Chapter 6 2 Mc Problems Interest Rates Answers

Page 212 M/C Problems Chapter 6: Interest Rates

56. Suppose the real risk-free rate is 3.50% and the future rate of

inflation is expected to be constant at 2.20%. 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. 5.14%

b. 5.42%

c. 5.70%

d. 5.99%

e. 6.28%

57. Suppose the real risk-free rate is 2.50% and the future rate of

inflation is expected to be constant at 4.10%. 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. 5.38%

b. 5.66%

c. 5.96%

d. 6.27%

e. 6.60%

58. The real risk-free rate is 3.05%, inflation is expected to be 2.75%

this year, and the maturity risk premium is zero. Ignoring any cross–

product terms, what is the equilibrium rate of return on a 1-year

Treasury bond?

a. 5.51%

b. 5.80%

c. 6.09%

d. 6.39%

e. 6.71%

59. Suppose the real risk-free rate is 3.00%, the average expected future

inflation rate is 2.25%, and a maturity risk premium of 0.10% per year

to maturity applies, i.e., MRP = 0.10%(t), where t is the 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. 5.08%

b. 5.35%

c. 5.62%

d. 5.90%

e. 6.19%

Chapter 6: Interest Rates M/C Problems Page 213

60. Suppose the real risk-free rate is 4.20%, the average expected future

inflation rate is 3.10%, and a maturity risk premium of 0.10% per year

to maturity applies, i.e., MRP = 0.10%(t), where t is the years to

maturity, hence the pure expectations theory is NOT valid. What rate

of return would you expect on a 4-year Treasury security? Disregard

cross-product terms, i.e., if averaging is required, use the arithmetic

average.

a. 6.60%

b. 6.95%

c. 7.32%

d. 7.70%

e. 8.09%

61. The real risk-free rate is 3.55%, inflation is expected to be 3.15%

this year, and the maturity risk premium is zero. Taking account of

the cross-product term, i.e., not ignoring it, what is the equilibrium

rate of return on a 1-year Treasury bond?

a. 5.840%

b. 6.148%

c. 6.471%

d. 6.812%

e. 7.152%

62. Suppose the yield on a 10-year T-bond is currently 5.05% and that on a

10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose

further that the MRP on a 10-year T–bond is 0.90%, that no MRP is

required on a TIPS, and that no liquidity premium is required on any

T-bond. Given this information, what is the expected rate of inflation

over the next 10 years? Disregard cross-product terms, i.e., if

averaging is required, use the arithmetic average.

a. 1.81%

b. 1.90%

c. 2.00%

d. 2.10%

e. 2.21%

63. Suppose the rate of return on a 10-year T-bond is 6.55%, the expected

average rate of inflation over the next 10 years is 2.0%, the MRP on a

10-year T-bond is 0.9%, no MRP is required on a TIPS, and no liquidity

premium is required on any Treasury security. Given this information,

what should the yield be on a 10-year TIPS? Disregard cross-product

terms, i.e., if averaging is required, use the arithmetic average.

a. 2.97%

b. 3.13%

c. 3.29%

d. 3.47%

e. 3.65%

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64. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate

bonds yield 6.75%. 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. 1.08%

b. 1.20%

c. 1.32%

d. 1.45%

e. 1.60%

65. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield

8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and

corporate bonds have a 0.4% liquidity premium versus a zero liquidity

premium for T-bonds, what is the default risk premium on the corporate

bond?

a. 1.90%

b. 2.09%

c. 2.30%

d. 2.53%

e. 2.78%

66. Koy Corporation’s 5-year bonds yield 7.00%, and 5-year T-bonds yield

5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for

5-year bonds is IP = 1.75%, the liquidity premium for Koy’s bonds is LP

= 0.75% versus zero for T-bonds, and the maturity risk premium for all

bonds is found with the formula MRP = (t – 1) × 0.1%, where t = number

of years to maturity. What is the default risk premium (DRP) on Koy’s

bonds?

