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Multiple Choice: Conceptual

Easy:

Financial markets Answer: d Diff: E

1

. The New York Stock Exchange is primarily

a. A secondary market.

b. A physical location auction market.

c. An overthecounter market.

d. Statements a and b are correct.

e. Statements b and c are correct.

Financial markets Answer: c Diff: E

!

. "hich o# the #ollowing statements is most correct$

a. The NYSE does not exist as a physical location% rather it represents a

loose collection o# dealers who trade stock electronically.

b. An example o# a primary market transaction is buying 1&& shares o#

"al'art stock #rom your uncle.

c. (apital market instruments include longterm debt and common stock.

d. Statements b and c are correct.

e. Statements a) b) and c are correct.

Financial markets Answer: d Diff: E

*

. "hich o# the #ollowing statements is most correct$

a. +# an investor sells 1&& shares o# 'icroso#t to his brotherinlaw)

this is a primary market transaction.

b. ,rivate securities are generally less li-uid than publicly traded

securities.

c. 'oney markets are where shortterm) li-uid securities are traded)

whereas capital markets represent the markets #or longterm debt and

common stock.

d. Statements b and c are correct.

e. All o# the statements above are correct.

Chapter 4 Page 1

CHAPTE !

THE "#$A$C#A% E$&#'$ME$T:

MA(ET), #$)T#T*T#'$), A$D #$TEE)T ATE)

Financial markets Answer: d Diff: E

.

. "hich o# the #ollowing is a secondary market transaction$

a. You sell !&& shares o# +/' stock in the open market.

b. You buy !&& shares o# +/' stock #rom your brother.

c. +/' issues ! million shares o# new stock to the public.

d. Statements a and b are correct.

e. All o# the statements above are correct.

Financial markets Answer: c Diff: E

0

. "hich o# the #ollowing statements is most correct$

a. 'oney markets are markets #or longterm debt and common stocks.

b. ,rimary markets are markets where existing securities are traded among

investors.

c. A derivative is a security whose value is derived #rom the price o#

some other 1underlying2 asset.

d. Statements a and b are correct.

e. Statements b and c are correct.

Financial markets Answer: c Diff: E N

3

. "hich o# the #ollowing statements is most correct$

a. "hile the distinctions are blurring) investment banks generally

speciali4e in lending money) whereas commercial banks generally help

companies raise capital #rom other parties.

b. 'oney market mutual #unds usually invest their money in a well

diversi#ied port#olio o# li-uid common stocks.

c. The NYSE operates as an auction market) whereas NAS5A6 is an example

o# a dealer market.

d. Statements b and c are correct.

e. All o# the statements above are correct.

Capital market instruments Answer: b Diff: E

7

. "hich o# the #ollowing is an example o# a capital market instrument$

a. (ommercial paper.

b. ,re#erred stock.

c. 8.S. Treasury bills.

d. /anker9s acceptances.

e. 'oney market mutual #unds.

Money markets Answer: e Diff: E

:

. 'oney markets are markets #or

a. ;oreign currency exchange.

b. (onsumer automobile loans.

c. (orporate stocks.

d. <ongterm bonds.

e. Shortterm debt securities.

Chapter 4 Page 2

Financial transactions Answer: a Diff: E

=

. "hich o# the #ollowing statements is correct$

a. The New York Stock Exchange is a physical location auction market.

b. 'oney markets include markets #or consumer automobile loans.

c. +# an investor sells shares o# stock through a broker) then it would

be a primary market transaction.

d. (apital market transactions involve only the purchase and sale o#

e-uity securities.

e. None o# the statements above is correct.

Financial transactions Answer: a Diff: E

1&

. You recently sold 1&& shares o# 'icroso#t stock to your brother at a

#amily reunion. At the reunion your brother gave you a check #or the

stock and you gave your brother the stock certi#icates. "hich o# the

#ollowing best describes this transaction$

a. This is an example o# a direct trans#er o# capital.

b. This is an example o# a primary market transaction.

c. This is an example o# an exchange o# physical assets.

d. This is an example o# a moneymarket transaction.

e. Statements a) b) and d are correct. Statement c is incorrect.

Financial transactions Answer: e Diff: E

11

. "hich o# the #ollowing statements is most correct$

a. +# you purchase 1&& shares o# 5isney stock #rom your brotherinlaw)

this is an example o# a primary market transaction.

b. +# 5isney issues additional shares o# common stock) this is an example

o# a secondary market transaction.

c. The NYSE is an example o# an overthecounter market.

d. Statements a and b are correct.

e. None o# the statements above is correct.

Financial transactions Answer: c Diff: E

1!

. You recently sold !&& shares o# 5isney stock to your brother. This is an

example o#>

a. A money market transaction.

b. A primary market transaction.

c. A secondary market transaction.

d. A #utures market transaction.

e. Statements a and b are correct.

Chapter 4 Page 3

Primary market transactions Answer: e Diff: E

1*

. "hich o# the #ollowing are examples o# a primary market transaction$

a. A company issues new common stock.

b. A company issues new bonds.

c. An investor asks his broker to purchase 1)&&& shares o# 'icroso#t

common stock.

d. All o# the statements above are correct.

e. Statements a and b are correct.

Risk and return Answer: d Diff: E

1.

. Your uncle would like to limit his interest rate risk and his de#ault

risk) but he would still like to invest in corporate bonds. "hich o# the

possible bonds listed below best satis#ies your uncle9s criteria$

a. AAA bond with 1& years to maturity.

b. /// perpetual bond.

c. /// bond with 1& years to maturity.

d. AAA bond with 0 years to maturity.

e. /// bond with 0 years to maturity.

Yield cure Answer: a Diff: E

10

. Assume that in#lation is expected to steadily decline in the years ahead)

but that the real risk#ree rate) k?) is expected to remain constant.

"hich o# the #ollowing statements is most correct$

a. +# the expectations theory holds) the Treasury yield curve must be

downward sloping.

b. +# the expectations theory holds) the yield curve #or corporate

securities must be downward sloping.

c. +# there is a positive maturity risk premium) the Treasury yield curve

must be upward sloping.

d. Statements b and c are correct.

e. All o# the statements above are correct.

Yield cure Answer: a Diff: E

13

. +# the yield curve is downward sloping) what is the yield to maturity on

a 1&year Treasury coupon bond) relative to that on a 1year Tbond$

a. The yield on the 1&year bond is less than the yield on a 1year bond.

b. The yield on a 1&year bond will always be higher than the yield on a

1year bond because o# maturity risk premiums.

c. +t is impossible to tell without knowing the coupon rates o# the

bonds.

d. The yields on the two bonds are e-ual.

e. +t is impossible to tell without knowing the relative risks o# the two

bonds.

Chapter 4 Page 4

Yield cure Answer: c Diff: E

17

. "hich o# the #ollowing statements is most correct$

a. 5ownward sloping yield curves are inconsistent with the expectations

theory.

b. The shape o# the yield curve depends only on expectations about #uture

in#lation.

c. +# the expectations theory is correct) a downward sloping yield curve

indicates that interest rates are expected to decline in the #uture.

d. Statements a and c are correct.

e. None o# the statements above is correct.

Yield cure Answer: e Diff: E

1:

. The real risk#ree rate o# interest) k?) is expected to remain constant

at * percent. +n#lation is expected to be * percent #or next year and

then ! percent a year therea#ter. The maturity risk premium is 4ero.

@iven this in#ormation) which o# the #ollowing statements is most

correct$

a. The yield curve #or 8.S. Treasury securities is downward sloping.

b. A 0year corporate bond has a higher yield than a 0year Treasury

security.

c. A 0year corporate bond has a higher yield than a 7year Treasury

security.

d. Statements a and b are correct.

e. All o# the statements above are correct.

Yield cure Answer: c Diff: E

1=

. "hich o# the #ollowing statements is most correct$

a. +# the maturity risk premium A'B,C is greater than 4ero) the yield

curve must be upward sloping.

b. +# the maturity risk premium A'B,C e-uals 4ero) the yield curve must

be #lat.

c. +# interest rates are expected to increase in the #uture and the

maturity risk premium A'B,C is greater than 4ero) the yield curve will

be upward sloping.

d. +# the expectations theory holds) the yield curve will never be

downward sloping.

e. All o# the statements above are correct.

Chapter 4 Page 5

Yield cure Answer: e Diff: E

!&

. ;or the #oreseeable #uture) the real risk#ree rate o# interest) k?) is

expected to remain at * percent. +n#lation is expected to steadily

increase over time. The maturity risk premium e-uals &.1At 1CD) where

t represents the bond9s maturity. En the basis o# this in#ormation)

which o# the #ollowing statements is most correct$

a. The yield on 1&year Treasury securities must exceed the yield on

!year Treasury securities.

b. The yield on 1&year Treasury securities must exceed the yield on

0year corporate bonds.

c. The yield on 1&year corporate bonds must exceed the yield on :year

Treasury securities.

d. Statements a and b are correct.

e. Statements a and c are correct.

!nterest rates Answer: c Diff: E

!1

. "hich o# the #ollowing statements is most correct$

a. +# companies have #ewer productive opportunities) interest rates are

likely to increase.

b. +# individuals increase their savings rate) interest rates are likely

to increase.

c. +# expected in#lation increases) interest rates are likely to increase.

d. All o# the statements above are correct.

e. Statements a and c are correct.

!nterest rates Answer: b Diff: E

!!

. "hich o# the #ollowing is likely to increase the level o# interest rates

in the economy$

a. Fouseholds start saving a larger percentage o# their income.

b. (orporations step up their plans #or expansion and increase their

demand #or capital.

c. The level o# in#lation is expected to decline.

d. All o# the statements above are correct.

e. None o# the statements above is correct.

!nterest rates Answer: d Diff: E N

!*

. "hich o# the #ollowing #actors are likely to lead to an increase in

nominal interest rates$

a. Fouseholds increase their savings rate.

b. (ompanies see an increase in their production opportunities that

leads to an increase in the demand #or #unds.

c. There is an increase in expected in#lation.

d. Statements b and c are correct.

e. All o# the statements above are correct.

Chapter 4 Page 6

!nterest rates Answer: b Diff: E N

!.

. "hich o# the #ollowing statements is most correct$

a. The yield on a *year Treasury bond cannot exceed the yield on a 1&

year Treasury bond.

b. The yield on a !year corporate bond will always exceed the yield on

a !year Treasury bond.

c. The yield on a *year corporate bond will always exceed the yield on

a !year corporate bond.

d. Statements b and c are correct.

e. All o# the statements above are correct.

Cost of money Answer: c Diff: E N

!0

. "hich o# the #ollowing is likely to lead to an increase in the cost o#

#unds$

a. (ompanies9 production opportunities decline) leading to a decline in

the demand #or #unds.

b. Fouseholds save a larger portion o# their income.

c. Fouseholds increase the amount o# money they borrow #rom their local

banks.

d. Statements a and b are correct.

e. Statements a and c are correct.

E"pectations t#eory Answer: c Diff: E

!3

. Assume that the expectations theory describes the term structure o#

interest rates. "hich o# the #ollowing statements is most correct$

a. +n e-uilibrium longterm rates e-ual short term rates.

b. An upwardsloping yield curve implies that interest rates are expected

to decline in the years ahead.

c. The maturity risk premium is 4ero.

d. Statements a and b are correct.

e. None o# the statements above is correct.

E"pectations t#eory Answer: a Diff: E

!7

. The real risk#ree rate) k?) is expected to remain constant at * percent

per year. +n#lation is expected to be ! percent per year #orever. Assume

that the expectations theory holds% that is) there is no maturity risk

premium. Treasury securities do not re-uire any de#ault risk or li-uidity

premiums. "hich o# the #ollowing statements is most correct$

a. The Treasury yield curve is #lat and all Treasury securities yield

0 percent.

b. The Treasury yield curve is upward sloping #or the #irst 1& years) and

then downward sloping.

c. The yield curve #or corporate bonds must be #lat) but corporate bonds

will yield more than 0 percent.

d. Statements a and c are correct.

e. Statements b and c are correct.

