Chapter 6: Interest Rates True/False Page 197
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
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 HARD. So, consider the amount of time students have when
selecting questions for an exam.
Note that there is some overlap between the T/F and the multiple choice questions, as
some T/F statements are used in the MC questions. See the preface for information on the
AACSB letter indicators (F, M, etc.) on the subject lines.
Multiple Choice: True/False
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
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
CHAPTER 6
INTEREST RATES
Page 198 True/False Chapter 6: Interest Rates
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
6. The four most fundamental factors that affect the cost of money are (1)
production opportunities, (2) time preferences for consumption, (3)
risk, and (4) weather conditions.
a. True
b. False
7. The four most fundamental factors that affect the cost of money are (1)
production opportunities, (2) time preferences for consumption, (3)
risk, and (4) the skill level of the economy’s labor force.
a. True
b. False
8. If the demand curve for funds increased but the supply curve remained
constant, we would expect to see the total amount of funds supplied and
demanded increase and interest rates in general also increase.
a. True
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
Chapter 6: Interest Rates True/False Page 199
11. If investors expect the rate of inflation to increase sharply in the
future, then we should not be surprised to see an upward-sloping yield
curve.
a. True
b. False
12. The risk that interest rates will increase, and that increase will lead
to a decline in the prices of outstanding bonds, is called “interest
rate risk,” or “price risk.”
a. True
b. False
13. The risk that interest rates will decline, and that decline will lead
to a decline in the income provided by a bond portfolio as interest and
maturity payments are reinvested, is called “reinvestment rate risk.”
a. True
b. False
14. The “yield curve” shows the relationship between bonds’ maturities and
their yields.
a. True
b. False
15. Because the maturity risk premium is normally positive, the yield curve
is normally upward sloping.
a. True
b. False
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
Page 200 True/False Chapter 6: Interest Rates
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. Fals
Chapter 6: Interest Rates Conceptual M/C Page 201
19. An upward-sloping yield curve is often call a “normal” yield curve,
while a downward-sloping yield curve is called “abnormal.”
a. True
b. False
20. Since yield curves are based on a real risk-free rate plus the expected
rate of inflation, at any given time there can be only one yield curve,
and it applies to both corporate and Treasury securities.
a. True
b. False
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
Multiple Choice: Conceptual
24. Assume that inflation is expected to decline steadily in the future,
but that the real risk-free rate, r*, will remain constant. Which of
the following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve must
be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve
must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield
curve must be upward sloping.
Page 202 Conceptual M/C Chapter 6: Interest Rates
d. If inflation is expected to decline, there can be no maturity risk
premium.
e. The expectations theory cannot hold if inflation is decreasing.
25. Which of the following factors would be most likely to lead to an
increase in nominal interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the Internet has just been introduced, and it
increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
e. The Federal Reserve decides to try to stimulate the economy.
26. Which of the following statements is CORRECT, other things held
constant?
a. If companies have fewer good investment opportunities, interest
rates are likely to increase.
b. If individuals increase their savings rate, interest rates are
likely to increase.
c. If expected inflation increases, interest rates are likely to
increase.
d. Interest rates on all debt securities tend to rise during recessions
because recessions increase the possibility of bankruptcy, hence the
riskiness of all debt securities.
e. Interest rates on long-term bonds are more volatile than rates on
short-term debt securities like T-bills.
27. Which of the following would be most likely to lead to a higher level
of interest rates in the economy?
a. Households start saving a larger percentage of their income.
b. Corporations step up their expansion plans and thus increase their
demand for capital.
c. The level of inflation begins to decline.
d. The economy moves from a boom to a recession.
e. The Federal Reserve decides to try to stimulate the economy.
28. 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.
Chapter 6: Interest Rates Conceptual M/C Page 203
d. The yield curve must be “humped.”
e. The yield curve must be upward sloping.
29. 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.
30. 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.
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.
31. 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.
Page 204 Conceptual M/C Chapter 6: Interest Rates
32. 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?
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.
33. 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.
