Chapter 3
What Do Interest Rates Mean and What Is Their
Role in Valuation?
◼ Multiple Choice Questions
1. A loan that requires the borrower to make the same payment every period until the maturity date is
called a
(a) simple loan.
(b) fixed-payment loan.
(c) discount loan.
(d) same-payment loan.
(e) none of the above.
2. A coupon bond pays the owner of the bond
(a) the same amount every month until maturity date.
(b) a fixed interest payment every period and repays the face value at the maturity date.
(c) the face value of the bond plus an interest payment once the maturity date has been reached.
(d) the face value at the maturity date.
(e) none of the above.
3. A bond’s future payments are called its
(a) cash flows.
(b) maturity values.
(c) discounted present values.
(d) yields to maturity.
4. A credit market instrument that pays the owner the face value of the security at the maturity date
and nothing prior to then is called a
(a) simple loan.
(b) fixed-payment loan.
(c) coupon bond.
(d) discount bond.
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 21
5. (I) A simple loan requires the borrower to repay the principal at the maturity date along with an
interest payment. (II) A discount bond is bought at a price below its face value, and the face value is
repaid at the maturity date.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
6. Which of the following are true of coupon bonds?
(a) The owner of a coupon bond receives a fixed interest payment every year until the maturity
date, when the face or par value is repaid.
(b) U.S. Treasury bonds and notes are examples of coupon bonds.
(c) Corporate bonds are examples of coupon bonds.
(d) All of the above.
(e) Only (a) and (b) of the above.
7. Which of the following are generally true of all bonds?
(a) The longer a bond’s maturity, the lower is the rate of return that occurs as a result of the
increase in an interest rate.
(b) Even though a bond has a substantial initial interest rate, its return can turn out to be negative if
interest rates rise.
(c) Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
8. (I) A discount bond requires the borrower to repay the principal at the maturity date plus an interest
payment. (II) A coupon bond pays the lender a fixed interest payment every year until the maturity
date, when a specified final amount (face or par value) is repaid.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
9. If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year is
(a) $650.
(b) $1,300.
(c) $130.
(d) $13.
(e) None of the above.
22 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
10. An $8,000 coupon bond with a $400 annual coupon payment has a coupon rate of
(a) 5 percent.
(b) 8 percent.
(c) 10 percent.
(d) 40 percent.
11. The concept of _________ is based on the common-sense notion that a dollar paid to you in the
future is less valuable to you than a dollar today.
(a) present value
(b) future value
(c) interest
(d) deflation
12. Dollars received in the future are worth _________ than dollars received today. The process of
calculating what dollars received in the future are worth today is called _________
(a) more; discounting.
(b) less; discounting.
(c) more; inflating.
(d) less; inflating.
13. The process of calculating what dollars received in the future are worth today is called
(a) calculating the yield to maturity.
(b) discounting the future.
(c) compounding the future.
(d) compounding the present.
14. With an interest rate of 5 percent, the present value of $100 received one year from now is
approximately
(a) $100.
(b) $105.
(c) $95.
(d) $90.
15. With an interest rate of 10 percent, the present value of a security that pays $1,100 next year and
$1,460 four years from now is approximately
(a) $1,000.
(b) $2,000
(c) $2,560.
(d) $3,000.
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 23
16. With an interest rate of 8 percent, the present value of $100 received one year from now is
approximately
(a) $93.
(b) $96.
(c) $100.
(d) $108.
17. With an interest rate of 6 percent, the present value of $100 received one year from now is
approximately
(a) $106.
(b) $100.
(c) $94.
(d) $92.
18. The interest rate that equates the present value of the cash flow received from a debt instrument with
its market price today is the
(a) simple interest rate.
(b) discount rate.
(c) yield to maturity.
(d) real interest rate.
19. The interest rate that financial economists consider to be the most accurate measure is the
(a) current yield.
(b) yield to maturity.
(c) yield on a discount basis.
(d) coupon rate.
