Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 21
a. The yield curve for both Treasury and corporate bonds should be flat.
b. The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be
downward sloping.
c. The yield curve for Treasury securities cannot be downward sloping.
d. The maturity risk premium would be zero.
e. If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end
up with more money if he or she bought 2-year bonds.
48. Which of the following statements is CORRECT?
a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.
b. The real risk-free rate is higher for corporate than for Treasury bonds.
c. Most evidence suggests that the maturity risk premium is zero.
d. Liquidity premiums are higher for Treasury than for corporate bonds.
e. The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero and that
differences in interest rates across different Treasury maturities are driven by expectations about future interest rates.
49. 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.
Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 22
c. The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long-term
basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward
sloping.
d. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield
curve for U.S. Treasury securities would, other things held constant, have an upward slope.
e. Liquidity premiums are generally higher on Treasury than on corporate bonds.
50. If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is
CORRECT?
a. An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future.
b. A 5-year T-bond would always yield less than a 10-year T-bond.
c. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
d. The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope.
e. If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.
51. Which of the following statements is CORRECT?
a. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve.
b. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.
c. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted.
d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve
cannot become inverted.
e. The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future.
Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 23
52. Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both
Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following
statements is CORRECT?
a. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.
b. The yield on any corporate bond must exceed the yields on all Treasury bonds.
c. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
d. The stated conditions 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.
53. Which of the following statements is CORRECT?
a. Downward sloping yield curves are inconsistent with the expectations theory.
b. The actual shape of the yield curve depends only on expectations about future inflation.
c. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected
to decline in the future.
d. If the yield curve is upward sloping, the maturity risk premium must be positive and the inflation rate must be
zero.
e. Yield curves must be either upward or downward sloping – they cannot first rise and then decline.
Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 25
problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned
more toward easy problems that address intuitive aspects of interest rate theory.
We should note one issue that can be confusing if it is not handled carefully – the use of arithmetic versus geometric
averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why
a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a
geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates
should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using
the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors,
uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In
both the text and test bank problems we make it clear to students which procedure to use.
Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to
keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems.
The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and
2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the
1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is
correct and thus the maturity risk premium is zero.
55. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 4.70% per year.
What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the
arithmetic average.
a. 2.81%
b. 2.48%
c. 2.23%
d. 2.12%
e. 2.30%
56. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 4.60%. What rate
of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-
product terms, i.e., if averaging is required, use the arithmetic average.
a. 6.08%
b. 10.13%
Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 26
c. 7.70%
d. 8.10%
e. 7.29%
57. Suppose the real risk-free rate is 2.50% and the future rate of inflation is expected to be constant at 2.80%. What rate
of return would you expect on a 5-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-
product terms, i.e., if averaging is required, use the arithmetic average.
a. 5.30%
b. 4.82%
c. 6.25%
d. 5.35%
e. 6.15%
Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 27
58. The real risk-free rate is 3.05%, inflation is expected to be 5.95% this year, and the maturity risk premium is zero.
Ignoring any cross-product terms, i.e., if averaging is required, use the arithmetic average, what is the equilibrium rate of
return on a 1-year Treasury bond?
a. 8.37%
b. 9.00%
c. 8.82%
d. 10.80%
e. 9.09%
59. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 6.60%, and a maturity risk
premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity. What
rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid?
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 8.83%
b. 7.47%
c. 9.12%
d. 9.70%
e. 8.54%
Chapter 06: Interest Rates
Copyright Cengage Learning. Powered by Cognero.
Page 30
d. 1.05%
e. 1.17%
64. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 7.10%. Also, corporate bonds have
a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury
and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?
a. 1.64%
b. 1.55%
c. 1.19%
d. 1.35%
e. 1.38%
