Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 3 Interest Rates and Rates of Return
3.1 The Interest Rate, Present Value, and Future Value
1) Suppose Matt’s New Cars issues a discount bond with a face value of $10,000 payable in one
year with an interest rate of 4%. How much will they receive for the bond?
A) $9,600
B) $9,615
C) $10,000
D) $10,400
2) The concept of present value
A) reveals that discount bonds have higher interest rates than coupon bonds.
B) reveals that fixed payment loans have higher interest rates than discount bonds.
C) is useful in comparing interest rates for different financial instruments.
D) limits the comparability of returns on different types of bonds.
3) The key difficulty in answering the question: “Would you be better off financing your new
home with a 15-year mortgage at 5% or by borrowing for five years at 4% and refinancing
thereafter?” is that
A) housing prices are very erratic.
B) the tax deductibility of mortgage interest payments has changed over time.
C) dollars paid in different periods do not have the same value.
D) 15-year mortgages are fixed-payment loans while 5-year mortgages are simple loans.
4) The key to present value calculations is that they
A) are appropriate only for funds in the same time period.
B) provide a common unit for measuring funds at different times.
C) provide accurate answers only in a low-inflation environment.
D) provide accurate answers only in a high-inflation environment.
5) Compounding refers to
A) the calculation of interest rates after the compounding effect of taxes has been allowed for.
B) the paying back of both interest and principal during the life of a fixed payment loan.
C) the process of earning interest on both the interest and the principal of an investment.
D) the increased value of an investment that arises from the payment of periodic interest.
6) If you deposit $500 in a savings account at an annual interest rate of 5%, how much will you
have in the account at the end of five years?
A) $625
B) $392
C) $638
D) $550
7) If you deposit $10,000 in a savings account at an annual interest rate of 6%, how much will
you have in the account at the end of three years?
A) $8,396
B) $11,800
C) $11,910
D) $10,600
8) $1 received n years from now has a value today of
A) ($1 + i)/i.
B) $1/(1 + i).
C) ($1 + i)n/i.
D) $1/(1 + i)n.
9) At an interest rate of 6%, how much will need to be invested today to have $10,000 in 5
years?
A) $5,000
B) $7,473
C) $10,000
D) $13,382
10) At an interest rate of 3%, what is the present value of $1000 to be received five years from
now?
A) $863
B) $1,667
C) $1,159
D) $850
11) If the annual interest rate is 8%, what would you expect to pay for a discount bond paying
$10,000 in ten years?
A) $4,632
B) $9,259
C) $10,000
D) $21,589
12) If the annual interest rate is 9%, what would you expect to pay for a discount bond paying
$10,000 in two years?
A) $8,417
B) $8,200
C) $10,000
D) $11,881
13) What are the three possible actions that could be taken when a bank becomes insolvent?
14) What are three reasons that banks charge interest on loans?
15) Suppose you put $500 in your savings account and earn 4% interest per year. How much will
you have in your account after two years? Be sure to round off to the nearest cent
16) Suppose you had $1000 and were deciding between two investments. One pays 5% a year
for two years while the other pays 8% the first year and 2% the second year. Which investment
would provide a higher return?
17) Suppose you have two clients who need your services for two years. One agreed to pay you
$50,000 one year from now and another $50,000 in two years while the other paid $35,000 after
one year, but $65,000 after two years. Assuming an interest rate of 10%, which one has a higher
present value? Round off to the nearest dollar.
3.2 Debt Instruments and Their Prices
1) Simple loans and discount bonds differ from coupon bonds and fixed-payment loans in that
A) interest on simple loans and discount bonds is taxable, while interest on coupon bonds and
fixed-payment loans is not.
B) interest on coupon bonds and fixed-payment loans is taxable, while interest on simple loans
and discount bonds is not.
C) interest rates on simple loans and discount bonds are generally higher than interest rates on
comparable coupon bonds and fixed-payment loans.
D) interest on simple loans and discount bonds is paid in a single payment, while issuers of
coupon bonds and fixed-payment loans make multiple payments of interest and principal.
2) Debt instruments are also called
A) equities.
B) credit market instruments.
C) prospectuses.
D) units of account.
3) A debt instrument represents
A) an ownership claim by the purchaser on the issuer.
B) a promise by a borrower to repay principal plus interest to a lender.
C) an attempt by a borrower in default to restore his or her credit.
D) a nontaxable asset, owned primarily by large corporations.
4) Issuers of coupon bonds
A) make a single payment of principal when the bonds matures, but multiple payments of
interest over the life of the bond.
B) make a single payment of interest and principal.
C) make multiple payments of principal, but a single payment of interest.
D) make a single payment of principal at the time the bond is issued and multiple payments of
interest over the life of the bond.
5) A simple loan involves
A) interest payments from the borrower to the lender periodically during the life of the loan.
B) no payment of interest by the borrower to the lender.
C) payment of interest by the borrower to the lender only at the time the loan matures.
D) payment only of principal. by the borrower to the lender at maturity.
6) The amount of funds the borrower receives from the lender with a simple loan is called the
A) principal.
B) equity.
C) claim.
D) collateral.
7) The total payment to a lender for a one-period simple loan is
A) (P + i)n.
B) P + i.