20. Financial economists consider the _________ to be the most accurate measure of interest rates.
(a) simple interest rate
(b) discount rate
(c) yield to maturity
(d) real interest rate
21. For a simple loan, the simple interest rate equals the
(a) real interest rate.
(b) nominal interest rate.
(c) current yield.
(d) yield to maturity.
24 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
22. For simple loans, the simple interest rate is _________ the yield to maturity.
(a) greater than
(b) less than
(c) equal to
(d) not comparable to
23. The yield to maturity of a one-year, simple loan of $500 that requires an interest payment of $40 is
(a) 5 percent.
(b) 8 percent.
(c) 12 percent.
(d) 12.5 percent.
24. The yield to maturity of a one-year, simple loan of $400 that requires an interest payment of $50 is
(a) 5 percent.
(b) 8 percent.
(c) 12 percent.
(d) 12.5 percent.
25. A $10,000, 8 percent coupon bond that sells for $10,000 has a yield to maturity of
(a) 8 percent.
(b) 10 percent.
(c) 12 percent.
(d) 14 percent.
26. Which of the following $1,000 face value securities has the highest yield to maturity?
(a) A 5 percent coupon bond selling for $1,000
(b) A 10 percent coupon bond selling for $1,000
(c) A 12 percent coupon bond selling for $1,000
(d) A 12 percent coupon bond selling for $1,100
27. Which of the following $1,000 face value securities has the highest yield to maturity?
(a) A 5 percent coupon bond selling for $1,000
(b) A 10 percent coupon bond selling for $1,000
(c) A 15 percent coupon bond selling for $1,000
(d) A 15 percent coupon bond selling for $900
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 25
28. Which of the following are true for a coupon bond?
(a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
(b) The price of a coupon bond and the yield to maturity are negatively related.
(c) The yield to maturity is greater than the coupon rate when the bond price is below the par value.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
29. Which of the following are true for a coupon bond?
(a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
(b) The price of a coupon bond and the yield to maturity are negatively related.
(c) The yield to maturity is greater than the coupon rate when the bond price is above the par value.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
30. Which of the following are true for a coupon bond?
(a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
(b) The price of a coupon bond and the yield to maturity are positively related.
(c) The yield to maturity is greater than the coupon rate when the bond price is above the par value.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
31. A consol bond is a bond that
(a) pays interest annually and its face value at maturity.
(b) pays interest in perpetuity and never matures.
(c) pays no interest but pays face value at maturity.
(d) rises in value as its yield to maturity rises.
32. The yield to maturity on a consol bond that pays $100 yearly and sells for $500 is
(a) 5 percent.
(b) 10 percent.
(c) 12.5 percent.
(d) 20 percent.
(e) 25 percent.
33. The yield to maturity on a consol bond that pays $200 yearly and sells for $1000 is
(a) 5 percent.
(b) 10 percent.
(c) 20 percent.
(d) 25 percent.
26 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
34. A frequently used approximation for the yield to maturity on a long-term bond is the
(a) coupon rate.
(b) current yield.
(c) cash flow interest rate.
(d) real interest rate.
35. The current yield on a coupon bond is the bond’s _________ divided by its _________.
(a) annual coupon payment; price
(b) annual coupon payment; face value
(c) annual return; price
(d) annual return; face value
36. When a bond’s price falls, its yield to maturity _________ and its current yield _________.
(a) falls; falls
(b) rises; rises
(c) falls; rises
(d) rises; falls
37. The yield to maturity for a one-year discount bond equals
(a) the increase in price over the year, divided by the initial price.
(b) the increase in price over the year, divided by the face value.
(c) the increase in price over the year, divided by the interest rate.
(d) none of the above.
38. If a $10,000 face value discount bond maturing in one year is selling for $8,000, then its yield to
maturity is
(a) 10 percent.
(b) 20 percent.
(c) 25 percent.
(d) 40 percent.
39. If a $10,000 face value discount bond maturing in one year is selling for $9,000, then its yield to
maturity is
(a) 9 percent.
