16) Consider a $30,000 car loan over six years at 7% APR. Assume an option where the car loan
offers 0% financing for the first two years of the loan or 7% financing over six years. What are
the payment choices to ensure that no interest on the loan is paid?
17) Consider a $20,000 car loan over five years at 8% APR. Assume an option where the car
loan offers 0% financing for the first two years of the loan or 8% financing over five years. What
are the payment choices to ensure that no interest on the loan is paid? Does this imply that
money is “free”? Explain.
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5.4 Nominal and Real Interest Rates
1) Nominal interest rates are the sum of two major components. These components are
________.
A) the real interest rate and expected inflation
B) the risk-free rate and expected inflation
C) the real interest rate and default premium
D) the real interest rate and the T-bill rate
2) Assume that you are willing to postpone consumption today and buy a certificate of deposit
(CD) at your local bank. Your reward for postponing consumption implies that at the end of the
year ________.
A) you will be able to consume fewer goods
B) you will be able to buy the same amount of goods or services
C) you will be able to buy fewer goods or services
D) you will be able to buy more goods or services
3) Which of the statements below is FALSE?
A) The real interest rate is the reward for waiting.
B) Nominal interest rates are the sum of two major components: the real interest rate and
expected inflation.
C) The reward for postponing consumption implies that at the end of the year you will be able to
buy more goods.
D) The prices of goods and services tend to decrease over time because of inflation.
4) Assume that you are willing to postpone consumption of $1,000 today and buy a certificate of
deposit (CD) at your local bank with the $1,000. Holding the CD for one year provides you with
an 8% reward for saving or postponing consumption. This reward for postponing consumption
implies that at the end of the year you will have how much more money for spending?
A) $79.50
B) $79.75
C) $79.90
D) $80.00
5) Suppose you postpone consumption so that by investing at 5% you will have an extra $500 to
spend in one year. Suppose that inflation is 2% during this time. What is the approximate real
increase in your purchasing power?
A) $800
B) $500
C) $300
D) $200
6) Suppose you postpone consumption and invest at 6% when inflation is 2%. What is the
approximate real rate of your reward for saving?
A) 6%
B) 5%
C) 4%
D) 3%
7) The real rate is 1.25% and inflation is 5.25%. What is the approximate nominal rate?
A) 6.50%
B) 5.25%
C) 3.25%
D) 1.25%
8) Becky is seeking to expand her stamp collection. Each year, stamps increase in price at a
seven percent rate. She believes that if she invests her money for one year, she should be able to
buy 24 stamps for what 23 stamps would cost today. What is her real interest rate or reward for
waiting?
A) 4.35%
B) 3.35%
C) 2.25%
D) 1.00%
9) Angel is seeking to expand her rare stamp collection. Each year, rare stamps increase in price
at a three percent rate. She believes that if she invests her money for one year, she should be able
to buy 16 stamps for what 15 stamps would cost today. What is her real interest rate (or reward
for waiting)?
A) Her real interest rate is about 4.23%.
B) Her real interest rate is about 5.33%.
C) Her real interest rate is about 6.33%.
D) Her real interest rate is about 6.67%.
10) Becky is seeking to expand her rare coin collection. Each year, rare coins increase in price at
a three percent rate. She believes that if she invests her money for one year, she should be able to
buy 26 coins for what 25 coins would cost today. What is the approximate nominal rate
necessary to compensate for waiting and to cover inflation?
A) 7.00%
B) 6.50%
C) 6.00%
D) 5.00%
11) Nancy is seeking to expand her rare stamp collection. Each year, rare stamps increase in
price at a three percent rate. She believes that if she invests her money for one year, she should
be able to buy 16 stamps for what 15 stamps would cost today. What is the approximate nominal
rate necessary to compensate for waiting and to cover inflation?
A) 3.00%
B) 3.67%
C) 6.67%
D) 9.67%
12) We can write the true relationship between the nominal interest rate and the real rate and
expected inflation as ________.
A) (1 + r) = (1 + r) × (1 + h*)
B) r = (1 + r*) × (1 + h) – 1
C) r* = (1 + r) × (1 + h) -1
D) r = (1 + r*) × (1 + h) + 1
13) We can write the true relationship between the nominal interest rate and the real rate and
expected inflation as ________.
A) (1 + r) = (1 + r) × (1 + h*)
B) r = (1 + r*) × (1 + h*) – 1
C) (1 + r) = (1 + r*) × (1 + h)
D) r = (1 + r*) × (1 + h) + 1
14) The Fisher Effect involves which of the items below?
A) Nominal rate, the real rate, and inflation
B) Nominal rate and the real rate only
C) Nominal rate and inflation only
D) Nominal rate, the bond rate, and inflation
15) A more precise calculation of the Fisher Effect includes ________.