Chapter 4 Page 7

E"pectations t#eory Answer: d Diff: E

!:

. Eneyear interest rates are 3 percent. The market expects 1year rates to

be 7 percent one year #rom now. The market also expects 1year rates will

be : percent two years #rom now. Assume that the expectations theory

holds regarding the term structure Athat is) the maturity risk premium

e-uals 4eroC. "hich o# the #ollowing statements is most correct$

a. The yield curve is downward sloping.

b. Today9s !year interest rate is : percent.

c. Today9s !year interest rate is 7 percent.

d. Today9s *year interest rate is 7 percent.

e. Today9s *year interest rate is = percent.

E"pectations t#eory Answer: e Diff: E

!=

. The real risk#ree rate o# interest is expected to remain constant at

* percent #or the #oreseeable #uture. Fowever) in#lation is expected to

steadily increase over the next !& years) so the Treasury yield curve is

upward sloping. Assume that the expectations theory holds. You are

considering two corporate bonds> a 0year corporate bond and a 1&year

corporate bond) each o# which has the same de#ault risk and li-uidity

risk. @iven this in#ormation) which o# the #ollowing statements is most

correct$

a. Since the expectations theory holds) this implies that 1&year

Treasury bonds must have the same yield as 0year Treasury bonds.

b. Since the expectations theory holds) this implies that the 1&year

corporate bonds must have the same yield as the 0year corporate

bonds.

c. Since the expectations theory holds) this implies that the 1&year

corporate bonds must have the same yield as 1&year Treasury bonds.

d. The 1&year Treasury bond must have a higher yield than the 0year

corporate bond.

e. The 1&year corporate bond must have a higher yield than the 0year

corporate bond.

Medium:

Financial transactions Answer: d Diff: M

*&

. +# the ;ederal Beserve sells G0& billion o# shortterm 8.S. Treasury

securities to the public) other things held constant) what will this tend

to do to shortterm security prices and interest rates$

a. ,rices and interest rates will both rise.

b. ,rices will rise and interest rates will decline.

c. ,rices and interest rates will both decline.

d. ,rices will decline and interest rates will rise.

e. There will be no changes in either prices or interest rates.

Chapter 4 Page 8

Financial transactions Answer: d Diff: M

*1

. "hich o# the #ollowing statements is most correct$

a. The distinguishing #eature between spot markets versus #utures markets

transactions is the maturity o# the investments. That is) spot market

transactions involve securities that have maturities o# less than one

year whereas #utures markets transactions involve securities with

maturities greater than one year.

b. (apital market transactions only include pre#erred stock and common

stock transactions.

c. +# @eneral Electric were to issue new stock this year it would be

considered a secondary market transaction since the company already

has stock outstanding.

d. /oth dealers in Nasda- and 1specialists2 in the NYSE hold inventories

o# stocks.

e. Statements a and d are correct.

!nterest rates Answer: b Diff: M

*!

. Assume interest rates on longterm government and corporate bonds were as

#ollows>

Tbond H 7.7!D A H =.3.D

AAA H :.7!D /// H 1&.1:D

The di##erences in rates among these issues were caused primarily by

a. Tax e##ects.

b. 5e#ault risk di##erences.

c. 'aturity risk di##erences.

d. +n#lation di##erences.

e. Statements b and d are correct.

!nterest rates Answer: b Diff: M

**

. "hich o# the #ollowing statements is most correct$

a. The yield on a *year Treasury bond cannot exceed the yield on a 1&

year Treasury bond.

b. The expectations theory states that the maturity risk premium #or

longterm bonds is 4ero and that di##erences in interest rates across

di##erent maturities are driven by expectations about #uture interest

rates.

c. 'ost evidence suggests that the maturity risk premium is 4ero.

d. Statements b and c are correct.

e. None o# the statements above is correct.

Chapter 4 Page 9

!nterest rates Answer: a Diff: M

*.

. "hich o# the #ollowing statements is most correct$

a. The yield on a !year corporate bond will always exceed the yield on a

!year Treasury bond.

b. The yield on a *year corporate bond will always exceed the yield on a

!year corporate bond.

c. The yield on a *year Treasury bond will always exceed the yield on a

!year Treasury bond.

d. All o# the statements above are correct.

e. Statements a and c are correct.

$erm structure t#eories Answer: b Diff: M

*0

. "hich o# the #ollowing statements is most correct$

a. The maturity premiums embedded in the interest rates on 8.S. Treasury

securities are due primarily to the #act that the probability o#

de#ault is higher on longterm bonds than on shortterm bonds.

b. Beinvestment rate risk is lower) other things held constant) on long

term than on shortterm bonds.

c. The expectations theory o# the term structure o# interest rates states

that borrowers generally pre#er to borrow on a longterm basis while

savers generally pre#er to lend on a shortterm basis) and that as a

result) the yield curve is normally upward sloping.

d. +# the maturity risk premium were 4ero and interest rates were

expected to decrease in the #uture) then the yield curve #or 8.S.

Treasury securities would) other things held constant) have an upward

slope.

e. None o# the statements above is correct.

E"pectations t#eory Answer: e Diff: M

*3

. +# the expectations theory o# the term structure is correct) which o# the

#ollowing statements is most correct$

a. An upward sloping yield curve implies that interest rates are expected

to be lower in the #uture.

b. +# 1year Treasury bills have a yield to maturity o# 7 percent) and

!year Treasury bills have a yield to maturity o# : percent) this

implies the market believes that 1year rates will be 7.0 percent one

year #rom now.

c. The yield on 0year corporate bonds should always exceed the yield on

*year Treasury securities.

d. Statements a and c are correct.

e. None o# the statements above is correct.

Chapter 4 Page 10

E"pectations t#eory Answer: a Diff: M

*7

. Assume that the expectations theory holds. "hich o# the #ollowing

statements about Treasury bill rates is most correct$ A!year rates apply

to bonds that will mature in two years) *year rates apply to bonds that

will mature in * years) and so onC.

a. +# !year rates exceed 1year rates) then the market expects interest

rates to rise.

b. +# !year rates are 7 percent) and *year rates are 7 percent) then

0year rates must also be 7 percent.

c. +# 1year rates are 3 percent and !year rates are 7 percent) then the

market expects 1year rates to be 3.0 percent in one year.

d. Statements a and c are correct.

e. Statements b and c are correct.

E"pectations t#eory Answer: c Diff: M

*:

. "hich o# the #ollowing statements is most correct$

a. The expectations theory o# the term structure implies that longterm

interest rates should always e-ual shortterm interest rates.

b. +# the expectations theory o# the term structure is correct) an upward

sloping yield curve implies a positive maturity risk premium A'B,C.

c. +# the expectations theory o# the term structure is correct) an upward

sloping yield curve implies that market participants believe that

interest rates are going to be higher in the #uture than they are

today.

d. Statements a and b are correct.

e. Statements b and c are correct.

E"pectations t#eory Answer: e Diff: M

*=

. "hich o# the #ollowing statements is most correct) assuming that the

expectations theory is correct$

a. +# the yield curve is upward sloping) the yield on a !year corporate

bond must be less than the yield on a 0year Treasury bond.

b. +# the yield curve is upward sloping) the yield on a !year Treasury

bond must be less than the yield on a 0year corporate bond.

c. +# the yield curve is downward sloping) the yield on a 1&year

Treasury bond must be less than the yield on an :year corporate bond.

d. All o# the statements above are correct.

e. Statements b and c are correct.

Chapter 4 Page 11

E"pectations t#eory Answer: c Diff: M

.&

. The interest rate on 1year Treasury securities is 0 percent. The interest

rate on !year Treasury securities is 3 percent. The expectations theory

is assumed to be correct. "hich o# the #ollowing statements is most

correct$

a. The maturity risk premium is positive.

b. The market expects that 1year rates will be 0.0 percent one year #rom

now.

c. The market expects that 1year rates will be 7 percent one year #rom

now.

d. The yield curve is downward sloping.

e. None o# the statements above is correct.

E"pectations t#eory Answer: d Diff: M

.1

. Assume that the expectations theory holds. "hich o# the #ollowing

statements is most correct$

a. The yield curve #or both Treasury securities and corporate securities

will be #lat.

b. The yield curve #or Treasury securities is #lat) but the yield curve

#or corporate securities is likely to be upward sloping.

c. The yield curve #or Treasury securities cannot be downward sloping.

d. The maturity risk premium is 4ero.

e. +# !year rates yield more than 1year rates) investors should not

purchase 1year bonds) and should instead purchase !year bonds.

Yield cure Answer: e Diff: M

.!

. Assume that the current yield curve is upward sloping) or normal. This

implies that

a. Shortterm interest rates are more volatile than longterm rates.

b. +n#lation is expected to subside in the #uture.

c. The economy is at the peak o# a business cycle.

d. <ongterm bonds are a better buy than shortterm bonds.

e. None o# the statements above is necessarily implied by the yield curve

given.

Yield cure Answer: e Diff: M

.*

. "hich o# the #ollowing is most correct$

a. +# the expectations theory is correct Athat is) the maturity risk

premium is 4eroC) then an upwardsloping yield curve means that the

market believes that interest rates will rise in the #uture.

b. A 0year corporate bond may have a yield less than a 1&year Treasury

bond.

c. The yield curve #or corporate bonds may be upward sloping even i# the

Treasury yield curve is #lat.

d. Statements b and c are correct.

e. All o# the statements above are correct.

Chapter 4 Page 12

Yield cure Answer: a Diff: M

..

. "hich o# the #ollowing is most correct$

a. +# the expectations theory is correct) we could see inverted yield

curves.

b. +# a yield curve is inverted) shortterm bonds have lower yields than

longterm bonds.

c. A positive maturity risk premium increases the likelihood that a yield

curve will be inverted.

d. Statements b and c are correct.

e. None o# the statements above is correct.

Yield cure Answer: e Diff: M

.0

. "hich o# the #ollowing statements is most correct$

a. +# the maturity risk premium is 4ero) the yield curve must be #lat.

b. A 1&year corporate bond must have a higher yield than a 0year

Treasury bond.

c. A 1&year Treasury bond must have a higher yield than a 0year

Treasury bond.

d. +# the Treasury yield curve is downward sloping) the yield curve #or

corporate bonds must also be downward sloping.

e. None o# the statements above is correct.

Yield cure Answer: c Diff: M

.3

. A bond trader observes the #ollowing in#ormation>

• The Treasury yield curve is downward sloping.

• There is a positive maturity risk premium.

• There is no li-uidity premium.

En the basis o# this in#ormation) which o# the #ollowing statements is

most correct$

a. A 1&year corporate bond must have a higher yield than a 0year

Treasury bond.

b. A 1&year Treasury bond must have a higher yield than a 1&year

corporate bond.

c. A 0year corporate bond must have a higher yield than a 1&year

Treasury bond.

d. Statements a and c are correct.

e. All o# the statements above are correct.

Chapter 4 Page 13

Yield cure Answer: d Diff: M N

.7

. The real risk#ree rate is expected to remain constant over time.

+n#lation is expected to be ! percent a year #or the next two years)

a#ter which time it is expected to average . percent a year. There is a

positive maturity risk premium on bonds that have a maturity greater than

1 year. "hich o# the #ollowing statements is most correct$

a. The yield on a 0year government bond must exceed that o# a !year

government bond.

b. The yield on a 0year corporate bond must exceed that o# a !year

government bond.

c. The yield on a 7year government bond must exceed that o# a 0year

corporate bond.

d. Statements a and b are correct.

e. All o# the statements above are correct.

Yield cure Answer: d Diff: M N

.:

. +n#lation is expected to increase steadily over the next 1& years. There

is also a positive maturity risk premium. The real risk#ree rate o#

interest is expected to remain constant. "hich o# the #ollowing statements

is most correct$ AFint> Bemember that the de#ault risk premium and the

li-uidity premium are 4ero #or Treasury securities> 5B, H <, H &.C

a. The yield on 1&year Treasury securities must exceed the yield on

7year Treasury securities.

b. The yield on 1&year corporate bonds must exceed the yield on 1&year

Treasury securities.

c. The yield on 7year corporate bonds must exceed the yield on 1&year

Treasury securities.

d. Statements a and b are correct.

e. All o# the statements above are correct.