a. 5.94%

b. 6.60%

c. 7.26%

d. 7.99%

e. 8.78%

67. Keys Corporation’s 5-year bonds yield 6.20% and 5-year T-bonds yield

4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for

5-year bonds is IP = 1.50%, the liquidity premium for Keys‘ bonds is LP =

0.5% versus zero for T-bonds, and the maturity risk premium for all bonds

is found with the formula MRP = (t – 1) × 0.1%, where t = number of years

to maturity. What is the default risk premium (DRP) on Keys’ bonds?

a. 1.17%

b. 1.30%

c. 1.43%

d. 1.57%

e. 1.73%

Chapter 6: Interest Rates M/C Problems Page 215

68. Kay Corporation‘s 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%.

The real risk-free rate is r* = 2.5%, the inflation premium for 5-year

bonds is IP = 1.50%, the default risk premium for Kay‘s bonds is DRP =

1.30% versus zero for T-bonds, and the maturity risk premium for all bonds

is found with the formula MRP = (t – 1) × 0.1%, where t = number of years

to maturity. What is the liquidity premium (LP) on Kay’s bonds?

a. 0.36%

b. 0.41%

c. 0.45%

d. 0.50%

e. 0.55%

69. Niendorf Corporation’s 5-year bonds yield 8.00%, and 5-year T-bonds

yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation

premium for 5-year bonds is IP = 1.65%, the default risk premium for

Niendorf’s bonds is DRP = 1.20% versus zero for T-bonds, and the

maturity risk premium for all bonds is found with the formula MRP =

(t – 1) × 0.1%, where t = number of years to maturity. What is the

liquidity premium (LP) on Niendorf’s bonds?

a. 1.31%

b. 1.46%

c. 1.62%

d. 1.80%

e. 2.00%

70. Kern Corporation’s 5-year bonds yield 7.30% and 5-year T-bonds yield

4.10%. The real risk-free rate is r* = 2.5%, the default risk premium

for Kern’s bonds is DRP = 1.90% versus zero for T-bonds, the liquidity

premium on Kern’s bonds is LP = 1.3%, and the maturity risk premium for

all bonds is found with the formula MRP = (t – 1) × 0.1%, where t =

number of years to maturity. What is the inflation premium (IP) on all

5-year bonds?

a. 1.20%

b. 1.32%

c. 1.45%

d. 1.60%

e. 1.68%

71. Crockett Corporation’s 5-year bonds yield 6.35%, and 5-year T-bonds

yield 4.75%. The real risk-free rate is r* = 3.60%, the default risk

premium for Crockett’s bonds is DRP = 1.00% versus zero for T-bonds,

the liquidity premium on Crockett’s bonds is LP = 0.90% versus zero for

T-bonds, and the maturity risk premium for all bonds is found with the

formula MRP = (t – 1) × 0.1%, where t = number of years to maturity.

What inflation premium (IP) is built into 5-year bond yields?

a. 0.68%

Page 216 M/C Problems Chapter 6: Interest Rates

b. 0.75%

c. 0.83%

d. 0.91%

e. 1.00%

72. Kelly Inc’s 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%.

The real risk-free rate is r* = 2.5%, the default risk premium for

Kelly’s bonds is DRP = 0.40%, the liquidity premium on Kelly’s bonds is

LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is

1.5%. What is the maturity risk premium (MRP) on all 5-year bonds?

a. 0.73%

b. 0.81%

c. 0.90%

d. 0.99%

e. 1.09%

73. Kop Corporation’s 5-year bonds yield 6.50%, and T-bonds with the same

maturity yield 4.40%. The default risk premium for Kop’s bonds is DRP

= 0.40%, the liquidity premium on Kop’s bonds is LP = 1.70% versus zero

on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk

premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free

rate, r*?

