Principles of Finance, 6e
Besley/Brigham
Chapter 05
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1. Which of the following statements is most correct? Other things held constant,
a.
the “liquidity preference theory” would generally lead to an upward sloping yield curve.
b.
the “market segmentation theory” would generally lead to an upward sloping yield curve.
c.
the “expectations theory” would generally lead to an upward sloping yield curve.
d.
the yield curve under “normal” conditions should be horizontal (i.e., flat.)
e.
a downward sloping yield curve would suggest that investors expect interest rates to increase in the future.
ANSWER:
a
RATIONALE:
The liquidity preference theory states that investors prefer shorter maturity bonds to
longer maturities, other things (like interest rates) held constant. That preference arises
because long-term bonds are exposed to more interest rate risk than short-term bonds. In
any event, the liquidity preference theory would lead to an upward sloping yield curve.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-a – 5 min.
TOPICS:
Term Structure of Interest Rates
2. Your uncle would like to restrict his interest rate risk and his default risk, but he still would like to invest in corporate
bonds. Which of the possible bonds listed below best satisfies your uncle’s criteria?
a.
AAA bond with 10 years to maturity.
b.
BBB perpetual bond.
c.
BBB bond with 10 years to maturity.
d.
AAA bond with 5 years to maturity.
e.
BBB bond with 5 years to maturity.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
3. If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that
on a 1-year T-bond?
a.
The yield on the 10-year bond is less than the yield on a 1-year bond.
b.
The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity
premiums.
c.
It is impossible to tell without knowing the coupon rates of the bonds.
d.
The yields on the two bonds are equal.
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e.
It is impossible to tell without knowing the relative risks of the two bonds.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
4. An inverted yield curve
a.
Exists when short-term rates exceed long-term rates.
b.
Exists when long-term rates exceed short-term rates.
c.
Represents the “normal term structure.”
d.
Signifies that investors can get higher returns by investing in bonds than by investing in stocks.
e.
Signifies that investors can get higher returns on stocks than on bonds.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
5. If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are
invalid, and we observe a downward sloping yield curve, which of the following is a true statement?
a.
Investors expect short-term rates to be constant over time.
b.
Investors expect short-term rates to increase in the future.
c.
Investors expect short-term rates to decrease in the future.
d.
It is impossible to say unless we know whether investors require a positive or negative maturity risk premium.
e.
The maturity risk premium must be positive.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
Principles of Finance, 6e
Besley/Brigham
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6. Which of the following statements is most correct?
a.
The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact
that the probability of default is higher on long-term bonds than on short-term bonds.
b.
Reinvestment rate risk is lower, other things held constant, on 30-day T-bills than on 30-year T-bonds.
c.
According to the market segmentation theory of the term structure of interest rates, we should normally expect
the yield curve to have an upward slope.
d.
The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow
on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield
curve is normally upward sloping.
e.
If the maturity risk premium were zero and the rate of inflation were expected to increase in the future, then
the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
ANSWER:
e
RATIONALE:
Statement e reflects the ideas of the expectations theory. Conversely, if the rate of
inflation were expected to decrease in the future, then the yield curve for U.S. Treasury
securities would, other things held constant, have a downward slope. The other
statements are false.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-a – 5 min.
TOPICS:
Term Structure
7. Which of the following statements is most correct?
a.
The more highly developed a nation’s financial system is, the more likely funds are to flow from savers to
borrowers by direct transfers as opposed to through financial intermediaries.
b.
If people in the aggregate have a strong time preference for current consumption as opposed to future
consumption, this factor will cause interest rates to be lower than if preferences were more toward future
consumption.
c.
If investors expect the rate of inflation to increase in the future, this would tend to cause the current short-term
interest rate to be higher than current long-term rates.
d.
The existence of maturity risk premiums is due to the fact that a change in interest rates has more effect on the
prices of short-term than long-term bonds.
e.
If a 1-year Treasury bond has a yield of 5 percent, if the expected rate of inflation during the coming year is 3
percent, and if the maturity risk and liquidity premiums on 1-year bonds are zero, then the real risk-free rate r*
must be 2 percent.
ANSWER:
e
RATIONALE:
Treasury securities have no default risk and essentially no liquidity risk, so if we assume
away an MRP, then this statement must be true.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
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8. Interest rates on 1-year, 2-year, and 3-year Treasury bills are 5%, 6%, and 7%, respectively. Assume that the pure
expectations theory holds and that the market is in equilibrium. Which of the following statements is most correct?
a.
The maturity risk premium is positive.
b.
Interest rates are expected to rise over the next two years.
c.
The market expects one-year rates to be 5.5% one year from today.
d.
Answers a, b, and c are all correct.
e.
Only answers b and c are correct.
ANSWER:
b
RATIONALE:
r = rRF + DRP + LP + MRP. For Treasury securities, DRP and LP are equal to zero.
