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Principles of Managerial Finance, Brief Ed., 8e (Zutter/Smart)
Chapter 6 Interest Rates and Bond Valuation
6.1 Interest rates and required returns
1) An interest rate or a required rate of return represents the cost of money.
2) A real rate of interest is the compensation paid by the borrower of funds to the lender
measured in today's dollars.
3) A nominal rate of interest is approximately equal to the sum of the real rate of interest plus the
risk free rate of interest.
4) The nominal interest rate on a risk-free investment is approximately equal to the sum of the
real rate of interest plus an inflation premium.
5) The nominal interest rate on a risky investment equals the risk-free rate plus a risk premium.
6) The nominal rate of interest on a bond is 8% and the expected inflation premium is 4%. This
results in an approximate real rate of interest of 4% on the bond.
7) Historically, the rate of return on U.S. Treasury bills is usually greater than the rate of
inflation.
8) The nominal rate of interest is the actual rate of interest charged by the supplier of funds and
paid by demander.
9) The term structure of interest rates is a graphical presentation of the relationship between the
maturity and rate of return.
10) An inverted yield curve is a downward-sloping yield curve that indicates that short-term
interest rates are generally higher than long-term interest rates.
11) A yield curve that reflects relatively similar borrowing costs for both short- and long-term
loans is called a normal yield curve.
12) Upward-sloping yield curves result from higher future inflation expectations, lender
preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term
loans relative to their respective demand.
13) A flat yield curve means that the rates do not vary much at different maturities.
14) A normal yield curve is upward-sloping and indicates generally cheaper short-term
borrowing costs than long-term borrowing costs.
15) A flat yield curve indicates generally cheaper long-term borrowing costs than short-term
borrowing costs.
16) The market segmentation theory suggests that the shape of the yield curve is determined by
the supply and demand for funds within each maturity segment.
17) The liquidity preference theory suggests that the shape of the yield curve is determined by
the supply and demand for funds within each maturity segment.
18) The liquidity preference theory suggests that short-term interest rates should be lower than
long-term interest rates most of the time.
19) The expectations theory suggests that the shape of the yield curve reflects investors
expectations about future interest rates.
20) A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than
long-term borrowing costs.
21) An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper
short-term borrowing costs than long-term borrowing costs.
22) The liquidity preference theory suggests that long-term interest rates tend to be higher than
short-term rates (and therefore the yield curve slopes up) due to the lower liquidity and higher
responsiveness to general interest rate movements of longer-term securities.
23) The components of risk premium includes business risk, financial risk, interest rate risk,
liquidity risk, and tax risk.
24) The possibility that the issuer of a bond will not pay the contractual interest or principal
payments as scheduled is called maturity risk.
25) The possibility that the issuer of a bond will not pay the contractual interest or principal
payments as scheduled is called default risk.
26) The ________ rate of interest is the rate that balances the supply of savings and the demand
for investment funds.
A) Nominal
B) Real
C) Risk-free
D) Equilibrium
27) Generally, an increase in risk will result in ________.
A) a lower required return or interest rate
B) a higher required return or interest rate
C) a higher inflation premium
D) a lower real interest rate
28) Although no investment is truly risk free, ________ are generally viewed as the closest thing
we can come to in the real world to a risk-free investment.
A) U.S. Treasury securities
B) AAA-rated corporate bonds
C) secured bonds
D) zero-coupon bonds
29) Ai Lun, a management trainee at a large New York-based bank, is trying to estimate the real
rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent,
and consumer prices have been rising steadily at a 2% rate for several years. What should Ai
Lun's estimate of the real rate be?
A) 5%
B) 1%
C) 3%
D) 2%
30) Nico invested an amount a year ago and calculated his return on investment. He found that
his purchasing power had increased by 15 percent as a result of his investment. If inflation
during the year was 4 percent, then Nico's ________.
A) real return on investment is more than 15 percent
B) nominal return on investment is more than 15 percent
C) nominal return on investment is less than 11 percent
D) real return on investment is equal to 4 percent
31) The ________ rate of interest is the actual rate charged by the supplier and paid by the
demander of funds.
A) Nominal
B) Real
C) Risk-free
D) Inflationary
32) The ________ is the compound annual rate of interest earned on a debt security purchased on
a given date and held to maturity.
A) risk premium
B) yield curve
C) risk-free rate
D) yield to maturity
33) A(n) ________ is a graphic depiction of the relation between the maturity and rate of return
for bonds with similar risks.
