Nominal Interest Rate, Real Rate, Inflation Premium, Maturity Risk Premium, Default Risk Premium

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

11) What is the term for a graphical representation of the relationship between interest rates and the

maturities of debt securities?

A) term curve

B) maturity chart

C) yield curve

D) inflationary expectations

Keywords: Yield Curve, Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

12) Which of the following is NOT a valid theory that attempts to explain the shape of the term structure

of interest rates?

A) the unbiased expectations theory

B) the liquidity preference theory

C) the market segmentation theory

D) the Fisher Effect theory

Keywords: Expectations Theory, Liquidity Preference Theory, Market Segmentation Theory, Term Structure of

Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

13) A “normal” yield curve is

A) downward sloping.

B) downward sloping, then upward sloping.

C) upward sloping.

D) upward sloping, then downward sloping.

Keywords: Normal Yield Curve

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

14) Which of the following premiums is NOT factored into the price of a long-term Treasury bond?

A) a real risk-free interest rate

B) a maturity premium

C) a default-risk premium

D) an inflation-risk premium

Keywords: Nominal Rate of Interest, Inflation Premium, Real Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

15) The ________ is the premium to compensate for the price change expected to occur over the life of the

bond or investment instrument.

A) inflation-risk premium

B) maturity premium

C) real risk-free interest rate premium

D) default-risk premium

Keywords: Nominal Rate of Interest, Inflation Premium, Real Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

16) Given the anticipated rate of inflation (i) of 1.7% and the real rate of interest (R) of 1.4%, find the

nominal rate of interest (r).

Keywords: Real Rate of Interest, Inflation Premium, Nominal Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

17) Given the rate information in the table below, estimate the nominal rate for a AA-rated corporate

bond. Assume a liquidity premium of 8 basis points. Identify as part of your answer the inflation risk

premium, the default risk premium, the maturity premium, and the liquidity premium.

3-month T-bills 2.0%

30-year Treasury bonds 5.0%

AA-rated corp. bonds 8.0%

Inflation Rate 1.0%

Keywords: Nominal Interest Rate, IRP, DRP, MP, LP

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

18) An investor buys a 20-year Bbb-rated corporate bond with a nominal annual rate of return of 10%.

The average inflation rate is expected to be 2%. The default risk premium is expected to be 5% and the

maturity premium is 4%. Calculate the real rate of interest.

Keywords: Fisher Effect, Real Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

19) The current rate of return on a one-year U.S. Government security is 3%. The rate of return on a two–

year U.S. Government security is 5%. According to the expectations theory, what is the return on a one–

year U.S. Government security purchased one year from today?

Keywords: Expectations Theory, Term Structure of Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

20) The date today is January 1, 2010. A one-year security maturing on 1/1/11 yields 3%. A two-year

security maturing on 1/1/12 yields 6%. A three-year security maturing on 1/1/13 yields 11%. Calculate the

expected annual return on a two-year security beginning 1/1/11 and maturing on 1/1/13.

Keywords: Expectations Theory, Term Structure of Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

21) If provided the nominal rate of interest (r) of 7.4% and the anticipated rate of inflation (i) of 4.5%,

what is the real rate of interest (R)?

Keywords: Nominal Rate of Interest, Inflation Premium, Real Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

22) Given the anticipated rate of inflation (i) of 2.13% and the real rate of interest (R) of 3.1%, find the

nominal rate of interest (r).

Keywords: Inflation Premium, Real Rate of Interest, Nominal Rate of Interest

Learning Obj.: L.O. 2.4

AACSB: Analytical Thinking

23) The yield curve in 2009 was very low, with short-term rates close to zero and long-term rates below 5

percent. What factors contributed to such low interest rates?

Keywords: Economic Crises, Yield Curve, Term Structure of Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking

24) Identify three prominent theories that attempt to explain the term structure of interest rates.

Keywords: Term Structure of Interest Rates

Learning Obj.: L.O. 2.4

AACSB: Reflective Thinking