104.
Determinants of Interest Rates for Individual Securities
The Wall Street Journal
reports
that the current rate on 10-year Treasury bonds is 3.25 percent and on 20-year Treasury
bonds is 5.50 percent. Assume that the maturity risk premium is zero. Calculate the expected
rate on a 10-year Treasury bond purchased ten years from today, E(10
r
10).
Essay Questions
105.
What is a derivative security and what determines its value?
106.
What shape does the term structure usually take? Why?
107.
What does the “term structure of interest rates” mean?
108.
Why is it useful to calculate forward rates?
109.
George Washington wants to invest in one of two corporate bonds issued by separate firms.
One bond yields 7 percent with a 10-year maturity; the other offers a 10 percent yield with a
nine-year maturity. George thinks the nine-year bond is the better deal since the rate is
higher. Is this necessarily so? Explain what factors George should consider before making a
choice.
110.
How do Financial Intermediaries (FIs) act as asset transformers?
111.
Who are some of the participants in the shadow banking system?
112.
Explain how the shadow banking system works.
113.
Classify the following transactions as taking place in the primary or secondary markets:
114.
Classify the following financial instruments as money market securities or capital market
securities:
Chapter 06 Understanding Financial Markets and Institutions Answer
Key
Multiple Choice Questions
1.
Which of these provide a forum in which demanders of funds raise funds by issuing new
financial instruments, such as stocks and bonds?
2.
In the United States, which of these financial institutions arrange most primary market
transactions for businesses?
3.
Primary market financial instruments include stock issues from firms allowing their equity
shares to be publicly traded on stock market for the first time. We usually refer to these
first-time issues as which of the following?
4.
Once firms issue financial instruments in primary markets, these same stocks and bonds
are then traded in which of these?
5.
Which of these feature debt securities or instruments with maturities of one year or less?
6.
Which of the following is NOT a money market instrument?
7.
Which of these money market instruments are short-term funds transferred between
financial institutions, usually for no more than one day?
8.
Which of the following is NOT a capital market instrument?
9.
Which of these capital market instruments are long-term loans to individuals or
businesses to purchase homes, pieces of land, or other real property?
10.
Which of these markets trade currencies for immediate or for some future stated
delivery?
11.
Which of these formalizes an agreement between two parties to exchange a standard
quantity of an asset at a predetermined price on a specified date in the future?
12.
Which of these does NOT perform vital functions to securities markets of all sorts by
channeling funds from those with surplus funds to those with shortages of funds?
13.
Which of these refer to the ease with which an asset can be converted into cash?
14.
Which of the following is the risk that an asset’s sale price will be lower than its purchase
price?
15.
Which of these is the interest rate that is actually observed in financial markets?
16.
Which of these is the interest rate that would exist on a default-free security if no inflation
were expected?
17.
Which of the following is the risk that a security issuer will miss an interest or principal
payment or continue to miss such payments?
18.
Which of these is NOT a participant in the shadow banking system?
19.
How is the shadow banking system the same as the traditional banking system?
20.
Which of the following is the continual increase in the price level of a basket of goods and
services?
21.
Which of these statements is true?
22.
Which of these is a comparison of market yields on securities, assuming all characteristics
except maturity are the same?
23.
According to this theory of term structure of interest rates, at any given point in time, the
yield curve reflects the market’s current expectations of future short-term rates.
24.
Which of the following theories argues that individual investors and financial institutions
have specific maturity preferences, and to encourage buyers to hold securities with
maturities other than their most preferred requires a higher interest rate?
25.
Which of these is the expected or “implied” rate on a short–term security that will originate
at some point in the future?
26.
Which of these is NOT a theory that explains the shape of the term structure of interest
rates?
27.
Interest rates A particular security’s default risk premium is 3 percent. For all securities,
the inflation risk premium is 2 percent and the real interest rate is 2.25 percent. The
security’s liquidity risk premium is 0.75 percent and maturity risk premium is 0.90 percent.
The security has no special covenants. What is the security’s equilibrium rate of return?