Further, the MRP is only appropriate for long-term bonds; since these Treasury securities
are short-term securities, MRP is close to zero. Therefore, statement a is false.
Statement c is false because (5% + x)/2 = 6%, where x equals one-year Treasury rates
one year from today. If you solve this equation you will find that x = 7%, not 5.5%. As a
result, statement b is the only correct statement.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-3 – Comprehension
Business Program-6 – Reflective Thinking
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-a – 5 min.
TOPICS:
Expectations Theory
9. If the Federal Reserve sells $50 billion of short-term U.S. Treasury securities to the public, other things held constant,
what will this tend to do to short-term security prices and interest rates?
a.
Prices and interest rates will both rise.
b.
Prices will rise and interest rates will decline.
c.
Prices and interest rates will both decline.
d.
Prices will decline and interest rates will rise.
e.
There will be no changes in either prices or interest rates.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
DISC-FIN-09 – Investments
Time Estimate-a – 5 min.
TOPICS:
Miscellaneous
Principles of Finance, 6e
Besley/Brigham
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10. In a recent year, interest rates on long-term government and corporate bonds were as follows:
T-bond
= 7.72%
A
= 9.64%
AAA
= 8.72%
BBB
= 10.18%
The differences in rates among these issues were caused primarily by
a.
Tax effects.
b.
Default risk differences.
c.
Maturity risk differences.
d.
Inflation differences.
e.
Answers b and d are both correct.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
11. Assume that the current yield curve is upward sloping, or normal. This implies that
a.
Short-term interest rates are more volatile than long-term rates.
b.
Inflation is expected to subside in the future.
c.
The economy is at the peak of a business cycle.
d.
Long-term bonds are a better buy than short-term bonds.
e.
None of the above statements is necessarily implied by the yield curve given.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
12. Which of the following statements is correct?
a.
The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact
that the probability of default is higher on long-term bonds than on short-term bonds.
b.
Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
c.
According to the market segmentation theory of the term structure of interest rates, we should normally expect
the yield curve to slope downward.
d.
The expectations theory of the term structure of interest rates states that borrowers generally prefer to borrow
on a long-term basis while savers generally prefer to lend on a short-term basis, and that as a result, the yield
Principles of Finance, 6e
Besley/Brigham
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curve normally is upward sloping.
e.
If the maturity risk premium was zero and the rate of inflation was expected to decrease in the future, then the
yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
13. Which of the following statements is correct?
a.
If different markets existed for long-term and short-term bonds, but lenders and borrowers could move freely
between markets, (1) the market segmentation theory could not really be an important determinant of the yield
curve, and (2) maturity risk premiums could not be significant.
b.
Because the default risk premium (DRP) and the liquidity premium (LP) are both essentially zero for U.S.
Treasury securities, the Treasury yield curve is influenced more heavily by expected inflation than corporate
bonds’ yield curves, i.e., we can be sure that a given amount of expected inflation will have more effect on the
slope of the Treasury yield curve than on the corporate yield curve.
c.
According to the market segmentation theory, investors prefer to buy debt with short maturities. Therefore, the
fundamental conclusion from this theory is that the yield curve normally should slope upwards.
d.
It is theoretically possible for the yield curve to have a downward slope, and there have been times when such
a slope existed. That situation was probably caused by investors’ liquidity preferences, i.e., by the factors
which underlie the liquidity preference theory.
e.
Yield curves for government and corporate bonds can be constructed from data that exist in the marketplace. If
the yield curves for several companies were plotted on a graph, along with the yield curve for U.S. Treasury
securities, the company with the largest total of DRP plus LP would have the highest yield curve.
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS:
14. Treasury securities that mature in 6 years currently have an interest rate of 8.5%. Inflation is expected to be 5% each
of the next three years and 6% each year after the third year. The maturity risk premium is estimated to be 0.1%(t − 1),
where t is equal to the maturity of the bond (i.e., the maturity risk premium of a one-year bond is zero). The real risk-free
rate is assumed to be constant over time. What is the real risk-free rate of interest?
a.
0.25%
b.
0.50%
Principles of Finance, 6e
Besley/Brigham
Chapter 05
c.
1.00%
d.
1.75%
e.
2.50%
ANSWER:
e
RATIONALE:
IP6
= [5%(3) + 6%(3)]/6 = 5.5%.
MRP
= 0.1%(t − 1) = 0.1%(5) = 0.5%.
rRF
= r* + MRP + IP
8.5%
= r* + 0.5% + 5.5%
r*
= 2.5%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-b – 10 min.
TOPICS:
Real Risk-Free Rate of Interest
15. Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero. If the annual rate of
interest on a 2-year Treasury bond is 10.5 percent and the rate on a 1-year Treasury bond is 12 percent, what rate of
interest should you expect on a 1-year Treasury bond one year from now?
a.
9.0%
b.
9.5%
c.
10.0%
d.
10.5%
e.