34. 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 yield on a 2-year corporate bond should always exceed the yield
on a 2-year Treasury bond.
c. The yield on a 3-year corporate bond should always exceed the yield
on a 2-year corporate bond.
d. The yield on a 10-year AAA-rated corporate bond should always exceed
the yield on a 5-year AAA-rated corporate bond.
e. The following represents a “possibly reasonable” formula for the
maturity risk premium on bonds: MRP = -0.1%(t), where t is the
years to maturity.
Chapter 6: Interest Rates Conceptual M/C Page 205
35. Which of the following statements is CORRECT?
a. The yield on a 2-year corporate bond should always exceed the yield
on a 2-year Treasury bond.
b. The yield on a 3-year corporate bond should always exceed the yield
on a 2-year corporate bond.
c. The yield on a 3-year Treasury bond should always exceed the yield
on a 2-year Treasury bond.
d. If inflation is expected to increase, then the yield on a 2-year
bond should exceed that on a 3-year bond.
e. The real risk-free rate should increase if people expect inflation
to increase.
36. Which of the following statements is CORRECT?
a. If inflation is expected to increase in the future, and if the
maturity risk premium (MRP) is greater than zero, then the Treasury
yield curve will have an upward slope.
b. If the maturity risk premium (MRP) is greater than zero, then the
yield curve must have an upward slope.
c. 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.
d. If the maturity risk premium (MRP) equals zero, the yield curve must
be flat.
e. The yield curve can never be downward sloping.
37. Assume that the current corporate bond yield curve is upward sloping.
Under this condition, then we could be sure that
a. Inflation is expected to decline in the future.
b. The economy is not in a recession.
c. Long-term bonds are a better buy than short-term bonds.
d. Maturity risk premiums could help to explain the yield curve’s upward
slope.
e. Long-term interest rates are more volatile than short-term rates.
38. Which of the following statements is CORRECT?
a. The higher the maturity risk premium, the higher the probability that
the yield curve will be inverted.
b. The most likely explanation for an inverted yield curve is that
investors expect inflation to increase.
c. The most likely explanation for an inverted yield curve is that
investors expect inflation to decrease.
d. If the yield curve is inverted, short-term bonds have lower yields
than long-term bonds.
e. Inverted yield curves can exist for Treasury bonds, but because of
default premiums, the corporate yield curve can never be inverted.
Page 206 Conceptual M/C Chapter 6: Interest Rates
39. Assume that interest rates on 20-year Treasury and corporate bonds are
as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
40. Assume that the current corporate bond yield curve is upward sloping,
or normal. Under this condition, we could be sure that
a. Long-term interest rates are more volatile than short-term rates.
b. Inflation is expected to decline in the future.
c. The economy is not in a recession.
d. Long-term bonds are a better buy than short-term bonds.
e. Maturity risk premiums could help to explain the yield curve’s
upward slope.
41. Assuming that the term structure of interest rates is determined as
posited by the pure expectations theory, which of the following
statements is CORRECT?
a. In equilibrium, long-term rates must be equal to short–term rates.
b. An upward-sloping yield curve implies that future short-term rates
are expected to decline.
c. The maturity risk premium is assumed to be zero.
d. Inflation is expected to be zero.
e. Consumer prices as measured by an index of inflation are expected to
rise at a constant rate.
42. Assume that the rate on a 1-year bond is now 6%, but all investors
expect 1-year rates to be 7% one year from now and then to rise to 8%
two years from now. Assume also that the pure expectations theory
holds, hence the maturity risk premium equals zero. Which of the
following statements is CORRECT?
a. The yield curve should be downward sloping, with the rate on a 1–
year bond at 6%.
b. The interest rate today on a 2-year bond should be approximately 6%.
c. The interest rate today on a 2-year bond should be approximately 7%.
d. The interest rate today on a 3-year bond should be approximately 7%.
e. The interest rate today on a 3-year bond should be approximately 8%.
Chapter 6: Interest Rates Conceptual M/C Page 207
43. The real risk-free rate of interest is expected to remain constant at
3% for the foreseeable future. However, inflation is expected to
increase steadily over the next 30 years, so the Treasury yield curve
has an upward slope. Assume that the pure expectations theory holds.
