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Chapter 06: Interest Rates
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
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
Chapter 06: Interest Rates
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
Chapter 06: Interest Rates
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
Chapter 06: Interest Rates
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
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
Chapter 06: Interest Rates
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
Chapter 06: Interest Rates
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.
Chapter 06: Interest Rates
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
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
Chapter 06: Interest Rates
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
Chapter 06: Interest Rates
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.
d.
If inflation is expected to decline, there can be no maturity risk premium.
e.
The expectations theory cannot hold if inflation is decreasing.
Chapter 06: Interest Rates
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.
Chapter 06: Interest Rates
d.
The economy moves from a boom to a recession.
e.
The Federal Reserve decides to try to stimulate the economy.
28. 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.
29. 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.
Chapter 06: Interest Rates
DATE MODIFIED:
6/23/2015 3:24 PM
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.
Chapter 06: Interest Rates
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.
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.
Chapter 06: Interest Rates
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?
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.
Chapter 06: Interest Rates
36. 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.
37. 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.
38. 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
Chapter 06: Interest Rates
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.
39. 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.
40. 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.
Chapter 06: Interest Rates
41. 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.
42. 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.
Chapter 06: Interest Rates
43. 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%.
44. 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.
Chapter 06: Interest Rates
45. 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.
46. 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.
Chapter 06: Interest Rates
47. 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.
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.