(b) 10 percent.
(c) 11 percent.
(d) 12 percent.
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 27
40. If a $10,000 face value discount bond maturing in one year is selling for $5,000, then its yield to
maturity is
(a) 5 percent.
(b) 10 percent.
(c) 50 percent.
(d) 100 percent.
41. If a $5,000 face value discount bond maturing in one year is selling for $5,000, then its yield to
maturity is
(a) 0 percent.
(b) 5 percent.
(c) 10 percent.
(d) 20 percent.
42. The Fisher equation states that
(a) the nominal interest rate equals the real interest rate plus the expected rate of inflation.
(b) the real interest rate equals the nominal interest rate less the expected rate of inflation.
(c) the nominal interest rate equals the real interest rate less the expected rate of inflation.
(d) both (a) and (b) of the above are true.
(e) both (a) and (c) of the above are true.
43. If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to maturity
of 7 percent, then the real interest rate on this bond is
(a) 7 percent.
(b) 22 percent.
(c) –15 percent.
(d) –8 percent.
(e) none of the above.
44. If you expect the inflation rate to be 5 percent next year and a one-year bond has a yield to maturity
of 7 percent, then the real interest rate on this bond is
(a) –12 percent.
(b) –2 percent.
(c) 2 percent.
(d) 12 percent.
28 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
45. The nominal interest rate minus the expected rate of inflation
(a) defines the real interest rate.
(b) is a better measure of the incentives to borrow and lend than is the nominal interest rate.
(c) is a more accurate indicator of the tightness of credit market conditions than is the nominal
interest rate.
(d) all of the above.
(e) only (a) and (b) of the above.
46. The nominal interest rate minus the expected rate of inflation
(a) defines the real interest rate.
(b) is a less accurate measure of the incentives to borrow and lend than is the nominal interest rate.
(c) is a less accurate indicator of the tightness of credit market conditions than is the nominal
interest rate.
(d) defines the discount rate.
47. In which of the following situations would you prefer to be making a loan?
(a) The interest rate is 9 percent and the expected inflation rate is 7 percent.
(b) The interest rate is 4 percent and the expected inflation rate is 1 percent.
(c) The interest rate is 13 percent and the expected inflation rate is 15 percent.
(d) The interest rate is 25 percent and the expected inflation rate is 50 percent.
48. In which of the following situations would you prefer to be borrowing?
(a) The interest rate is 9 percent and the expected inflation rate is 7 percent.
(b) The interest rate is 4 percent and the expected inflation rate is 1 percent.
(c) The interest rate is 13 percent and the expected inflation rate is 15 percent.
(d) The interest rate is 25 percent and the expected inflation rate is 50 percent.
49. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,200 one
year later?
(a) 5 percent
(b) 10 percent
(c) –5 percent
(d) 25 percent
(e) None of the above
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 29
50. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $900 one
year later?
(a) 5 percent
(b) 10 percent
(c) –5 percent
(d) –10 percent
(e) None of the above
51. The return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,100 one year
later is
(a) 5 percent.
(b) 10 percent.
(c) 14 percent.
(d) 15 percent.
52. The return on a 10 percent coupon bond that initially sells for $1,000 and sells for $900 one year
later is
(a) –10 percent.
(b) –5 percent.
(c) 0 percent.
(d) 5 percent.
53. Which of the following are generally true of all bonds?
(a) The only bond whose return equals the initial yield to maturity is one whose time to maturity is
the same as the holding period.
(b) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on
bonds whose term to maturities are longer than the holding period.
(c) The longer a bond’s maturity, the greater is the price change associated with a given interest rate
change.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
54. Which of the following are true concerning the distinction between interest rates and return?
(a) The rate of return on a bond will not necessarily equal the interest rate on that bond.
(b) The return can be expressed as the sum of the current yield and the rate of capital gains.
(c) The rate of return will be greater than the interest rate when the price of the bond falls between
time t and time t + 1.