Corporate yield cure Answer: d Diff: M

.=

. (hurchill (orporation Iust issued bonds that will mature in 1& years.

@eorge (orporation Iust issued bonds that will mature in 1! years. /oth

bonds are standard coupon bonds that cannot be retired early. The two

bonds are e-ually li-uid. "hich o# the #ollowing statements is most

correct$

a. +# the yield curve #or Treasury securities is #lat) (hurchill9s bond

will have the same yield as @eorge9s bonds.

b. +# the yield curve #or Treasury securities is upward sloping) @eorge9s

bonds will have a higher yield than (hurchill9s bonds.

c. +# the two bonds have the same level o# de#ault risk) their yields

will also be the same.

d. +# the Treasury yield curve is upward sloping and (hurchill has less

de#ault risk than @eorge) then (hurchill9s bonds will have a lower

yield.

e. +# the Treasury yield curve is downward sloping) @eorge9s bonds will

have a lower yield.

Chapter 4 Page 14

Multiple Choice: P+o,lems

Easy:

E"pected interest rates Answer: d Diff: E N

0&

. The real risk#ree rate o# interest is * percent. +n#lation is expected

to be . percent this coming year) Iump to 0 percent next year) and

increase to 3 percent the year a#ter AYear *C. According to the

expectations theory) what should be the interest rate on *year) risk

#ree securities today$

a. 1:D

b. 1!D

c. 3D

d. :D

e. 1&D

E"pected interest rates Answer: a Diff: E

01

. Eneyear government bonds yield 3 percent and !year government bonds

yield 0.0 percent. Assume that the expectations theory holds. "hat does

the market believe the rate on 1year government bonds will be one year

#rom today$

a. 0.&&D

b. 0.0&D

c. 0.70D

d. 3.&&D

e. 7.&&D

E"pected interest rates Answer: a Diff: E

0!

. Assume that the expectations theory holds) and that li-uidity and

maturity risk premiums are 4ero. +# the annual rate o# interest on a

!year Treasury bond is 1&.0 percent and the rate on a 1year Treasury

bond is 1! percent) what rate o# interest should you expect on a 1year

Treasury bond one year #rom now$

a. =.&D

b. =.0D

c. 1&.&D

d. 1&.0D

e. 11.&D

Chapter 4 Page 15

E"pected interest rates Answer: b Diff: E

0*

. Eneyear Treasury bills yield 3 percent) while Treasury notes with

!year maturities yield 3.7 percent. +# the expectations theory holds

Athat is) the maturity risk premium is 4eroC) what is the market9s

#orecast o# what 1year Tbills will be yielding one year #rom now$

a. 3.7D

b. 7..D

c. 7.:D

d. :.&D

e. :.!D

E"pected interest rates Answer: b Diff: E

0.

. Twoyear Treasury securities yield 3.7 percent) while 1year Treasury

securities yield 3.* percent. Assume that the maturity risk premium

A'B,C e-uals 4ero. "hat does the market anticipate will be the yield on

1year Treasury securities one year #rom now$

a. 3.7D

b. 7.1D

c. 1*.&D

d. 3.0D

e. 1&.!D

E"pected interest rates Answer: c Diff: E

00

. Eneyear Treasury securities yield 0 percent) !year Treasury securities

yield 0.0 percent) and *year Treasury securities yield 3 percent. Assume

that the expectations theory holds. "hat does the market expect will be

the yield on 1year Treasury securities two years #rom now$

a. 3.&D

b. 3.0D

c. 7.&D

d. 7.0D

e. :.&D

E"pected interest rates Answer: c Diff: E N

03

. The real risk#ree rate o# interest) k?) is . percent) and it is expected

to remain constant over time. +n#lation is expected to be

! percent per year #or the next three years) a#ter which time in#lation

is expected to remain at a constant rate o# 0 percent per year. The

maturity risk premium is e-ual to &.1At 1CD) where t H the bond9s

maturity. "hat is the yield on a 1&year Treasury bond$

a. :.1D

b. :.=D

c. =.&D

d. =.1D

e. =.=D

Chapter 4 Page 16

E"pected interest rates Answer: d Diff: E N

07

. You observe the #ollowing yield curve #or Treasury securities>

'aturity Yield

1 year 0.0D

! years 0.:

* years 3.&

. years 3.*

0 years 3.0

Assume that the pure expectations hypothesis holds. "hat does the market

expect will be the yield on .year securities) 1 year #rom today$

a. 3.&&D

b. 3.*&D

c. 3..&D

d. 3.70D

e. 7.*&D

!nflation rate Answer: c Diff: E

0:

. @iven the #ollowing data) #ind the expected rate o# in#lation during the

next year.

• k? H real risk#ree rate H *D.

• 'aturity risk premium on 1&year Tbonds H !D. +t is 4ero on 1year

bonds) and a linear relationship exists.

• 5e#ault risk premium on 1&year) Arated bonds H 1.0D.

• <i-uidity premium H &D.

• @oing interest rate on 1year Tbonds H :.0D.

a. *.0D

b. ..0D

c. 0.0D

d. 3.0D

e. 7.0D

!nflation rate Answer: d Diff: E

0=

. Suppose that the annual expected rates o# in#lation over each o# the next

#ive years are 0 percent) 3 percent) = percent) 1* percent) and 1!

percent) respectively. "hat is the average expected in#lation rate over

the 0year period$

a. 3D

b. 7D

c. :D

d. =D

e. 1&D

Chapter 4 Page 17

Default risk premium Answer: b Diff: E N

3&

. The real risk#ree rate) k?) is * percent. +n#lation is expected to

average ! percent a year #or the next three years) a#ter which time

in#lation is expected to average *.0 percent a year. Assume that there

is no maturity risk premium. A 7year corporate bond has a yield o# 7.3

percent. Assume that the li-uidity premium on the corporate bond is &..

percent. "hat is the de#ault risk premium on the corporate bond$

a. &.7&D

b. 1.*.D

c. 1..0D

d. !.&1D

e. !.!&D

Medium:

E"pected interest rates Answer: c Diff: M

31

. You are given the #ollowing data>

• k? H real risk#ree rate H .D.

• (onstant in#lation premium H 7D.

• 'aturity risk premium H 1D.

• 5e#ault risk premium #or AAA bonds H *D.

• <i-uidity premium #or longterm Tbonds H !D.

Assume that a highly li-uid market does not exist #or longterm Tbonds)

and the expected rate o# in#lation is a constant. @iven these

conditions) the nominal risk#ree rate #or Tbills is ) and the rate

on longterm Treasury bonds is .

a. .D% 1.D

b. .D% 10D

c. 11D% 1.D

d. 11D% 10D

e. 11D% 17D

E"pected interest rates Answer: b Diff: M

3!

. 5rongo (orporation9s .year bonds currently yield 7.. percent. The real

risk#ree rate o# interest) k?) is !.7 percent and is assumed to be

constant. The maturity risk premium A'B,C is estimated to be &.1DAt 1C)

where t is e-ual to the time to maturity. The de#ault risk and li-uidity

premiums #or this company9s bonds total &.= percent and are believed to be

the same #or all bonds issued by this company. +# the average in#lation

rate is expected to be 0 percent #or years 0) 3) and 7) what is the yield

on a 7year bond #or 5rongo (orporation$

a. :.7&D

b. :.*.D

c. 7..&D

d. =.!&D

e. :.0.D

Chapter 4 Page 18

E"pected interest rates Answer: b Diff: M

3*

. The real risk#ree rate is expected to remain constant at * percent.

+n#lation is expected to be ! percent a year #or the next * years) and

then . percent a year therea#ter. The maturity risk premium is &.1DAt

1C) where t e-uals the maturity o# the bond. AThe maturity risk premium

on a 0year bond is &.. percent.C A 0year corporate bond has a yield o#

:.. percent. "hat is the yield on a 7year corporate bond that has the

same de#ault risk and li-uidity premiums as the 0year corporate bond$

a. :.7*D

b. :.=.D

c. :.30D

d. 7.=:D

e. =.!.D

E"pected interest rates Answer: b Diff: M

3.

. The real risk#ree rate o# interest) k?) is * percent. +n#lation is

expected to be . percent this year) 0 percent next year) and * percent

per year therea#ter. The maturity risk premium e-uals &.1DAt 1C) where

t e-uals the bond9s maturity. That is) a 0year bond has a maturity risk

premium o# &.. percent or &.&&.. A 0year corporate bond yields :

percent. "hat is the yield on a 1&year corporate bond that has the same

de#ault risk and li-uidity premiums as the 0year corporate bond$

a. 7.!D

b. :.!D

c. :.&D

d. 3.:D

e. :..D

E"pected interest rates Answer: d Diff: M

30

. The real risk#ree rate o# interest) k?) e-uals ! percent. +n#lation is

expected to be ! percent per year over the next #ive years and then

* percent per year therea#ter. The maturity risk premium A'B,C e-uals

&.&0DAt 1C) where t H the maturity o# the bond. A 1&year corporate

bond has a yield o# 7.: percent. A 1!year corporate bond has the same

de#ault risk and li-uidity premiums as the 1&year corporate bond. "hat

is the yield on the 1!year bond$

a. 7..:D

b. 7.=&D

c. :.0&D

d. 7.=:D

e. :.*&D

Chapter 4 Page 19

E"pected interest rates Answer: b Diff: M

33

. Assume that k? H !.&D% the maturity risk premium is #ound as 'B, H &.1DAt

1C) where t H years to maturity% the de#ault risk premium #or corporate

bonds is #ound as 5B, H &.&0DAt 1C% the li-uidity premium is 1 percent

#or corporate bonds only% and in#lation is expected to be * percent) .

percent) and 0 percent during the next three years and then 3 percent

therea#ter. "hat is the di##erence in interest rates between 1&year

corporate and Treasury bonds$

a. &..0D

b. 1..0D

c. !.!&D

d. !.70D

e. *.!0D

E"pected interest rates Answer: a Diff: M

37

. Threeyear Treasury securities currently yield 3 percent) while .year

Treasury securities currently yield 3.0 percent. Assume that the

expectations theory holds. "hat does the market believe the rate will be

on 1year Treasury securities three years #rom now$

a. :.&D

b. :.0D

c. =.&D

d. =.0D

e. 1&.&D

E"pected interest rates Answer: d Diff: M

3:

. Eneyear Treasury securities yield 3.= percent) while !year Treasury

securities yield 7.! percent. +# the expectations theory is correct

Athat is) the maturity risk premium is 4eroC what does the market

anticipate will be the yield on 1year Treasury securities one year #rom

now$

a. 3.&D

b. 3.7D

c. 7.!D

d. 7.0D

e. :.&D

Chapter 4 Page 20

E"pected interest rates Answer: d Diff: M

3=

. You observe the #ollowing yields on Treasury securities o# various

maturities>

'aturity Yield

1 year 3.&D

* years 3..

3 years 3.0

= years 3.:

1! years 7.&

10 years 7.!

8sing the expectations theory) #orecast the interest rate on =year

Treasuries) six years #rom now. AThat is) what will be the yield on

=year Treasuries) issued in 3 years9 time$C

a. 3.0&D

b. 3.30D

c. 3.:&D

d. 7.37D

e. :.&&D

E"pected interest rates Answer: d Diff: M

7&

. You observe the #ollowing yield curve #or Treasury securities>

'aturity Yield

1 year 3.!D

! years 3..

* years 3.7

. years 3.=

0 years 7.1

Assume that the expectations theory is correct. "hat does the market

expect the interest rate on *year securities to be 1 year #rom now$

a. 3.37D

b. 3.7&D

c. 3.=&D

d. 7.1*D

e. 7.0&D

Chapter 4 Page 21

E"pected interest rates Answer: d Diff: M

71

. You observe the #ollowing yield curve #or Treasury securities>

'aturity Yield

1 year ..3D

! years ..:

* years ..=

. years ..:

0 years 0.!

Assume that the expectations theory holds. "hat does the market expect

the interest rate on 1year securities to be #our years #rom today$

a. ..:D

b. 0.!D

c. 0.3D

d. 3.:D

e. *0..D

E"pected interest rates Answer: b Diff: M

7!