A) nominal rate, the bond rate, and inflation
B) nominal rate the real rate, expected inflation, and the product of the real rate and expected
inflation
C) nominal rate and inflation only
D) nominal rate and the real rate only
16) The Fisher Effect tells us that the true nominal rate is actually made up of three components.
These three components are ________.
A) the nominal rate, the real rate, and the inflation rate
B) the real rate, the inflation rate, and the product of the real rate and the nominal rate
C) the real rate, the inflation rate, and the product of the real rate and inflation
D) the real rate and the product of the real rate and inflation
17) Which of the statements below is FALSE?
A) The Fisher Effect is the relationship between three items: the nominal rate, the real rate, and
inflation.
B) In the Fisher Effect, r* is the real interest rate.
C) The product of the real rate and the inflation rate can be thought of as the additional
compensation needed for the fact that the interest being earned during the year is not subject to
inflation.
D) In the Fisher Effect, r is the nominal interest rate.
18) Nominal interest rates are the sum of two major components: the real interest rate and the
maturity premium.
19) The Fisher Effect is the relationship between three items: the nominal rate, the real rate, and
inflation.
20) The true nominal interest rate equals the real rate plus inflation plus (real rate × inflation).
21) The Fisher Effect states the relationship between the nominal rate (r), the real rate (r*), and
inflation (h). Suppose r= 5% and h = 4%. Many would say that the nominal rate is 9%. Is this
true? Explain in terms of the relationship between the real rate and the inflation rate over time.
1) Which of the statements below is FALSE?
A) An advertised rate is a nominal rate.
B) An advertised rate can be referred to as the annual percentage rate or annual percentage yield.
C) An advertised rate can be referred to as the APR or APY.
D) When you visit any financial institution, you will see only one advertised rate.
2) The two major components of the interest rate that cause rates to vary across different
investment opportunities or loans are ________.
A) the default premium and the bankruptcy premium
B) the liquidity premium and the maturity premium
C) the default premium and the maturity premium
D) the inflation premium and the maturity premium
3) Which of the statements below is FALSE?
A) No part of the default premium has to do with the frequency of default by the borrower.
B) For the home loan, the collateral (the house) is an asset that will increase in value over time
(in general) compared to a car loan where the collateral (the car) decreases in value over time.
C) With a house, the potential loss due to default is less than a car because the growing value of
the asset should be sufficient to cover the outstanding balance (principal) of the loan.
D) A personal credit card essentially has no collateral so the potential loss is even higher if the
customer defaults on his or her credit card payments.
4) Which of the statements below is FALSE?
A) A part of the default premium has to do with the frequency of default by the borrower.
B) For the home loan, the collateral (the house) is an asset that will increase in value over time
(in general), compared with a car loan in which the collateral (the car) decreases in value over
time.
C) With a car, the potential loss due to default is less than a house because the growing value of
the asset should be sufficient to cover the outstanding balance (principal) of the loan.
D) A personal credit card essentially has no collateral, so the potential loss is even higher if the
customer defaults on his or her credit card payments.
5) The ________ compensates the investor for the additional risk that the loan will not be repaid
in full.
A) default premium
B) inflation premium
C) real rate
D) interest rate
6) The frequency of default on a home loan is ________ the frequency of default on a credit
card.
A) much lower than
B) much higher than
C) a bit lower than
D) a bit higher than
7) Which of the statements below is TRUE?
A) The frequency of bankruptcy for a high-tech up-start firm is lower than for a blue-chip firm,
so we see higher borrowing rates for start-ups than for mature firms.
B) The frequency of bankruptcy for a high-tech up-start firm is higher than for a blue-chip firm,
so we see lower borrowing rates for start-ups than for mature firms.
C) The frequency of bankruptcy for a high-tech up-start firm is lower than for a blue-chip firm,
so we see lower borrowing rates for start-ups than for mature firms.
D) The frequency of bankruptcy for a high-tech up-start firm is higher than for a blue-chip firm,
so we see higher borrowing rates for start-ups than for mature firms.
8) Which of the statements below is FALSE?
A) If you invest money for a short period and buy a six-month CD, you will not receive as high
an interest rate as if you bought a CD with a longer maturity period.
B) The difference in rates as the borrowing time or investment horizon increases is due to the
maturity premium of the investments.
C) The maturity premium represents that portion of the yield that compensates the investor for
the additional waiting time or the lender for the additional time it takes to receive repayment in
full.
D) The longer the loan, the greater the risk of nonpayment and the lower the interest rate the
lender demands.
9) Which of the below is NOT a major component of interest rates?