a. 2.04%

b. 2.14%

c. 2.26%

d. 2.38%

e. 2.50%

74. 5-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%,

and the maturity risk premium (MRP) on 5-year T-bonds is 0.4%. There is

no liquidity premium on these bonds. What is the real risk-free rate,

r*?

a. 2.59%

b. 2.88%

c. 3.20%

d. 3.52%

e. 3.87%

75. 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*? The cross-product term should be

considered , i.e., if averaging is required, use the geometric average.

a. 3.68%

b. 3.87%

c. 4.06%

d. 4.26%

e. 4.48%

Chapter 6: Interest Rates M/C Problems Page 217

76. Suppose the real risk-free rate is 3.50% and the future rate of

inflation is expected to be constant at 2.20%. What rate of return

would you expect on a 1-year Treasury security, assuming the pure

expectations theory is valid? Include cross-product terms, i.e., if

averaging is required, use the geometric average.

a. 5.21%

b. 5.49%

c. 5.78%

d. 6.07%

e. 6.37%

77. Suppose the real risk-free rate is 3.00%, the average expected future

inflation rate is 2.25%, and a maturity risk premium of 0.10% per year

to maturity applies, i.e., MRP = 0.10%(t), where t is the years to

maturity. What rate of return would you expect on a 1-year Treasury

security, assuming the pure expectations theory is NOT valid? Include

the cross-product term, i.e., if averaging is required, use the

geometric average.

a. 5.15%

b. 5.42%

c. 5.69%

d. 5.97%

e. 6.27%

78. Suppose the interest rate on a 1-year T-bond is 5.0% and that on a

2-year T-bond is 7.0%. Assuming the pure expectations theory is

correct, what is the market’s forecast for 1-year rates 1 year from

now?

a. 7.36%

b. 7.75%

c. 8.16%

d. 8.59%

e. 9.04%

79. Suppose 1-year Treasury bonds yield 4.00% while 2-year T-bonds yield

5.10%. Assuming the pure expectations theory is correct, and thus the

maturity risk premium for T-bonds is zero, what is the yield on a 1–

year T-bond expected to be one year from now?

a. 5.90%

b. 6.21%

c. 6.52%

d. 6.85%

e. 7.19%

Page 218 M/C Problems Chapter 6: Interest Rates

80. Suppose the real risk-free rate is 3.25%, the average future inflation

rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity

applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is

the years to maturity. Suppose also that a liquidity premium of 0.50%

and a default risk premium of 0.90% apply to A-rated corporate bonds but

not to T-bonds. How much higher would the rate of return be on a 10-year

A-rated corporate bond than on a 5-year Treasury bond? Here we assume

that the pure expectations theory is NOT valid. Disregard cross-product

terms, i.e., if averaging is required, use the arithmetic average.

a. 1.75%

b. 1.84%

c. 1.93%

d. 2.03%

e. 2.13%

81. Suppose the real risk-free rate is 3.50%, the average future inflation

rate is 2.50%, a maturity premium of 0.02% per year to maturity

applies, i.e., MRP = 0.20%(t), where t is the years to maturity.

Suppose also that a liquidity premium of 0.50% and a default risk

premium of 1.35% applies to A-rated corporate bonds. What is the

difference in the yields on a 5-year A-rated corporate bond and on a

10-year Treasury bond? Here we assume that the pure expectations

theory is NOT valid, and disregard any cross-product terms, i.e., if

averaging is required, use the arithmetic average.

a. 0.77%

b. 0.81%

c. 0.85%

d. 0.89%

e. 0.94%

82. Suppose the interest rate on a 1-year T-bond is 5.00% and that on a

2-year T-bond is 6.00%. Assume that the pure expectations theory is

NOT valid, and the MRP is zero for a 1-year T-bond but 0.40% for a 2–

year bond. What is the yield on a 1-year T-bond expected to be one

year from now?

a. 5.32%

b. 5.60%

c. 5.89%

d. 6.20%

e. 6.51%

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CHAPTER 6

ANSWERS AND SOLUTIONS

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