(d) All of the above are true.
(e) Only (a) and (b) of the above are true.
30 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
55. If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond
would you prefer to have been holding?
(a) A bond with one year to maturity
(b) A bond with five years to maturity
(c) A bond with ten years to maturity
(d) A bond with twenty years to maturity
56. Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to maturity of
15 percent. If the interest rate on one-year bonds rises from 15 percent to 20 percent over the course
of the year, what is the yearly return on the bond you are holding?
(a) 5 percent
(b) 10 percent
(c) 15 percent
(d) 20 percent
57. (I) Prices of longer-maturity bonds respond more dramatically to changes in interest rates. (II) Prices
and returns for long-term bonds are less volatile than those for short-term bonds.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
58. (I) Prices of longer-maturity bonds respond less dramatically to changes in interest rates. (II) Prices
and returns for long-term bonds are less volatile than those for shorter-term bonds.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
59. The riskiness of an asset’s return that results from interest rate changes is called
(a) interest-rate risk.
(b) coupon-rate risk.
(c) reinvestment risk.
(d) yield-to-maturity risk.
60. If an investor’s holding period is longer than the term to maturity of a bond, he or she is exposed to
(a) interest-rate risk.
(b) reinvestment risk.
(c) bond-market risk.
(d) yield-to-maturity risk.
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 31
61. Reinvestment risk is the risk that
(a) a bond’s value may fall in the future.
(b) a bond’s future coupon payments may have to be invested at a rate lower than the bond’s yield
to maturity.
(c) an investor’s holding period will be short and equal in length to the maturity of the bonds he or
she holds.
(d) a bond’s issuer may fail to make the future coupon payments and an investor will have no cash
to reinvest.
62. (I) The average lifetime of a debt security’s stream of payments is called duration. (II) The duration
of a portfolio is the weighted average of the durations of the individual securities, with the weights
reflecting the proportion of the portfolio invested in each.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
63. The duration of a ten-year, 10 percent coupon bond when the interest rate is 10 percent is 6.76 years.
What happens to the price of the bond if the interest rate falls to 8 percent?
(a) it rises 20 percent
(b) it rises 12.3 percent
(c) it falls 20 percent
(d) it falls 12.3 percent
32 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ True/False
1. A bond’s current market value is equal to the present value of the coupon payments plus the present
value of the face amount.
2. Discounting the future is the procedure used to find the future value of a dollar received today.
3. The current yield is the best measure of an investor’s return from holding a bond.
4. Unless a bond defaults, an investor cannot lose money investing in bonds.
5. The current yield is the yearly coupon payment divided by the current market price.
6. Prices for long-term bonds are more volatile than for shorter-term bonds.
7. A long-term bond’s price is less affected by interest rate movements than is a short–term bond’s
price.
8. Increasing duration implies that interest-rate risk has increased.
9. All else being equal, the greater the interest rate the greater is the duration.
10. Interest-rate risk is the uncertainty that an investor faces because the interest rate at which a bond’s
future coupon payments can be invested is unknown.
11. The real interest rate is equal to the nominal rate minus inflation.
12. The current yield goes up as the price of a bond falls.
Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation? 33
◼ Essay
1. Distinguish between coupon rate, yield to maturity, and current yield.
2. Describe the cash flows received from owning a coupon bond.
3. What concept is used to value a bond?
4. How is a bond’s current yield calculated? Why is current yield a more accurate approximation of
yield to maturity for a long-term bond than for a short-term bond?
5. Why are long-term bonds more risky than short-term bonds?
6. What is interest-rate risk and how is it measured?
7. Why may a bond’s rate of return differ from its yield to maturity?
8. How does reinvestment risk differ from interest-rate risk?
9. What is the distinction between the nominal interest rate and the real interest rate? Which is a better
indicator of incentives to borrow and lend? Why?
10. Describe how Treasury Inflation Protection Securities (TIPS) work and how they help policymakers
estimate expected inflation.