C) i(1 + i).
D) P(1 + i).
8) Suppose First National Bank makes a one-year simple loan of $1,000 at 7% interest to Harry’s
Restaurant. At the end of one year Harry’s Restaurant will pay First National
A) $934.58.
B) $1007.
C) $1700.
D) $1070.
9) The most common type of simple loan is a(an)
A) automobile loan from a bank.
B) mortgage loan from a bank.
C) commercial loan from a bank.
D) corporate bond.
10) A discount bond resembles a simple loan in that
A) the interest on neither is taxable.
B) the borrower repays in a single payment.
C) both represent assets to the borrowers who issue them.
D) both have par values greater than their face values.
11) A discount bond involves
A) interest payments from the borrower to the lender periodically during the life of the loan.
B) payment by the borrower to the lender of the face value of the loan at maturity.
C) no payment of principal by the borrower to the lender.
D) payment of interest by the borrower to the lender every six months during the life of the loan.
12) Which of the following is NOT a discount bond?
A) a U.S. savings bond
B) a U.S. Treasury bill
C) a U.S. Treasury note
D) a zero-coupon bond
13) A coupon bond involves
A) interest payments from the borrower to the lender periodically during the life of the loan and
payment by the borrower to the lender of the face value of the loan at maturity.
B) interest and principal payments from the borrower to the lender periodically during the life of
the loan.
C) periodic payments by the borrower to the lender that include both principal and interest.
D) periodic payments by the borrower to the lender that include principal, but not interest.
14) The coupon rate is the
A) annual coupon payment divided by the face value of the bond.
B) annual coupon payment divided by the market value of the bond.
C) difference between the face value of the bond and its par value.
D) coupon paid every 6 months divided by par value.
15) Which of the following is a coupon bond?
A) a U.S. savings bond
B) a U.S. Treasury bill
C) a U.S. Treasury note
D) a zero-coupon bond
16) Which of the following is NOT true of a fixed payment loan?
A) The borrower is required to make regular periodic payments to the lender.
B) The payments made by the borrower include both interest and principal.
C) The borrower is left with a substantial unpaid principal at the maturity of the loan.
D) A home mortgage is an example of fixed payment loan.
17) Which of the following is a fixed payment loan?
A) a home mortgage
B) a U.S. Treasury bill
C) a U.S. Treasury note
D) a zero-coupon bond
18) Which of the following is NOT a fixed payment loan?
A) a home mortgage
B) a car loan
C) a U.S. Treasury note
D) a student loan
19) Treasury STRIPS are
A) tax-exempt bonds.
B) simple loans.
C) discount bonds.
D) fixed payment loans.
20) Treasury STRIPS came into existence because
A) investors demanded a tax-free long-term bond.
B) the Treasury wished to shift from long-term borrowing to short-term borrowing.
C) high inflation rates led to an increased demand for high-yield bonds.
D) investors demanded long-term discount bonds.
21) The current yield is equal to
A) the coupon divided by the market price of the bond.
B) the yield to maturity, if the bond is a coupon bond.
C) the coupon divided by the par value of the bond.
D) the market price of the bond divided by its par value.
22) A coupon bond has an annual coupon of $75, a par value of $1000, and a market price of
$900. Its current yield equals
A) 7.50%.
B) 8.33%.
C) its yield to maturity.
D) Not enough information has been provided to calculate the current yield for this bond.
23) Which of the following is NOT fixed on a coupon bond?
A) coupon
B) coupon rate
C) market price
D) par value
24) Which of the following is fixed on a coupon bond?
A) coupon rate
B) current yield
C) market price
D) yield to maturity
25) Suppose a firm receives $975 for a discount bond with a face value of $1000 to be repaid in
one year. What is the amount of interest on the bond? What is the interest rate on the bond?
Report a percentage with two decimal places.
26) Suppose a bond has a coupon of $75, face value of $1000, and current price of $1100. What
is the coupon rate? What is its current yield? Report a percentage with two decimal places.
27) How do payments on a fixed-payment loan differ from a coupon bond?
3.3 Bond Prices and Yield to Maturity
1) Suppose Matt’s New Cars issues and sells a one-year discount bond for $9,259 and repays
$10,000 at maturity. The interest rate on this bond would be
A) 2.6%.
B) 7.41%.
C) 8%.
D) 10%.
2) The yield to maturity is equal to
A) the interest rate at which the present value of an asset’s returns is equal to its price today.
B) the face value or par value of a coupon bond.
C) any payments received from an asset at the date the asset matures.
D) interest rate on the asset minus any taxes owed on the interest received.
3) For simple loans, the yield to maturity
A) is always less than the specified simple interest rate.
B) is always greater than the specified simple interest rate.
C) is always equal to the specified simple interest rate.
D) may be less than, greater than, or equal to the specified simple interest rate, depending on the
maturity of the loan.
4) What is the yield to maturity on a simple loan that requires payment of $500 plus $30 in
interest one year from now?
A) 6%
B) 6.38%
C) 5.3%
D) Not enough information has been provided to determine the answer.
5) The yield to maturity on a new one-year discount bond equals
A) (F V- P)/P.
B) (D – FV)/P.
C) (FV – P)/FV.
D) (P – FV)/FV.