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Page 216 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 217
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%
Page 218 M/C Problems Chapter 6: Interest Rates
e. 3.65%
Chapter 6: Interest Rates M/C Problems Page 219
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 221
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 222 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%
Chapter 6: Interest Rates M/C Problems Page 223
e. 4.48%
Page 224 M/C Problems Chapter 6: Interest Rates
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%
Chapter 6: Interest Rates M/C Problems Page 225
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%
CHAPTER 6
ANSWERS AND SOLUTIONS
Chapter 6: Interest Rates Answers Page 231