You are also considering two corporate bonds, one with a 5-year
maturity and one with a 10-year maturity. Both have the same default
and liquidity risks. Given these assumptions, which of these
statements is CORRECT?
a. Since the pure expectations theory holds, the 10-year corporate bond
must have the same yield as the 5-year corporate bond.
b. Since the pure expectations theory holds, all 5-year Treasury bonds
must have higher yields than all 10-year Treasury bonds.
c. Since the pure expectations theory holds, all 10-year corporate
bonds must have the same yield as 10-year Treasury bonds.
d. The 10-year Treasury bond must have a higher yield than the 5-year
corporate bond.
e. The 10-year corporate bond must have a higher yield than the 5-year
corporate bond.
44. If the pure expectations theory of the term structure is correct, which
of the following statements would be CORRECT?
a. An upward-sloping yield curve would imply that interest rates are
expected to be lower in the future.
b. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year
Treasury bill has a yield to maturity of 8%, this would imply the
market believes that 1-year rates will be 7.5% one year from now.
c. The yield on a 5-year corporate bond should always exceed the yield
on a 3-year Treasury bond.
d. Interest rate (price) risk is higher on long-term bonds, but
reinvestment rate risk is higher on short-term bonds.
e. Interest rate (price) risk is higher on short-term bonds, but
reinvestment rate risk is higher on long-term bonds.
45. Assuming the pure expectations theory is correct, which of the
following statements is CORRECT?
a. If 2-year Treasury bond rates exceed 1-year rates, then the market
must expect interest rates to rise.
b. If both 2-year and 3-year Treasury rates are 7%, then 5-year rates
must also be 7%.
c. If 1-year rates are 6% and 2-year rates are 7%, then the market
expects 1-year rates to be 6.5% in one year.
d. Reinvestment rate risk is higher on long-term bonds, and interest
rate (price) risk is higher on short-term bonds.
e. Interest rate (price) risk and reinvestment rate risk are relevant
to investors in corporate bonds, but these concepts do not apply to
Treasury bonds.
Page 208 Conceptual M/C Chapter 6: Interest Rates
46. If the pure expectations theory holds, which of the following
statements is CORRECT?
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.
47. 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.
48. 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. 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.
Chapter 6: Interest Rates Conceptual M/C Page 209
49. 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.
50. 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.
51. 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.
Page 210 Conceptual M/C Chapter 6: Interest Rates
52. 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.
53. Short Corp just issued bonds that will mature in 10 years, and Long
Corp issued bonds that will mature in 20 years. Both bonds promise to
pay a semiannual coupon, they are not callable or convertible, and they
are equally liquid. Further assume that the Treasury yield curve is
based only on the pure expectations theory. Under these conditions,
which of the following statements is CORRECT?
a. If the yield curve for Treasury securities is flat, Short’s bond
must under all conditions have the same yield as Long’s bonds.
b. If the yield curve for Treasury securities is upward sloping, Long’s
bonds must under all conditions have a higher yield than Short’s
bonds.
c. If Long’s and Short’s bonds have the same default risk, their yields
must under all conditions be equal.
d. If the Treasury yield curve is upward sloping and Short has less
default risk than Long, then Short’s bonds must under all conditions
have a lower yield than Long’s bonds.
e. If the Treasury yield curve is downward sloping, Long’s bonds must
under all conditions have the lower yield.
54. Suppose the U.S. Treasury issued $50 billion of short-term securities
and sold them to the public. Other things held constant, what would be
the most likely effect on short-term securities’ prices and interest
rates?
a. Prices and interest rates would both rise.
b. Prices would rise and interest rates would decline.
c. Prices and interest rates would both decline.
d. Prices would decline and interest rates would rise.
e. There is no reason to expect a change in either prices or interest
rates.
Chapter 6: Interest Rates M/C Problems Page 211
Multiple Choice: Problems
Interest rates are important in finance, and it is important for all students to understand the
basics of how they are determined. However, the chapter really has two aspects that become
clear when we try to write test questions and problems for the chapter. First, the material on the
fundamental determinants of interest rates—the real risk-free rate plus a set of premiums—is
logical and intuitive, and easy in a testing sense. However, the second set of material, that
dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is
more mathematical and less intuitive, and test questions dealing with it tend to be more difficult,
especially for students who are not good at math.
As a result, problems on the chapter tend to be either relatively easy or relatively
difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank
for prior editions, we tended to use primarily difficult 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)]0.5 – 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 3.20% 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. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%