A) yield curve
B) supply function
C) risk-return profile
D) aggregate demand curve
34) According to the expectations hypothesis, a(n) ________ yield curve reflects higher expected
future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
35) According to the expectations hypothesis, a(n) ________ yield curve reflects lower expected
future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
36) The term structure of interest rates is the relationship between ________.
A) the present value of principal and coupon rate of the bonds
B) the general expectation of inflation and nominal rate of return for bonds
C) the general expectation of inflation and real rate of return for bonds
D) the maturity and rate of return for bonds with similar level of risk
37) A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs
than short-term borrowing costs is called ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) linear yield curve
38) An upward-sloping yield curve that indicates cheaper short-term borrowing costs than long-
term borrowing costs is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal yield curve
39) A yield curve that reflects relatively similar borrowing costs for both short-term and long-
term loans is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal curve
40) The theory suggesting that for any given issuer, long-term interest rates tends to be higher
than short-term rates is called ________.
A) expectation hypothesis
B) liquidity preference theory
C) market segmentation theory
D) interest parity theory
41) Which of the following explains the general shape of the yield curve?
A) Expectations theory
B) Perfect market theory
C) Capital asset pricing theory
D) Securities market theory
42) Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM
common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based
on this information, the shape of the yield curve is ________.
A) upward sloping
B) downward sloping
C) flat
D) normal
43) ________ mainly explains the tendency for the yield curve to be upward sloping.
A) Expectations theory
B) Liquidity preference theory
C) Market segmentation theory
D) Investor perception theory
44) Which of the following affects the slope of yield curve?
A) tax rates
B) dividend policy
C) selection of accounting standards
D) liquidity preferences
45) Which of the following is TRUE of the risk premium?
A) T-bills have a have a higher risk premium compared with Treasury bonds.
B) Government bonds have a higher risk premium compared with corporate bonds.
C) Junk bonds have a lower risk premium investment-grade bonds.
D) The lower-rated corporate issues have a higher risk premium than that of the higher rated
corporate issues.
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46) Current interest rates on bonds of different maturities look like this:
Maturity Rate
1-year 2.50%
2-year 2.75%
3-year 3.00%
If the expectations hypothesis is true, what interest rate would you expect a 1-year bond to pay, 2
years from now?
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Copyright © 2019 Pearson Education, Inc.
Answer: The expectations hypothesis says that the equilibrium in the bond market is such that
investors earn the same expected return over a given time horizon whether they buy a single
long-term bond or a sequence of short-term bonds. In this example, suppose an investor buys a 3-
year bond. Their total return will be (1.03)3 - 1 = 9.2727%. Or to say this another way, $1
invested in the 3-year bond will grow to $1(1.03)3 = $1.092727 over 3 years.
Suppose instead that an investor buys a 2-year bond and then when that bond matures, the
investor buys a brand new 1-year bond. It is the rate on this second bond that the question is
asking about....what is the rate on a 1-year bond, 2 years from now? The expectations hypothesis
says that the investor who buys the 2-year bond today and then buys another 1-year bond should
earn the same return as an investor who buys the 3-year bond today. Both investors are investing
over a 3-year horizon, and they should earn the same return no matter what type of bonds they
hold over that horizon. So let E(r) be the expected return on the 1-year bond, two years from
now. The investor who buys the 2-year bond today and then the 1-year bond after that will earn
the following return:
(1.0275)2 × (1+E(r)) - 1
Or we could say that $1 invested in this way will grow to $1(1.0275)2(1+E(r)) over the 3 years.
But as already stated, this has to equal what the other investor earns, so equating the returns from
the two strategies we have
(1.0275)2(1+(E(r)) = 1.092727
Solve for E(r) and you obtain 3.50%.
Here's an intuitive way to get this answer.
For simplicity, ignore compounding for a moment. "Investor A" buys the 3-year bond paying 3%
and earns 9% over 3 years. "Investor B" buys the 2-year bond and earns 5.5% over 2 years
(2.75% per year for 2 years). How much does Investor B need to earn in the 3rd year to get the
same return that Investor A earned? The answer is 3.5% because Investor B earns 2.75% +
2.75% + 3.5% = 9%, the same as Investor A. Because we have ignored compounding, the math
here should be considered as an approximate solution, but as you can see, the answer is nearly
the same (i.e., the same to two decimal places) as the answer we obtained by doing math that did
not ignore compounding.
Diff: 3
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
AACSB: Analytical Thinking
47) Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.