11.0%
ANSWER:
a
RATIONALE:
R2 = (R1 in Year 1 + R1 in Year 2)/2 10.5% = (12% + R1 in Year 2)/2 R1 in Year 2 = 9%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-b – 10 min.
TOPICS:
Expected Interest Rates
16. Given the following data, find the expected rate of inflation during the next year.
r* = real risk-free rate = 3%.
Maturity risk premium on 10-year T-bonds = 2%. It is zero on 1-year bonds, and a linear relationship exists.
Default risk premium on 10-year, A-rated bonds = 1.5%.
Liquidity premium = 0%.
Going interest rate on 1-year T-bonds = 8.5%.
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a.
3.5%
b.
4.5%
c.
5.5%
d.
6.5%
e.
7.5%
ANSWER:
c
RATIONALE:
rNom = r* + IP + DRP + LP + MRP 8.5% = 3% + IP + 0 + 0 + 0 IP = 5.5%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-b – 10 min.
TOPICS:
Inflation Rate
17. Assume that expected rates of inflation over the next 5 years are 4 percent, 7 percent, 10 percent, 8 percent, and 6
percent, respectively. What is the average expected inflation rate over this 5-year period?
a.
6.5%
b.
7.5%
c.
8.0%
d.
6.0%
e.
7.0%
ANSWER:
e
RATIONALE:
IP5 = (4% + 7% + 10% + 8% + 6%)/5 = 7%. Note: The geometric average is 6.981%,
which rounds to 7%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-b – 10 min.
TOPICS:
Average Inflation
18. Suppose that the annual expected rates of inflation over each of the next five years are 5 percent, 6 percent, 9 percent,
13 percent, and 12 percent, respectively. What is the average expected rate of inflation over the 5-year period?
a.
6%
b.
7%
c.
8%
d.
9%
e.
10%
ANSWER:
d
Principles of Finance, 6e
Besley/Brigham
Chapter 05
d.
1.00%
e.
1.13%
ANSWER:
e
RATIONALE:
r* = 1.0%. MRP = 0.2%(10 − 1) = 1.8%. DRP = 0.07%(9) = 0.63%. LP = 0.5%.
rit = r* + IPt + DRPt + LPt + MRPt.
rATT
= 1.0% + 4.6% + 0.63% + 0.5% + 1.8%
=
8.53%
rT-Bond
= 1.0% + 4.6% + 0% + 0% + 1.8% =
7.40
Difference
1.13%
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-b – 10 min.
TOPICS:
Expected Interest Rates
21. You are given the following data:
r* = real risk-free rate
= 4%
Constant inflation premium
= 7%
Maturity risk premium
= 1%
Default risk premium for AAA bonds
= 3%
Liquidity premium for long-term T-bonds
= 2%
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation is a constant.
Given these conditions, the nominal risk-free rate for T-bills is ____, and the rate on long-term Treasury bonds is ____.
a.
4%; 14%
b.
4%; 15%
c.
11%; 14%
d.
11%; 15%
e.
11%; 17%
ANSWER:
c
RATIONALE:
Nominal risk-free rate: rRF = r* + IP = 4% + 7% = 11%. T-bond rate: rRF = r* + IP + DRP +
LP + MRP = 4% + 7% + 0% + 2% + 1% = 14%. Note that there is no default premium on
a Treasury security.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Principles of Finance, 6e
Besley/Brigham
Chapter 05
Type of security
Yield
1-year
4.5%
2-year
4.6
3-year
4.8
4-year
5.0
What is the one-year nominal interest rate and the inflation premium that is expected in Year 4?
a.
5.0%; 2.0%
b.
4.5%; 1.5%
c.
3.0%; 1.8%
d.
5.6%; 2.6%
e.
There is not enough information to answer this question.
ANSWER:
d
RATIONALE:
4 S = 2.0% × 4 = 8.0% t = 1 3 S = 1.8% × 3 = 5.4% t = 1 IP4 = 2.6% First, note that the
nominal 1-year rate for Year 4 is r4 = 3% + IP4. We know that the average IP for the four
years is 2.0% = 5.0% − 3.0%. We also know that the average IP for the first three years
is 1.8%. Thus, the difference between cumulative IP in Year 4, or IP1 + IP2 + IP1 + IP4,
and the cumulative IP in Year 3 represents the inflation premium for Year 4.
Consequently, r4 = 3.0% + 2.6% = 5.6%.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-04 – International Financial Management
DISC-FIN-09 – Investments
Time Estimate-b – 10 min.
TOPICS:
Interest Rate Forecast
28. What is the yield on a one-year corporate bond with a $1,000 face value that pays a 12% annual dividend if it was
purchased for $950 and held until maturity?
a.
12.0%
b.
12.6%
c.
17.0%
d.
17.9%
ANSWER:
POINTS:
DIFFICULTY:
ACCREDITING STANDARDS:
TOPICS: