Chapter 06: Interest Rates
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The difficulty of these questions as seen by students will depend on (1) what was discussed in class and (2) how long
students have to answer the questions. If time is not an issue, then many of the questions could be classified as EASY, but
under exam conditions with time pressure, many might be regarded as being CHALLENGING. So, consider the amount of
time students have when selecting questions for an exam.
Note that there is some overlap between the True/False and the multiple choice questions, as some T/F statements are
used in the MC questions.
1. One of the four most fundamental factors that affect the cost of money as discussed in the text is the current state of the
weather. If the weather is dark and stormy, the cost of money will be higher than if it is bright and sunny, other things held
constant.
a. True
b. False
2. One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of
inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held
constant.
a. True
b. False
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3. 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
4. One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for
consumption. The higher the time preference, the lower the cost of money, other things held constant.
a. True
b. False
5. The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences
for consumption, (3) risk, and (4) inflation.
a. True
b. False
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b. False
9. During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when
inflation is declining.
a. True
b. False
10. If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond
should be equal to the real risk-free rate, r*.
a. True
b. False
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16. Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure
the yield curve and find a downward slope, you must have done something wrong.
a. True
b. False
17. If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would
be higher than that on a 1-year T-bill.
a. True
b. False
18. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to
decline in the future.
a. True
b. False
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21. Suppose the federal deficit increased sharply from one year to the next, and the Federal Reserve kept the money
supply constant. Other things held constant, we would expect to see interest rates decline.
a. True
b. False
22. 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
23. One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability of
production opportunities and their expected rates of return. If production opportunities are relatively good, then interest
rates will tend to be relatively high, other things held constant.
a. True
b. False
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30. 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.
31. If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond
compare to that on a 1-year T-bill?
a. The yield on a 10-year bond would be less than that on a 1-year bill.
b. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk
premium.
c. It is impossible to tell without knowing the coupon rates of the bonds.
d. The yields on the two securities would be equal.
e. It is impossible to tell without knowing the relative risks of the two securities.
32. Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3%
next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information,
which of the following statements is CORRECT?
a. The yield curve for U.S. Treasury securities will be upward sloping.
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b. A 5-year corporate bond must have a lower yield than a 5-year Treasury security.
c. A 5-year corporate bond must have a lower yield than a 7-year Treasury security.
d. The real risk-free rate cannot be constant if inflation is not expected to remain constant.
e. This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.
33. Which of the following statements is CORRECT?
a. If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping.
b. If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat.
c. If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the
Treasury bond yield curve must be upward sloping.
d. If the expectations theory holds, the Treasury bond yield curve will never be downward sloping.
e. 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.
34. A bond trader observes the following information:
The Treasury yield curve is downward sloping.
Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.
Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity
premium is built into corporate bond yields.
On the basis of this information, which of the following statements is most CORRECT?
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a. A 10-year corporate bond must have a higher yield than a 5-year Treasury bond.
b. A 10-year Treasury bond must have a higher yield than a 10-year corporate bond.
c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.
d. The corporate yield curve must be flat.
e. Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping.
35. The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next
2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases
with years to maturity. Given these conditions, which of the following statements is CORRECT?
a. The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
b. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
c. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
d. The conditions in the problem cannot all be true—they are internally inconsistent.
e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or
negative slope.
36. Which of the following statements is CORRECT?