A) Real rate
B) Inflation premium
C) Historical interest rates
D) Default premium
10) The borrowing rate for real estate is more than the borrowing rates for autos, boats, and
VISA Reward credit cards.
11) Differences in borrowing rates can generally be explained by the level of risk of the
investment or loan and by the length of the investment or loan.
12) We assign a very low probability of default to the U.S. Treasury and thus assume that all
Treasury bills will be paid in full at maturity and thus have a zero default premium.
13) Why are there different interest rates on loans and securities?
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5.6 Yield Curves
1) A yield curve constructed using Treasury securities has each of the following components
embedded in the nominal interest rates ________.
A) the real rate, expected inflation and a default risk premium
B) expected inflation, a default risk premium and a maturity premium
C) the real rate, expected inflation, and a maturity premium
D) the real rate, a default risk premium and expected inflation
2) James is a rational investor wishing to maximize his return over a 20-year period. The current
yield curve is inverted with one-year rates at 5.00% and 20-year rates at 3.50%. James will invest
in the lower-rate 20-year bonds if ________.
A) he thinks rates will fall in the future and locking in long-term rates today may provide the
highest long-run average return
B) he thinks rates will rise in the future and locking in long-term rates today may provide the
lowest long-run average return
C) he thinks rates will remain flat at 5% in the future and locking in long-term rates today will
prevent him from appearing greedy to those without this investment opportunity
D) he thinks rates will rise in the future and locking in long-term rates today may provide the
highest long-run average return
3) The most common shape for a yield curve is upward sloping.
4) In constructing a yield curve you place interest rates on the vertical axis, and risk on the
horizontal axis.
1) Annual rates of inflation in the United States has ________ since 1950.
A) been stationary
B) been below 3%
C) been above 10%
D) varied over time
2) We can get an average real rate if we assume expected inflation and actual inflation are on
average the same ________.
A) when we look over a relatively long period of time
B) when we look over a relatively short period of time
C) among different countries
D) among neighboring countries
3) Which of the statements below is FALSE regarding interest rates in the United States from
2000 through 2013?
A) The average annual rate for the 3-month Treasury bill has varied from a low of 0.03% to a
high of 5.66%.
B) The average annual rate for the 3-month U.S. Treasury bill was 3.93%.
C) The average annual rate of Treasury Bonds was 3.93%.
D) The average annual rate of AAA Corporate Bonds was 5.32%.
4) If we want to get some idea about a/an ________ over time between two specific assets, we
can compare the returns on top-rated corporate bonds and U.S. government bonds.
A) inflation premium
B) default premium
C) maturity premium
D) liquidity premium
5) Which of the four interest rate components had the greatest average annual percentage
increase in the period from 1950-1999?
A) Real rate
B) Inflation premium
C) Historical interest rates
D) Default premium
6) Which of the four interest rate components had the smallest average annual percentage in the
period from 1950-1999?
A) Maturity premium
B) Real rate
C) Inflation premium
D) Default premium
7) Which of the statements below is FALSE regarding interest rates in the period 1950-1999?
A) Inflation averaged 4.05%.
B) The real rate averaged 1.18%.
C) The default premium averaged 7.05%.
D) The maturity premium averaged 1.28% (for twenty-year maturity differences).
8) Which of the statements below is TRUE regarding interest rates in the period 2000-2013?
A) The average annual rate of return earned by T-bills exceeded the average annual rate of return
earned by T-bonds.
B) The average annual rate of return earned by T-bills exceeded the average annual rate of return
earned by Corporate bonds.
C) The average annual rate of return earned by AAA Corporate bonds exceeded the average
annual rate of return earned by T-bonds.
D) The average annual rate of return earned by T-bills exceeded the average annual rate of return
earned by AAA Corporate bonds.
9) The rates on Treasury bills in the United States have been lower on average since the year
2000 than in the 50 years from 1950-1999.
10) The default risk premium for U.S. corporate bonds was greater in the last 50 years of the
20th century than in the first decade of the 21st century.
11) The maturity premium for Treasury Bonds over Treasury bills rose in the first part of the
21st century compared to the premium over the last 50 years of the 20th century.
12) If we want to get some idea about a default premium over time between two specific assets,
we can compare the returns on short-term or medium-term bonds with those on large company
stocks.
13) The risk-free rate (for the three-month U.S. Treasury bill) in the United States has varied
from slightly under 1% to a high of 15% in the period from 1950 to 1999.
14) The historically low Treasury bill rates between 2008 and 2013 reflect the Federal Reserve’s
action to stimulate the economy following the 2008 financial meltdown.
15) What does the historical record of interest rates and inflation in the United States look like?