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48) Current interest rates on bonds of different maturities look like this:
Maturity Rate
1-year 2.50%
2-year 2.75%
3-year 3.00%
If the expectations hypothesis is true, what interest rate would you expect a 2-year bond to pay, 1
year from now?
17
Copyright © 2019 Pearson Education, Inc.
Answer: The expectations hypothesis says that the equilibrium in the bond market is such that
investors earn the same expected return over a given time horizon whether they buy a single
long-term bond or a sequence of short-term bonds. In this example, suppose an investor buys a 3-
year bond. Their total return will be (1.03)3 - 1 = 9.2727%. Or to say this another way, $1
invested in the 3-year bond will grow to $1(1.03)3 = $1.092727 over 3 years.
Suppose instead that an investor buys a 1-year bond and then when that bond matures, the
investor buys a brand new 2-year bond. It is the rate on this second bond that the question is
asking about....what is the rate on a 2-year bond, 1 year from now? The expectations hypothesis
says that the investor who buys the 1-year bond today and then buys another 2-year bond should
earn the same return as an investor who buys the 3-year bond today. Both investors are investing
over a 3-year horizon, and they should earn the same return no matter what type of bonds they
hold over that horizon. So let E(r) be the annual expected return on the 2-year bond, two years
from now. The investor who buys the 1-year bond today and then the 2-year bond after that will
earn the following return:
(1.025) × (1+E(r))2 - 1
Or we could say that $1 invested in this way will grow to $1(1.025)(1+E(r))2 over the 3 years.
But as already stated, this has to equal what the other investor earns, so equating the returns from
the two strategies we have
(1.025)(1+(E(r))2 = 1.092727
Solve for E(r):
(1+E(r))2 = 1.0927/1.025
1 + E(r) = (1.092727/1.025)(0.5)
E(r) = 0.0325 = 3.25%
Here's an intuitive way to get this answer.
For simplicity, ignore compounding for a moment. "Investor A" buys the 3-year bond paying 3%
and earns 9% over 3 years. "Investor B" buys the 1-year bond and earns 2.5%. How much does
Investor B need to earn in the next 2 years to get the same return that Investor A earned? The
answer is 3.25% because Investor B earns 2.5% + 3.25% + 3.25% = 9%, the same as Investor A.
Because we have ignored compounding, the math here should be considered as an approximate
solution, but as you can see, the answer is nearly the same (i.e., the same to two decimal places)
as the answer we obtained by doing math that did not ignore compounding.
Diff: 3
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
AACSB: Analytical Thinking
49) Suppose the expectations hypothesis is true. The interest rate on a bond maturing in one year
is 2%, and the interest rate on a bond maturing in two years is 3%. The interest rate that investors
expect next year on a one-year bond is ________.
A) 2%
B) 3%
C) 4%
D) 5%
50) Jeff is trying to forecast what the annual interest rate on a three-year bond will be two years
from now, and he believes that the expectations hypothesis is the basis upon which he should
build his forecast. Currently the rates of return on bonds of different maturities look like this:
Maturity Rate
1-year 3.00%
2-year 3.50%
3-year 3.75%
4-year 4.00%
5-year 4.00%
Based on the expectations hypothesis, what forecast should Jeff make for the return on a three-
year bond, two years in the future?
A) 4.0%
B) 4.25%
C) 4.33%
D) 13%
51) Suppose the expectations hypothesis is true. The current rate of return on a one-year bond is
3%, and the current rate of return on a 2-year bond is 2.5%. What is the expected rate of return
next year on a one-year bond?
A) 2%
B) 0.5%
C) 1.5%
D) 1%
52) Suppose the expectations hypothesis is true. If the yield curve is flat this means that
________.
A) investors do not expect interest rates to change in the future
B) investors expect interest rates to rise in the future
C) investors expect interest rates to fall in the future
D) investors do not require a premium for expected inflation
53) Explain liquidity risk, default risk, and interest rate risk.
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Copyright © 2019 Pearson Education, Inc.
6.2 Government and corporate bonds
1) The coupon rate on a bond represents the percentage of the bond's par value that will be paid
annually, typically in two equal semiannual payments, as interest.
2) Restrictive covenants are contractual clauses in long-term debt agreements that place certain
operating and financial constraints on the borrower.
3) The reason for a difference in the yield between a Aaa corporate bond and an otherwise
identical Baa bond is the risk premium; other things being equal.
4) Standard debt provisions specify certain record keeping and general business practices that
must be followed by the bond issuer.
5) A trustee is a paid party representing the bond issuer in the bond indenture.