. (urrently) *year Treasury securities yield 0.. percent) 7year Treasury

securities yield 0.: percent) and 1&year Treasury securities yield 3.!

percent. +# the expectations theory is correct) what does the market

expect will be the yield on *year Treasury securities seven years #rom

today$

a. 3.0.D

b. 7.1*D

c. 0.:&D

d. ..0:D

e. 0.3:D

E"pected interest rates Answer: d Diff: M

7*

. Threeyear treasury securities yield 0 percent) 0year treasury

securities yield 3 percent) and :year treasury securities yield

7 percent. +# the expectations theory is correct) what is the expected

yield on 0year Treasury securities three years #rom now$

a. 0.&D

b. 7.&D

c. 3.7D

d. :.!D

e. 3.&D

Chapter 4 Page 22

E"pected interest rates Answer: c Diff: M

7.

. +n the market today) you observe the #ollowing yields on Treasury

securities>

'aturity Yield

* years 3.!D

0 years 0.=

: years 0.7

Assume that the expectations theory holds. "hat does the market expect

the yield on *year Treasury securities to be #ive years #rom today$

a. 0.0&D

b. 3.&1D

c. 0.*7D

d. 0.7&D

e. =.&&D

E"pected interest rates Answer: e Diff: M

70

. You observe the #ollowing yield curve #or Treasury securities>

'aturity Yield

1 year 0.3D

! years 0.:

0 years 3.!

7 years 3.3

= years 3.:

Assuming that the expectations theory holds) what does the market expect

the yield on !year Treasury securities to be #ive years #rom today$

a. 0.:&D

b. 3.!&D

c. 3.3&D

d. 3.=!D

e. 7.3&D

Chapter 4 Page 23

E"pected interest rates Answer: b Diff: M

73

. You observe the #ollowing term structure #or Treasury securities>

'aturity Yield

1 year 0.1D

! years 0..

* years 0.3

. years 0.7

0 years 3.&

Assume that the expectations theory holds. "hat does the market expect

will be the yield on !year Treasury securities three years #rom today$

a. 0..D

b. 3.3D

c. 3.:D

d. 7.3D

e. 0.:D

E"pected interest rates Answer: d Diff: M

77

. A #ixedincome analyst has made the #ollowing assessments>

• The real risk#ree rate is expected to remain at !.0 percent #or the

next 1& years.

• +n#lation is expected to be * percent this year) . percent next year)

and 0 percent a year therea#ter.

• The maturity risk premium is &.1DAt 1C) where t H the maturity o#

the bond Ain yearsC.

A 0year corporate bond currently yields :.0 percent. "hat will be the

yield on the bond) one year #rom now) i# the above assessments are

correct) and the bond9s de#ault premium and li-uidity premium remain

unchanged$

a. 7.*&D

b. :..&D

c. :.0&D

d. :.70D

e. :.:0D

Chapter 4 Page 24

E"pected interest rates Answer: b Diff: M

7:

. The real risk#ree rate o# interest is * percent. The market expects

that in#lation will be * percent each year #or the next 0 years) and then

will average 0 percent a year therea#ter. The maturity risk premium is

estimated to be 'B,

t

H &.1DAt 1C. +n other words) the maturity risk

premium on a !year security is &.1 percent or &.&&1. "hat is the yield

on a Treasury bond that matures in 1! years$

a. :.1&D

b. :.!7D

c. :..0D

d. :.0*D

e. :.3:D

E"pected interest rates Answer: c Diff: M

7=

. The real risk#ree rate o# interest is ! percent. The market expects

that in#lation will be * percent each year #or the next #ive years) and

then will average 0 percent a year therea#ter. The maturity risk premium

is estimated to be 'B,

t

H &.1DAt 1C. +n other words) the maturity risk

premium on a !year security is &.1 percent or &.&&1. A 1&year

corporate bond yields :.3 percent. "hat is the yield on an

:year corporate bond that has the same de#ault risk and li-uidity as the

1&year bond$

a. 3..0D

b. 7.=&D

c. :.10D

d. :..!D

e. :.3&D

E"pected interest rates Answer: b Diff: M

:&

. Tenyear bonds have an interest rate o# 3.0 percent) while 10year bonds

have an interest rate o# 3.& percent. +# the expectations theory is

correct) what does the market believe will be the interest rate on 0year

bonds) 1& years #rom now$

a. 0.0&D

b. 0.&&D

c. 1!.0&D

d. 3.!0D

e. 7.&&D

Chapter 4 Page 25

E"pected interest rates Answer: b Diff: M

:1

. The real risk#ree rate) k?) is expected to remain constant at

* percent. +n#lation is expected to average ! percent per year #or the

next #ive years and then * percent per year therea#ter. The maturity

risk premium e-uals &.1DAt 1C) where t H the bond9s maturity. AThe 'B,

o# a *year security is &.! percent) or &.&&!C. (urrently) a 1&year

corporate bond has a yield o# 7.: percent. "hat is the yield on a

10year corporate bond that has the same de#ault risk and li-uidity

premiums as the 1&year corporate bond$

a. :.*&D

b. :..7D

c. :.07D

d. :.:&D

e. =.:&D

E"pected interest rates Answer: b Diff: M

:!

. Assume that the current interest rate on a 1year bond is : percent) the

current rate on a !year bond is 1& percent) and the current rate on a *

year bond is 1! percent. +# the expectations theory is correct) what is

the 1year interest rate expected during Year *$

a. 1!.&D

b. 13.&D

c. 1*.0D

d. 1&.0D

e. 1..&D

E"pected interest rates Answer: a Diff: M N

:*

. You observe the #ollowing yield curve #or Treasury securities>

'aturity Yield

1 year 3.&D

! years 0.:

* years 0.0

. years 0.3

0 years 0.:

Assume that the expectations theory holds. "hat does the market expect

that threeyear interest rates will be one year #rom today$

a. 0..7D

b. 0.0&D

c. 0.3&D

d. 0.:7D

e. 0.=&D

Chapter 4 Page 26

E"pected interest rates Answer: a Diff: M N

:.

. You observe the #ollowing yield curve #or Treasury securities>

'aturity Yield

1 year 0.:D

! years 3.!

* years 3.0

. years 3.!

0 years 3.&

Assume that the expectations theory is correct. "hat does the market

expect the rate on twoyear Treasury securities will be three years #rom

today$

a. 0.!0D

b. 3.!&D

c. 3.&&D

d. 0.:7D

e. 3.0&D

E"pected interest rates Answer: b Diff: M N

:0

. You observe the #ollowing yield curve #or 8.S. Treasury securities>

'aturity Yield

1 year 0.!D

! years 0.0

* years 0.:

. years 3.*

0 years 3.*

Assume that the pure expectations hypothesis holds. "hat does the

market expect will be the yield on threeyear Treasury securities) one

year #rom today$

a. 3..3D

b. 3.37D

c. 3.=:D

d. 7.*.D

e. 7.:&D

Chapter 4 Page 27

E"pected interest rates Answer: c Diff: M N

:3

. The real risk#ree rate is expected to remain constant at * percent.

+n#lation is expected to be . percent a year #or the next #our years) and

then * percent a year therea#ter. The maturity risk premium is &.1At 1CD)

where t e-uals the maturity o# the bond. AThe maturity risk premium on a

0year bond is &.. percent or &.&&..C A 7year corporate bond has a yield

o# =.: percent A&.&=:C. "hat is the yield on a 1&year corporate bond

that has the same de#ault risk premium and li-uidity premium as the 7year

corporate bond$

a. =.3*D

b. =.7*D

c. =.=*D

d. 1&.&*D

e. 1&.10D

Real risk%free rate of interest Answer: d Diff: M

:7

. You read in The Wall Street Journal that *&day Tbills are currently

yielding : percent. Your brotherinlaw) a broker at Jyoto Securities)

has given you the #ollowing estimates o# current interest rate premiums>

• +n#lation premium H 0D.

• <i-uidity premium H 1D.

• 'aturity risk premium H !D.

• 5e#ault risk premium H !D.

En the basis o# these data) the real risk#ree rate o# return is

a. &D

b. 1D

c. !D

d. *D

e. .D

!nflation rate Answer: c Diff: M

::

. A 1&year Treasury bond currently yields 7 percent. The real risk#ree

rate o# interest) k?) is *.1 percent. The maturity risk premium has been

estimated to be &.1DAt 1C) where t H the maturity o# the bond. A;or a

*year bond the maturity risk premium is &.! percent or &.&&!.C +n#lation

is expected to average !.0 percent a year #or each o# the next #ive years.

"hat is the expected average rate o# in#lation between years #ive and ten$

a. !.0D

b. *.&D

c. *.0D

d. ..&D

e. ..0D

Chapter 4 Page 28

!nflation rate Answer: b Diff: M

:=

. Assume that a *year Treasury note has no maturity risk premium) and that

the real risk#ree rate o# interest is * percent. +# the Tnote carries

a yield to maturity o# 1* percent) and i# the expected average in#lation

rate over the next ! years is 11 percent) what is the implied expected

in#lation rate during Year *$

a. 7D

b. :D

c. =D

d. 17D

e. 1:D

!nflation rate Answer: d Diff: M

=&

. The Wall Street Journal -uotes the yield on 0year Treasury bonds as

0.. percent. Also) the current 1year Treasury bond has a yield o#

0 percent. +# the real risk#ree rate is * percent and is expected to

remain constant) and the expectations theory is correct) what is the

average annual expected in#lation #or the .year period during Years !

through 0$

a. &.3*D

b. 0.0&D

c. 1.1&D

d. !.0&D

e. &.0&D

!nflation rate Answer: b Diff: M

=1

. The real risk#ree rate) k?) is * percent. Twoyear Treasury securities

yield 3.0 percent) while *year Treasury securities yield 7 percent. The

Treasury securities have a maturity risk premium H &.1DAt 1C) where t H

the maturity o# the security. Assume that the de#ault risk premium and

li-uidity premium on all Treasury securities e-uals 4ero. The expected

in#lation rate #or this next year AYear 1C is *.!0 percent. "hat does the

market anticipate will be the in#lation rate three years #rom now$

a. *.00D

b. ..3&D

c. 0.&&D

d. 0.!0D

e. 0.0&D

Chapter 4 Page 29

!nflation rate Answer: b Diff: M

=!

. The real risk#ree rate is expected to remain at * percent. +n#lation is

expected to be * percent this year and . percent next year. The maturity

risk premium is estimated to be e-ual to &.1DAt 1C) where t H the

maturity o# a bond Ain yearsC. All Treasury securities are highly

li-uid) and there#ore have no li-uidity premium. Threeyear Treasury

bonds yield &.0 percentage points A&.&&0C more than !year Treasury bonds

Athat is) !year bond yield plus &.0DC. "hat is the expected level o#

in#lation in Year *$

a. ..0D

b. ..7D

c. 0.&D

d. 0.3D

e. 3.*D

!nflation rate Answer: a Diff: M

=*

. A 0year corporate bond has an : percent yield. A 1&year corporate bond

has a = percent yield. The two bonds have the same de#ault risk premium

and li-uidity premium. The real risk#ree rate) k?) is expected to

remain constant at * percent. +n#lation is expected to be * percent a

year #or the next #ive years. A#ter #ive years) in#lation is expected to

be constant at some rate) K) which may or may not be * percent. The

maturity risk premium e-uals &.1DAt 1C) where t e-uals time until the

bond9s maturity. +n other words) the maturity risk premium on the

0year bond is &.. percent or &.&&.. "hat is the market9s expectation

today o# the average level o# in#lation #or Years 3 through 1&) that is)

what is K$

a. ..&D

b. 3.&D

c. 1.0D

d. &.=D

e. 7.&D

Chapter 4 Page 30

!nflation rate Answer: e Diff: M

=.

. Assume that today is Lanuary 1) !&&*. A 0year corporate bond maturing on

Lanuary 1) !&&:) has a yield to maturity o# 7.0 percent. A 1&year

corporate bond maturing on Lanuary 1) !&1*) with the same li-uidity and

de#ault risk premiums as the 0year corporate bond has a yield to maturity

o# :.! percent. The annual real risk#ree rate o# interest) k?) is

expected to remain constant at ! percent. The maturity risk premium e-uals

&.1DAt 1C) where t H the bond9s maturity in years. A;or example) the

maturity risk premium on a 0year bond is &.. percent or &.&&..C +n#lation

is expected to average ! percent per year #or the next #ive years. "hat is

the average annual expected in#lation between Lanuary !&&: and Lanuary

!&1*$

a. !.!D

b. &.!D

c. *..D

d. &.3D

e. !..D

Default risk premium Answer: a Diff: M

=0

. The 1&year bonds o# @ator (orporation are yielding : percent per year.

Treasury bonds with the same maturity are yielding 3.. percent per year.

The real risk#ree rate Ak?C has not changed in recent years and is

* percent. The average in#lation premium is !.0 percent and the maturity

risk premium takes the #orm> 'B, H &.lDAt lC) where t H number o#

years to maturity. +# the li-uidity premium is &.0 percent) what is the

de#ault risk premium on the corporate bond$

a. 1.1D

b. !.0D

c. 1.!D

d. &.7D

e. 1.3D

Maturity risk premium Answer: d Diff: M

=3

. The real risk#ree rate is ! percent. The in#lation rate is expected to

be * percent a year #or the next three years and then . percent a year

therea#ter. Assume that the de#ault risk and li-uidity premiums on all

Treasury securities e-ual 4ero. You observe that 1&year Treasury bonds

yield 1 percent more than the yield on 0year Treasury bonds. "hat is

the di##erence in the maturity risk premium on the two bonds$ AThat is)

what is 'B,

1&

'B,

0

$C

a. &.1D

b. &.*D

c. &.0D

d. &.7D

e. 1.&D

Chapter 4 Page 31

Maturity risk premium Answer: a Diff: M

=7

. An investor in Treasury securities expects in#lation to be * percent in

Year 1) . percent in Year !) and 0 percent each year therea#ter. Assume

that the real risk#ree rate is * percent) and that this rate will remain

constant over time. Twoyear Treasury securities yield 3.: percent)

while .year Treasury securities yield 7.3 percent. "hat is the

di##erence in the maturity risk premiums A'B,sC on the two securities)

that is) what is 'B,

.

'B,

!

$

a. &.&0D

b. &.1&D

c. &.10D

d. &.:&D

e. &.=&D

Maturity risk premium Answer: d Diff: M

=:

. The real risk#ree rate is * percent. The in#lation rate is expected to

be . percent #or the next two years) ..0 percent #or Years * and .) and

0 percent #or each year therea#ter. The li-uidity and de#ault risk

premiums are e-ual to 4ero #or Treasury securities. The 3year Treasury

bonds yield &.3 percent more than .year Treasury bonds) and the maturity

risk premium on the 3year Treasury bonds A'B,

3

C is &.= percent. "hat is

the maturity risk premium on the .year Treasury bonds A'B,

.

C$

a. &.3&D

b. &.!0D

c. &.*&D

d. &.00D

e. &...D

Multiple Part:

(The following information applies to the next two problems.)

<ooking in today9s newspaper) you observe the #ollowing yield curve in#ormation>

'aturity Yield

1 year 0.&D

! years 0.0

* years 3.&

. years $$$

0 years 7.&

E"pected interest rates Answer: c Diff: E N

==

. +# the pure expectations hypothesis holds) what does the market expect

that the oneyear rate will be one year #rom now$

a. 0.&D

b. 0.0D

c. 3.&D

d. 3.0D

e. 7.&D

Chapter 4 Page 32

E"pected interest rates Answer: e Diff: E N

1&&

. Assume that the pure expectations hypothesis holds and that the market

expects that the oneyear rate will be 7.! percent #our years #rom today.

"hat is the #ouryear rate today$

a. 0.!&D

b. 3.!&D

c. 3.0&D

d. 3.:&D

e. 3.=0D

(The following information applies to the next two problems.)

A 0year Treasury bond has a 0 percent yield. A 1&year Treasury bond has a

3 percent yield. A 1&year corporate bond has an : percent yield. The market

expects that in#lation will average !.0 percent over the next 1& years A+,

1&

H

!.0DC. Assume that there is no maturity risk premium A'B, H &C) and that the

annual real risk#ree rate o# interest) k?) will remain constant over the next

1& years. AFint> Bemember that the de#ault risk premium and the li-uidity

premium are 4ero #or Treasury securities> 5B, H <, H &C.

Aera&e inflation Answer: b Diff: M N

1&1

. "hat does the market expect that in#lation will average over the next

#ive years$

a. 1.&D

b. 1.0D

c. !.&D

d. !.0D

e. *.0D

E"pected interest rates Answer: c Diff: M N

1&!

. A 0year corporate bond has the same de#ault risk premium and li-uidity

premium as the 1&year corporate bond described above. "hat is the yield

on this 0year corporate bond$

a. 3.&D

b. 3.0D

c. 7.&D

d. 7.0D

e. :.&D

(The following information applies to the next two problems.)

Assume that the real risk#ree rate o# interest) k?) e-uals * percent) and it

is expected to be constant over time. Expected in#lation is expected to be

* percent in Year 1) . percent in Year !) and 0 percent in Year *. Assume that

the maturity risk premium A'B,C H &.

Chapter 4 Page 33

E"pected interest rates Answer: c Diff: E N

1&*

. "hat is the interest rate on Treasury securities that mature in three

years$

a. 3.&D

b. 3.0D

c. 7.&D

d. 7.0D

e. :.&D

E"pected inflation Answer: e Diff: E N

1&.

. The interest rate on Treasury securities that mature in #our years is

: percent. "hat is expected in#lation in Year .$

a. *.&D

b. 0.&D

c. 3.&D

d. 7.&D

e. :.&D

(The following information applies to the following two problems.)

Assume that the pure expectations hypothesis is correct. AThat is) the

maturity risk premium A'B,C e-uals 4ero.C The current term structure o#

interest rates #or Treasury securities is as #ollows>

'aturity Yield

1 year 3.&D

! years 3.0

0 years 7.&

1& years 7.0

10 years 7.!

!& years 3.0

E"pected interest rates Answer: a Diff: M N

1&0

. "hat does the market think will be the yield on 0year Treasury

securities 1& years #rom now$

a. 3.3&D

b. 3.=0D

c. 7.&0D

d. 7.0&D

e. :.1&D

E"pected interest rates Answer: d Diff: M N

1&3

. The market thinks that two years #rom now) the rate on oneyear Treasury

securities will be 3.: percent. "hat does the market think the rate

will be on twoyear Treasury securities one year #rom now$

a. 3.3D

b. 3.7D

c. 3.:D

d. 3.=D

e. 7.&D

Chapter 4 Page 34

Chapter 4 Page 35

CHAPTE !

A$)-E) A$D )'%*T#'$)

1' Financial markets Answer: d Diff: E

!' Financial markets Answer: c Diff: E

Statement a is #alse% this describes the overthecounter market. Statement b

is #alse% this is a secondary market transaction. Statement c is true%

there#ore) the other statements are #alse.

*' Financial markets Answer: d Diff: E

Statement d is the correct choice) because both statements b and c are correct.

Statement a is incorrect% this is a secondary market transaction.

.' Financial markets Answer: d Diff: E

Statements a and b are both secondary market transactions% one is a private

transaction) and one is public) but they both occur on the secondary market.

There#ore) statements a and b are true. Statement c is #alse because this is

a primary market transaction. A+t is the #irst time these shares have been

o##ered.C Since statements a and b are both true) statement d is the correct

choice.

0 ' Financial markets

Answer: c Diff: E

Statement a is #alse% money markets are the markets #or shortterm) highly

li-uid debt securities. Statement b is #alse% primary markets are the markets

where corporations raise new capital. Statement c is true% this is the

de#inition o# a derivative.

3' Financial markets Answer: c Diff: E N

The correct answer is statement c. Statement a is incorrect% investment banks

Asuch as @oldman Sachs or 5ean "itterC speciali4e in helping #irms raise

external capital) while commercial banks are more active in lending money.

Statement b is incorrect% money market #unds typically invest their #unds in

shortterm) li-uid) lowrisk debt securities. A list o# money market

instruments can be #ound in (hapter 0 o# the textbook.

7' Capital market instruments Answer: b Diff: E

The capital market is the market #or longterm debt and corporate stock. The

only longterm instrument in the choices given is pre#erred stock.

:' Money markets Answer: e Diff: E

=' Financial transactions Answer: a Diff: E

Statement a is correct% the other statements are #alse. (onsumer auto loans

typically have maturities in excess o# one year. 'oney markets are the

markets #or debt securities with maturities o# less than one year. +# an

investor sells shares through a broker) this is a secondary market

transaction. The purchase and sale o# longterm debt is also a capital market

transaction.

1& . Financial transactions

Answer: a Diff: E

This is a secondary market transaction) while the stock exchanged is a

#inancial capital asset.

11' Financial transactions Answer: e Diff: E

1!' Financial transactions Answer: c Diff: E

Selling 5isney stock is an example o# a secondary market transaction.

1*' Primary market transactions Answer: e Diff: E

Statement c is a secondary market transaction.

1.' Risk and return Answer: d Diff: E

10' Yield cure Answer: a Diff: E

+# the expectations theory holds) the Treasury yield curve must be downward

sloping. Since everyone is expecting in#lation to be declining) then the

average in#lation rate #or the next 0 years will be less than the average

in#lation rate #or this year. There#ore) the +, will decline as maturity

increases) and statement a is true.

"e cannot say #or sure that the yield curve #or corporate securities must be

downward sloping i# the expectations theory holds because both the 'B, and 5B,

increase with time. +# the #all in in#lation is small) but the increase in

'B, and 5B, through time is large) the yield curve #or corporate securities

may be upward sloping. There#ore) statement b is #alse.

Statement c depends on the relative magnitudes o# the two premiums that a##ect

Treasuries) 'B, and +,. +# the decline in +, is greater than the increase in

'B,) then the yield curve will still be downward sloping. There#ore) statement

c is #alse.

13' Yield cure Answer: a Diff: E

17' Yield cure Answer: c Diff: E

The shape o# the yield curve depends primarily on two #actors>

A1C expectations about #uture in#lation and A!C the relative riskiness o#

securities with di##erent maturities.

1:' Yield cure Answer: e Diff: E

The re-uired return on treasuries is> k H k? M +, M 'B,. Since 'B, H &) k H

k? M +,. <ongerterm treasuries will have lower yields than shorterterm

treasuries as the +, Ain#lation premiumC is declining over time. So)

statement a is correct. A corporate bond o# e-ual maturity to a treasury bond

will always have a higher yield because o# the de#ault risk on the corporate

bond. So statement b is correct. ;rom statements a and b) statement c is

correct also.

1=' Yield cure Answer: c Diff: E

The maturity risk premium A'B,C and the expectations o# #uture interest rates

determine the shape o# the yield curve. There#ore) statements a and b are

#alse since they ignore interest rate expectations. Statement d is #alse% it

is entirely possible to have a downwardsloping yield curve under the

expectations theory.

!&' Yield cure Answer: e Diff: E

The re-uired return on Treasuries is k H k? M +, M 'B,. +n#lation increases)

so the +, on a 1&year Treasury is higher than the +, on a

!year Treasury. Also) 'B, H &.1DAt 1C. 'B, on the !year Treasury H

&.1DA! 1C H &.1D. 'B, on the 1&year Treasury H &.1DA1& 1C H &.=D.

There#ore) both the 'B, and the +, on the 1&year Treasury exceed the 'B, and

the +, on the !year Treasury) so the overall yield on the

1&year Treasury must be higher than the yield on the !year Treasury.

There#ore) statement a is true.

kATreasuryC H k? M +, M 'B,. kA(orporateC H k? M +, M 5B, M <, M 'B,. Since

the corporate bond has the extra risk premia) it will have a higher yield #or

two bonds o# the same maturity) but in statement b the bonds have di##erent

maturities) so we cannot say #or sure that this is true or #alse. There#ore)

statement b is #alse.

Yield

Treasury

1& :

'aturity

(orporate

Since we know that the corporate bond has to have a higher yield than the

Treasury bond #or all bonds o# the same maturity) we know the yield curve #or

the corporate bond must be higher than the yield curve #or the Treasury bond.

"e also know that the yield curve is upward sloping because in#lation steadily

increases over time. +# you look at the graph) it9s obvious that statement c

must be true. Since statements a and c are both true) then statement e is the

correct choice.

!1' !nterest rates Answer: c Diff: E

!!' !nterest rates Answer: b Diff: E

The correct answer is statement b. +# savings increase) money available to

lend increases Ain other words) supply increasesC. This would cause interest

rates to decrease. Er) you can view this as the demand #or money decreases)

which also causes interest rates to decrease. So) statement a in incorrect.

An increase in borrowing has the exact opposite e##ect. The demand increases)

so interest rates increase. Thus) statement be is correct. Since k H k? M +,

M 5B, M <, M 'B,) i# +, decreases) k decreases. So statement c is incorrect.

!*. !nterest rates Answer: d Diff: E N

The correct answer is statement d. An increase in household savings

increases money available) shi#ting the supply curve to the right) causing

interest rates to #all. So) statement a is incorrect. /oth statements b and

c are correct. An increase in demand will increase interest rates) and an

increase in expected in#lation will increase interest rates. So) statement d

is the correct choice.

!. ' !nterest rates

Answer: b Diff: E N

The correct answer is statement b. /oth statements a and c are incorrect

because expected in#lation can be positive) 4ero) or negative. "ithout #urther

in#ormation on the expected #uture in#lation rate) statements a and c cannot be

evaluated. ;or statement b) both bonds have the same expected in#lation. A

corporate bond always has some de#ault risk premium) while the Treasury bond

does not) so the yield on the !year corporate bond must exceed the yield on

the !year Treasury bond.

!0' Cost of money Answer: c Diff: E N

The correct answer is statement c. +# companies9 production opportunities

decline leading to a decline in the demand #or #unds) companies will be

borrowing less. +# companies borrow less) the banks will need to lower rates

in order to entice them to keep borrowing more. "henever demand #alls) prices

Athat is) the cost o# #undsC will #all too. There#ore) this will lead to a

decrease in the cost o# #unds) not an increase) and statement a is incorrect.

+# households save a larger portion o# their income) deposits at banks will

increase. That is) the supply o# #unds increases. +# deposits go up) banks

will reduce their interest rates until they can entice companies to borrow more

o# these new #unds. There#ore) this will cause a decrease in the cost o#

#unds) not an increase) so statement b is incorrect. +# households increase

the money they borrow #rom banks) banks will have decreased deposits. That is)

the supply o# #unds decreases. +# the supply decreases) the price Athat is)

the cost o# #undsC will increase. There#ore) statement c is correct.

!3' E"pectations t#eory Answer: c Diff: E

This is assumed by the expectations theory.

!7' E"pectations t#eory Answer: a Diff: E

The return on the Treasury would be k? M +, H *D M !D H 0D. +# in#lation is

expected to be ! percent #orever) then the yield curve will be #lat. Statement a

is true. +# in#lation will be constant #orever) the yield curve will not slope

up or downit will be #lat #orever. There#ore) statement b is #alse. Yes)

corporate bonds will yield more than 0 percent because o# de#ault risk. Fowever)

the yield curve will not be #lat #or corporate bonds because de#ault risk

increases with time to maturity. A company may have a low probability o# de#ault

today) but can you say the same with certainty #or !& or *& years #rom today$

There#ore) statement c is #alse.

!:' E"pectations t#eory Answer: d Diff: E

Statement d is correct% the other statements are incorrect. Statement a is

incorrect% the yield curve is upward sloping. Statement b is incorrect% the

!year rate is A3D M 7DCN! H 3.0D. Statement c is incorrect% see b above.

Statement d is correct% the *year rate is A3D M 7D M :DCN* H 7D. Statement e

is incorrect% see d above.

!= . E"pectations t#eory

Answer: e Diff: E

Statement a is #alse% the 1&year Treasury bond should have a higher yield

than the 0year Treasury bond because the yield curve is upward sloping.

Statement b is #alse% the 1&year corporate bond should have a higher yield

than the 0year corporate bond because the yield curve is upward sloping.

Statement c is #alse% it ignores the de#ault risk o# corporate bonds.

Statement d is #alse% again) it ignores the de#ault risk and li-uidity premia

on the corporate bond. Statement e is correct% both bonds have the same risk)

so the shape o# the yield curve means that the longermaturity bond must have

the higher yield.

*&' Financial transactions Answer: d Diff: M

*1' Financial transactions Answer: d Diff: M

Statements a) b) and c are incorrect. Spot and #utures markets are

distinguished by whether assets are sold #or 1onthespot2 delivery or #uture

delivery. <ongterm debt issues are capital market transactions. New stock

o##erings are primary market transactions regardless o# whether or not the

company has issued stock in the past.

*!' !nterest rates Answer: b Diff: M

**' !nterest rates Answer: b Diff: M

Statement b is correct% the others are #alse. +# the yield curve were

downward sloping) then the yield on a *year Treasury would be greater than

the yield on a 1&year Treasury. 'ost evidence suggests that there is a

positive maturity risk premium.

*.' !nterest rates Answer: a Diff: M

The corporate bond also has a de#ault risk premium) giving it a higher yield.

*0' $erm structure t#eories Answer: b Diff: M

*3' E"pectations t#eory Answer: e Diff: M

Statement e is correct% the other statements are #alse. The expectations theory

would say that an upward sloping yield curve implies that #uture interest rates

are expected to be higher than current rates. @iven the in#ormation in statement

b) the expectations theory would predict that

1year interest rates one year #rom now would be =D. Then the !year rate would

be &.0A7DC M &.0A=DC H :D. ;iveyear corporate bond yields might be lower than

*year treasury bills i# the yield curve were downward sloping.

*7' E"pectations t#eory Answer: a Diff: M

Statement a is correct% the other statements are #alse. Jnowing !year rates

and *year rates permits no in#erence regarding 0year rates. Fowever) knowing

!year rates and *year rates beginning in two years would permit applying the

expectations theory to in#er 0year rates. @iven the data concerning one and

!year rates in statement c) the market expects 1year rates in one year to be

:D.

*:' E"pectations t#eory Answer: c Diff: M

*=' E"pectations t#eory Answer: e Diff: M

Statement a is incorrect. The yield curves could be such that the yield on a

!year corporate bond exceeds the yield on a 0year Treasury bond) e.g.) when

the yield curve #or corporate bonds is very steeply upward sloping and the

yield curve #or Treasury bonds is relatively gradually upward sloping.

.&' E"pectations t#eory Answer: c Diff: M

3D H A0D M 7DCN!.

.1' E"pectations t#eory Answer: d Diff: M

.!' Yield cure Answer: e Diff: M

.*' Yield cure Answer: e Diff: M

..' Yield cure Answer: a Diff: M

.0' Yield cure Answer: e Diff: M

Statement e is correct% the others are #alse. Statement a is #alse% Iust

because 'B, H &) it doesn9t mean the yield curve must be #lat. The yield

curve could be upward or downward sloping. Statement b is #alse% the yield

curve could be downward sloping) in which case the 0year

Tbond would have a higher yield than the 1&year corporate bond. Statement c

is #alse% the yield curve could be downward sloping. Statement d is #alse% the

5B, could be upward sloping.

.3' Yield cure Answer: c Diff: M

The easiest way to see this is to draw a picture. The yield curve is downward

sloping) and a corporate bond always has a higher yield than a Treasury

because the corporate yield includes de#ault risk and li-uidity premiums. ;or

this -uestion) however) the li-uidity premium is 4ero.

(

T

+nterest Bate

ADC

Years to 'aturity 1& 0

Statement a is #alse. You really can9t tell what the relationship between the

1&year corporate and a 0year Treasury would be. +n this diagram) the rate

on the 1&year corporate looks like it has a higher yield) but i# 5B, were

slightly smaller) the lines would be closer together) and the 1&year

corporate could have a lower yield than the

0year Treasury. Statement b is #alse. The 1&year Treasury will always have

a lower yield than a 1&year corporate because the corporate yield includes

the de#ault risk premium. Statement c is correct. /ecause the yield curve is

downward sloping) and because the Treasury curve is lower than the corporate

curve) the 0year corporate will have a higher yield than any 1&year bond o#

similar or less risk Athat is) a TreasuryC.

.7' Yield cure Answer: d Diff: M N

The correct answer is statement d. ;rom the in#ormation given in the

-uestion) we know that the yield curve is upward sloping. Statement a is

correct. Statement b is also correct% the corporate bond has a longer

maturity and it carries additional risk premiums Ade#ault risk and li-uidity

premiumsC over the government bond. Statement c is incorrect% a 7year

government bond could have a greater yield than the 0year corporate bond) but

not necessarily. This depends upon the magnitude o# the de#ault risk and

li-uidity premiums associated with the corporate bond. There#ore) statement d

is the correct choice.

.:' Yield cure Answer: d Diff: M N

The correct answer is statement d. Becall that k H k? M +, M 'B, M <, M 5B,)

but 5B, H <, H &. Statement a is correct since +,

1&

M 'B,

1&

O +,

7

M 'B,

7

.

Statement b is correct% 5B, and <, O & #or corporate bonds) but e-ual to 4ero

#or Treasuries. Statement c may or may not be correct% it depends on how #ast

the +, is rising.

.=' Corporate yield cure Answer: d Diff: M

/ecause the yield curve is upward sloping) all else e-ual) (hurchill9s bonds

will have a lower yield than @eorge9s bonds. As (hurchill9s bonds are also

less risky) this will hold. Note that statement b is #alse because it doesn9t

consider risk. +# (hurchill9s bonds are riskier than @eorge9s) (hurchill9s

bonds will have a higher yield than @eorge9s.

0&' E"pected interest rates Answer: d Diff: E N

Average in#lation H

*

3D M 0D M .D

H 0D.

k

B;

H k? M +, H *D M 0D H :D.

01' E"pected interest rates Answer: a Diff: E

+# the 1year rate in one year is K% A3D M KCN! H 0.0D% K H 0D.

0!' E"pected interest rates Answer: a Diff: E

k

!

H Ak

1

in Year 1 M k

1

in Year !CN!

1&.0D H A1!D M k

1

in Year !CN!

k

1

in Year ! H =D.

0*

' E"pected interest rates Answer: b Diff: E

1year Tbill H 3D.

!year Tnote H 3.7D.

3.7D H

!

K M 3D

K H 3.7DA!C 3D

H 7..D.

0.' E"pected interest rates Answer: b Diff: E

8sing the expectations theory) the rate on !year securities is the arithmetic

average o# 1year securities now and 1year securities in one year. &.&37 H

A&.&3* M KCN!. K H &.&71 H 7.1D.

00 . E"pected interest rates

Answer: c Diff: E

+#

!

k

1

is the yield on a 1year treasury in two years) we can say>

* P 3D H A! P 0.0D M

!

k

1

C

1:D H 11D M

!

k

1

!

k

1

H 7D.

03' E"pected interest rates Answer: c Diff: E N

+, is going to be the average in#lation rate over the 1&year period. There

will be * years o# ! percent in#lation) then 7 years o# 0 percent in#lation.

k H k? M +, M 'B,

H .D M A!D × * M 0D × 7CN1& M &.1A1& 1CD

H .D M A3D M *0DCN1& M &.1A=DC

H .D M ..1D M &.=D

H =.&D.

07' E"pected interest rates Answer: d Diff: E N

The pure expectations hypothesis allows us to say that a longterm security

yield is comprised o# a weighted average o# securities with shorter

maturities.

3.0D H A0.0D M .KCN0

*!.0D H 0.0D M .K

!7.&D H .K

3.70D H K.

0:' !nflation rate Answer: c Diff: E

k

Nom

H k? M +, M 5B, M <, M 'B,

:.0D H *D M +, M & M & M &

+, H 0.0D.

0=' !nflation rate Answer: d Diff: E

+,

0

H A0D M 3D M =D M 1*D M 1!DCN0 H =D.

3&' Default risk premium Answer: b Diff: E N

k

(7

H k? M +,

7

M 'B,

7

M 5B,

7

M <,

7

7.3D H *.&D M A!D × * M *.0D × .CN7 M &.&D M 5B,

7

M &..D

7.3D H *.&D M !.:071D M &.&D M 5B,

7

M &..D

7.3D H 3.!071D M 5B,

7

5B,

7

H 1.*.!=D.

31' E"pected interest rates Answer: c Diff: M

Nominal risk#ree rate>

k

B;

H k? M +, H .D M 7D H 11D.

Tbond rate>

k

B;

H k? M +, M 5B, M <, M 'B, H .D M 7D M &D M !D M 1D H 1.D.

Note that there is no de#ault risk premium on a Treasury security.

3!' E"pected interest rates Answer: b Diff: M

The 'B, #or the .year bond is &.1DA. 1C H &.*D. ;ind the .year +, as 7..D H

!.7D M &.*D M &.=D M +,

.

) or +,

.

H *.0D. (alculate the 7year +, as Q*.0DA.C M

0DA*CRN7 H ..1.D. The 'B, #or the 7year bond is &.1DA7 1C H &.3D. ;inally) the

yield on the 7year bond is !.7D M &.3D M &.=D M ..1.D H :.*.D.

3*' E"pected interest rates Answer: b Diff: M

The return on the 0year corporate bond is calculated as #ollows>

k

0

H k? M +, M 'B, M 5B, M <,

:..D H *D M QA!D × *C M A.D × !CRN0 M &..D M 5B, M <,

5B, M <, H !.!D.

Now) calculate the 7year corporate bond yield>

k

7

H *D M QA!D × *C M A.D × .CRN7 M &.3D M !.!D

H *D M *.1.!=D M &.3D M !.!D

H :.=.!=D ≈ :.=.D.

3. . E"pected interest rates

Answer: b Diff: M

Step 1> (alculate <, M 5B, #or the 0year bond>

:D H *D M +,

0

M &..D M <, M 5B,

:D H *D M A*D P * M 0D M .DCN0 M &..D M <, M 5B,

:D H *D M *.3D M &..D M <, M 5B,

<, M 5B, H 1D.

Step !> Now) calculate the return #or the 1&year bond>

k

1&

H *D M +,

1&

M &.=D M 1D

k

1&

H *D M A*D P : M 0D M .DCN1& M &.=D M 1D

k

1&

H :.!D.

30' E"pected interest rates Answer: d Diff: M

Step 1> 8sing the 1&yr bond yield) determine the de#ault risk and li-uidity

premiums>

k

1&

H k

B;

M +,

1&

M 'B,

1&

M 5B, M <,

7.:D H !D

M

QA!D × 0C

M

A*D × 0CRN1&

M

A&.&0DCA1& S 1C

M

5B,

M

<,

7.:D H !D M !.0D M &..0D M 5B, M <,

!.:0D H 5B, M <,.

Step !> Solve #or the 1!yr bond yield substituting 5B, M <, H !.:0D) as

solved in Step 1>

k

1!

H !D M QA!D × 0C M A*D × 7CRN1! M A&.&0DCA1! S 1C M 5B, M <,

k

1!

H !D M !.0:**D M &.00D M !.:0D

k

1!

H 7.=:**D ≈ 7.=:D.

33' E"pected interest rates Answer: b Diff: M

k? H !D% 'B, H &.1DAt 1C% 5B, H &.&0DAt 1C% <, H 1D corporate only.

+

1

H *D% +

!

H .D% +

*

H 0D% +

.

and a#ter H 3D. (

1&

T

1&

H $

+,

1&

H

1&

3DA7C M 0D M .D M *D

H

1&

0.D

H 0..D.

k H k? M +, M <, M 5B, M 'B,.

(

1&

H !D M 0..D M 1D M &.&0DA=C M &.1DA=C H =.70D.

T

1&

H !D M 0..D M &D M &D M &.=D H :.*&D.

(

1&

T

1&

H =.70D :.*&D H 1..0D.

37' E"pected interest rates Answer: a Diff: M

Say the 1year rate in three years is K.

;rom expectations theory> 3.0D H A3DA*C M KA1CCN.

3.0DA.C H 3DA*C M K

!3D H 1:D M K

K H :D.

3:' E"pected interest rates Answer: d Diff: M

k

1

H 3.=D% k

!

H 7.!D.

7.!D H A3.=D M KCN!

1...D H 3.=D M K

K H 7.0D.

3=' E"pected interest rates Answer: d Diff: M

;irst) #ind the total yield #or 10 years>

7.!D × 10 yrs. H 1&:D.

(alculate the total yield #or the #irst six years>

3.0D × 3 yrs. H *=D.

Now) we can #ind the total yield that must be earned #or the next nine years>

1&:D *=D H 3=D.

;inally) #ind the yield per year>

3=DN= yrs. H 7.37D.

7&' E"pected interest rates Answer: d Diff: M

You want to buy a security one year #rom today) and you want to hold it #or *

years. You will hold this investment to the end o# the #ourth year. +# an

investor wants to invest #or . years) he has two choices> A1C /uy a .year

bond that yields 3.=D per year% or A!C buy a 1year bond that yields 3.!D)

then buy a *year bond in 1 year. The -uestion is asking #or the yield on

this bond. The expectations theory makes it impossible #or the investor to

1pro#it2 by choosing A1C over A!C) or vice versa. Since the expectations

about #uture in#lation are already in all the interest rates) an investor will

expect to get the same overall return with either strategy. +# the investor

picks choice T1) he will get a .year return o# 3.=D per year. +# he picks

choice T!) he will get a 1year return o# 3.!D and * years o# an unknown

yield)

1

k

*

. Since the investor shouldn9t do better with one strategy over the

other) the two strategies must e-ual each other.

. × 3.=D H A1 × 3.!DC M A* ×

1

k

*

C

!1..D H * ×

1

k

*

7.1*D H

1

k

*

.

There#ore) the yield on a *year Treasury one year #rom now will be 7.1*D.

71' E"pected interest rates Answer: d Diff: M

The return on the 0year bond is 0.! percent) so an investor who buys this

bond gets a return o# 0.! percent each year he holds the bond. The return on

the .year bond is ..: percent) so an investor who buys this bond gets a

return o# ..: percent each year he holds the bond. A#ter he holds the bond

#or #our years) he can buy a bond #or one year. Fe must get the same average

return by holding this combination o# a .year bond and a 1year bond as he

would have received by holding a 0year bond. Etherwise) he would choose the

combination o# bonds that gives him the highest return. The expected yield .

years #rom now on a 1year bond

is

.

k

1

.

..:D × . M

.

k

1

H 0.!D × 0

1=.!D M

.

k

1

H !3D

.

k

1

H 3.:D.

7!' E"pected interest rates Answer: b Diff: M

+# you wanted to invest your money in Treasuries #or 1& years) you have

several choices. You can buy a 1&year Treasury) or you can buy a

7year Treasury today) #ollowed by a *year Treasury) or you can buy a *year

Treasury today) #ollowed by a 7year Treasury. The expectations theory

concludes that you should receive the same total return #or the 1& years) no

matter which alternative you choose.

This -uestion gives us in#ormation about the 1&year security yield) and some

in#ormation about buying a 7year security #ollowed by a *year security. The

return on a *year Treasury seven years #rom today is written as

7

k

*

.

Since the returns must be e-ual) we can write the #ollowing e-uation>

1& × 3.!D H A7 × 0.:DC M A* ×

7

k

*

C

3!D H .&.3D M A* ×

7

k

*

C

!1..D H * ×

7

k

*

7.1*D H

7

k

*

.

7*' E"pected interest rates Answer: d Diff: M

Bemember) i# you purchase a *year Treasury today) and then a 0year Treasury

a#ter that A#or a total investment o# : yearsC) you will have to earn the same

total yield as you would on an :year Treasury purchased today. So) let

*

k

0

be

the interest rate on the 0year Treasury three years #rom now>

: × 7D H A* × 0DC M A0 ×

*

k

0

C

03D H 10D M A0 ×

*

k

0

C

.1D H A0 ×

*

k

0

C

:.!D H

*

k

0

.

There#ore) the yield on a 0year Treasury three years #rom today)

*

k

0

) is

:.!D.

7.' E"pected interest rates Answer: c Diff: M

You have a choice o# purchasing one :year Treasury) or one 0year Treasury

#ollowed by one *year Treasury. "e have the data #or the 0year and :year

securities) so we can solve #or the yield on the *year security #ive years

#rom now. The return on the *year security #ive years #rom today is

0

k

*

.

: × 0.7D H A0 × 0.=DC M A* ×

0

k

*

C

.0.3&D H !=.0&D M A* ×

0

k

*

C

13.1&D H A* ×

0

k

*

C

0.*7D H

0

k

*

.

70' E"pected interest rates Answer: e Diff: M

The return on the 7year bond is 3.3 percent) so an investor who buys this

bond receives a return o# 3.3 percent each year he holds the bond. The return

on the 0year bond is 3.! percent) so an investor who buys this bond receives

a return o# 3.! percent each year he holds the bond. A#ter he holds the bond

#or 0 years) he can buy a !year bond% however) according to the expectations

theory) he must receive the same average return by holding this combination o#

a 0year bond and a !year bond as he would have received by holding a 7year

bond. Etherwise) he would choose the combination o# bonds that gives him the

highest return. The return on the !year bond #ive years #rom now is written

as

0

k

!

.

7

DC 3 . 3 A 7 ×

H

7

k ! D ! . 3 0

! 0

× + ×

7

D ! . .3

H

7

C k ! A D *1

! 0

× +

10.!D H A! ×

0

k

!

C

7.3D H

0

k

!

.

73' E"pected interest rates Answer: b Diff: M

The expected yield is

*

k

!

. According to the expectations theory)

A* × 0.3DC M A! ×

*

k

!

C H A0 × 3.&DC

13.:D M !A

*

k

!

C H *&D

*

k

!

H 3.3D.

77' E"pected interest rates Answer: d Diff: M

;irst) #ind the amount o# de#ault and li-uidity premia built into the

0year bond>

<i-uidity M de#ault premia H k

0

k? +,

0

'B,

0

.

+,

0

H A*D M .D M 0D M 0D M 0DCN0 H ...D.

'B, H &.1DA0 1C H &..D.

<i-uidity M de#ault premia H :.0D !.0D ...D &..D H 1.!D.

Now) #ind the in#lation premium and 'B, #or a .year bond one year into the

#uture>

+n#lation ,remium H A.D M 0D M 0D M 0DCN. H ..70D.

'B, H &.1DA. 1C H &.*D.

;inally) calculate the yield on the .year bond one year #rom now>

1

k

.

H k? M +,

.

M 'B,

.

M A5e#ault M <i-uidity premiaC

1

k

.

H !.0D M ..70D M &.*D M 1.!D H :.70D.

7:' E"pected interest rates Answer: b Diff: M

k H k? M +, M 'B,% 5B, H <, H &.

+, H QA*DC0 M A0DC7RN1! H ..1337D.

'B, H &.1DA1! S 1C H 1.1D.

k

1!

H *D M ..17D M 1.1D

H :.!7D.

7=' E"pected interest rates Answer: c Diff: M

k H k? M +, M 'B, M 5B, M <,

;or the 1&year corporate bond>

:.3D H !D M QA*DCA0C M A0DCA0CRN1& M A&.1DCA1& 1C M 5B, M <,

5B, M <, H 1.7D.

;or the :year corporate bond>

k H !D M QA*DCA0C M A0DCA*CRN: M &.1DA: 1C M 1.7D H :.10D.

:&' E"pected interest rates Answer: b Diff: M

8sing the expectations theory>

3D H QA1& × 3.0DC M A0 ×

1&

k

0

CRN10. Solving #or

1&

k

0

) the rate on a 0year bond

in 1& years) we get>

1&

k

0

H 0D.

:1' E"pected interest rates Answer: b Diff: M

k H k? M +, M 'B, M 5B, M <,

(onsider the 1&year corporate bond>

k

(1&

H *D M

1&

yrsC 0 A*D yrsC 0 D ! A × + ×

M &.1DA1& S 1C M 5B, M <,

7.:D H *D M

1&

D 10 D 1& +

M &.=D M 5B, M <,

1..D H 5B, M <,.

Now consider the 10year corporate bond>

k

(10

H *D M

10

yrsC 1& A*D yrsC 0 D ! A × + ×

M &.1DA10 S 1C M 1..D

k

(10

H *D M

10

D *& D 1& +

M 1..D M 1..D

k

(10

H *D M !.3337D M 1..D M 1..D

k

(10

H :..37D ≈ :..7D.

:!' E"pected interest rates Answer: b Diff: M

k

1

) k

!

) k

*

)

Security 'aturity (urrent Bate Year 1 Year ! Year *

1 year :D

:D

! year 1&D

:D

1!D

* year 1!D

:D

1!D $

(alculate k

!

) the 1year rate in Year !>

1&D H A:D M k

!

CN!

k

!

H 1!D.

(alculate k

*

) the 1year rate in Year *>

1!D H A:D M 1!D M k

*

CN*

*3D H !&D M k

*

k

*

H 13D.

:*' E"pected interest rates Answer: a Diff: M N

You need to #ind the threeyear interest rate one year #rom today>

& 1

1 Yr.> U U

& 1 !

! Yrs.> U U U

& 1 ! *

* Yrs.> U U U U

& 1 ! * .

. Yrs.> U U U U U

& 1 ! * . 0

0 Yrs.> U U U U U U

1 ! * .

U U U U

3.&D

0.:D 0.:D

0.0D

0.3D

0.:D

0.0D 0.0D

0.3D 0.3D 0.3D

0.:D 0.:D 0.:D 0.:D

KD KD KD

+# an investor wants to invest #or #our years) he has two choices>

a. /uy a #ouryear bond that yields 0.3D per year.

b. /uy a oneyear bond that yields 3.&D per year) then buy a threeyear bond.

The -uestion is asking #or the yield on this threeyear bond.

The expectations theory makes it impossible #or the investor to 1pro#it2 by

choosing a over b) or vice versa. Since all o# the expectations about #uture

in#lation are already in all the interest rates) an investor will expect to

receive the same overall return with either strategy.

+# he picks a) he will receive #our years o# 0.3D returns. +# he picks b) he

will receive one year at 3.&D) and three years with an unknown yield Acall it

KC. Since he shouldn9t do better with one choice over the other) the two

strategies must e-ual each other>

. × 0.3D H 3D M *K

!!..D H 3D M *K

13..D H *K

0..7D H K.

:.' E"pected interest rates Answer: a Diff: M N

& 1

1 Yr.> U U

& 1 !

! Yrs.> U U U

& 1 ! *

* Yrs.> U U U U

& 1 ! * .

. Yrs.> U U U U U

& 1 ! * . 0

0 Yrs.> U U U U U U

* . 0

U U U

0.:D

3.!D 3.!D

3.0D

3.!D

3.&D

3.0D 3.0D

3.!D 3.!D 3.!D

3.&D 3.&D 3.&D 3.&D

KD KD

+# you wanted to have Treasuries #or a total o# #ive years) you would have two

choices. You could buy a #iveyear Treasury) or you could buy a threeyear

Treasury) and at its maturity) buy a twoyear Treasury. Your overall expected

return must be the same with both strategies. The -uestion is asking #or the

yield on this !year Treasury) three years #rom now.

0A3.&DC H *A3.0DC M !K

*&D H 1=.0D M !K

1&.0D H !K

0.!0D H K.

:0' E"pected interest rates Answer: b Diff: M N

k

1

H 0.!D% k

.

H 3.*D.

1

k

*

denotes the threeyear rate) one year #rom now.

. × k

.

H A1 × k

1

C M A* ×

1

k

*

C

. × 3.*D H 0.!D M A* ×

1

k

*

C

!&D H * ×

1

k

*

3.37D H

1

k

*

.

:3' E"pected interest rates Answer: c Diff: M N

"e are given the yield on a 7year corporate bond) and we must #ind the yield

#or a 1&year corporate bond. The #act that they have the same de#ault risk

and li-uidity premium is the key to solving this problem.

k

(7

H k? M +,

7

M 'B,

7

M A5B, M <,C

=.:D H *D M

7

C * DA * C . DA . +

M &.1DA7 1C M A5B, M <,C

=.:D H *D M *.07D M &.3D M A5B, M <,C

!.3*D H 5B, M <,.

Now that we have solved #or the de#ault risk and li-uidity premiums) we can

carry the value #orward and solve #or the yield on a 1&year corporate bond.

k

(1&

H k? M +,

1&

M 'B,

1&

M A5B, M <,C

k

(1&

H *D M

1&

C 3 DA * C . DA . +

M &.1DA1& 1C M !.3*D

k

(1&

H *D M *..D M &.=D M !.3*D

k

(1&

H =.=*D.

:7' Real risk%free rate of interest Answer: d Diff: M

Tbill rate H k? M +,

:D H k? M 0D

k? H *D.

::' !nflation rate Answer: c Diff: M

k

T1&

H k? M +, M 'B,

7D H *.1D M Q!.0DA0C M 0KRN1& M &.1DA1& 1C

7D H *.1D M A1!.0D M 0KCN1& M &.=D

*D H A1!.0D M 0KCN1&

*&D H 1!.0D M 0K

17.0D H 0K

K H *.0D.

:=' !nflation rate Answer: b Diff: M

k

B;

H k? M +,

1*D H *D M +,

+, H 1&D.

There#ore) the average in#lation expected over the next * years is

1& percent. 8sing an arithmetic average>

1&D H

*

+, M 11D M 11D

*

*&D H !!D M +,

*

+,

*

H :D.

=&' !nflation rate Answer: d Diff: M

;irst) #ind the expected rate o# interest on .year Treasury bonds issued in

one year as #ollows> 0..D H A1N0CA0DC M A.N0CAKDC or K H 0.0D. Now) solve

#or the in#lation premium over the .year period by subtracting the real risk

#ree rate #rom the expected #uture rate or 0.0D *D H !.0D.

=1' !nflation rate Answer: b Diff: M

k

!

H 3.0D H *D M &.1D M A*.!0D M +

!

CN!

*..D H A*.!0D M +

!

CN!

3.:D H *.!0D M +

!

+

!

H *.00D.

k

*

H 7D H *D M &.!D M A*.!0D M *.00D M +

*

CN*

*.:D H A*.!0D M *.00D M +

*

CN*

11..D H *.!0D M *.00D M +

*

+

*

H ..3D.

=!' !nflation rate Answer: b Diff: M

;irst) #ind the yield on !year Tbonds>

k

!

H k? M +, M 'B,

H *D M A*D M .DCN! M &.1D

H &.&33 H 3.3D.

Note that the in#lation premium is an average o# the #irst two years.

Now) we know that the *year Tbond yields &.0D more than the !year

Tbond>

k

*

H 3.3D M &.0D H 7.1D.

Next) #ind the in#lation premium by working backwards>

+,

*

H k

*

k? 'B,

*

H 7.1D *D &.!D H &.&*= H *.=D.

;ind expected in#lation in Year * A+

*

represents the third year expected

in#lationC>

*.=D H A*D M .D M +

*

CN*

11.7D H 7D M +

*

..7D H +

*

.

=*' !nflation rate Answer: a Diff: M

Step 1> k H k? M +, M 5B, M <, M 'B,.

8sing k

0

) #ind 5B, M <,>

&.&: H &.&* M &.&* M 5B, M <, M &.&&.

5B, M <, H &.&13.

Step !> Now you can #ind K>

&.&= H &.&* M Q0A&.&*C M 0AKCRN1& M &.&13 M &.&&=

K H &.&. H .D.

=.' !nflation rate Answer: e Diff: M

Step 1> (alculate the de#ault risk and li-uidity premiums using in#ormation

#or the 0year bond>

k H k? M +, M 5B, M <, M 'B,.

;or the 0year corporate bond>

7.0D H !D M A!D × 0CN0 M 5B, M <, M &.1DA0 1C

7.0D H !D M !D M 5B, M <, M &..D

*.1D H 5B, M <,.

Step !> (alculate the average in#lation rate #or !&&: through !&1* by

substituting the in#ormation #ound in Step 1 using data #or the 1&

year corporate bond>

:.!D H !D M A!D × 0 M 0KCN1& M *.1D M &.1DA1& 1C

:.!D H !D M A1&D M 0KCN1& M *.1D M &.=D

:.!D H 3D M A1&D M 0KCN1&

!.!D H A1&D M 0KCN1&

!!D H 1&D M 0K

1! H 0K

!..D H K.

=0' Default risk premium Answer: a Diff: M

"e9re given all the components to determine the yield on @ator (orp. bonds

except the de#ault risk premium A5B,C and 'B,. (alculate the 'B, as &.1DA1&

1C H &.=D. Now) we can solve #or the 5B, as #ollows> :D H *D M !.0D M &.=D M

&.0D M 5B,) or 5B, H 1.1D.

=3' Maturity risk premium Answer: d Diff: M

k

1&

H k

0

M 1D.

k

1&

H !D M Q*DA*C M A.DCA7CRN1& M 'B,

1&

H !D M *.7D M 'B,

1&

H 0.7D M 'B,

1&

.

k

0

H !D M Q*DA*C M A.DCA!CRN0 M 'B,

0

H !D M *..D M 'B,

0

H 0..D M 'B,

0

.

Bemember) k

1&

H k

0

M 1D.

0.7D M 'B,

1&

H 0..D M 'B,

0

M 1D

'B,

1&

'B,

0

H 0..D M 1D 0.7D

H &.7D.

=7' Maturity risk premium Answer: a Diff: M

;irst) calculate the in#lation premiums #or the next two and #our years)

respectively. They are +,

!

H A*D M .DCN! H *.0D and +,

.

H A*D M .D M 0D M

0DCN. H ..!0D. The real risk#ree rate is given as *D. Thus) 3.:D H *D M

*.0D M 'B,

!

) or 'B,

!

H &.*D. Similarly) 7.3D H *D M ..!0D M 'B,

.

) or 'B,

.

H

&.*0D. Thus) 'B,

.

'B,

!

H &.*0D &.*&D H &.&0D.

=:' Maturity risk premium Answer: d Diff: M

The 3year in#lation premium +,

3

H A.D M .D M ..0D M ..0D M 0D M 0DCN3 H ..0D.

The 3year Treasury bond yield is *D M ..0D M &.=D H :..&D. The .year

Treasury bonds yield &.3D less) or :..&D &.3&D H 7.:&D. The

.year in#lation premium +,

.

H A.D M .D M ..0D M ..0DCN. H ..!0D. Solve #or

'B,

.

as 7.:&D H *D M ..!0D M 'B,

.

) or 'B,

.

H 7.:&D 7.!0D H &.00D.

==' E"pected interest rates Answer: c Diff: E N

This is a simple pure expectations -uestion that gives you the oneyear rate

and the twoyear rate) but asks #or the oneyear rate) one year #rom now. "e

must apply the concept that the twoyear rate is an average o# oneyear rates.

Ak

1

denotes the oneyear rate%

1

k

1

denotes the oneyear rate) one year #rom

now) etc.C

k

!

H

!

k k

1 1 1

+

0.0D H

!

k D & . 0

1 1

+

11.&D H 0.&D M

1

k

1

3.&D H

1

k

1

.

1&&' E"pected interest rates Answer: e Diff: E N

"e are given the #iveyear rate Ak

0

C and the oneyear rate) #our years #rom

now A

.

k

1

C. There#ore) we can solve #or the current #ouryear rate>

k

0

H

0

C 1 A k C . A k

1 . .

+

7.&D H

0

7.!D C . A k

.

+

*0.&D H A.Ck

.

M 7.!D

!7.:D H A.Ck

.

3.=0D H k

.

.

1&1' Aera&e inflation Answer: b Diff: M N

"e know k

T0

H 0D) and k

T1&

H 3D Aboth givenC. Since +,

1&

H !.0D) then k

T1&

H k? M

!.0D. ASince these are Treasuries 5B, H <, H &.C

Step 1> Solve #or the real risk#ree rate>

k

T1&

H k? M !.0D

3D H k? M !.0D

*.0D H k?.

Step !> Solve #or average in#lation over next 0 years>

k

T0

H k? M +,

0

0D H *.0D M +,

0

+,

0

H 1.0D.

1&!' E"pected interest rates Answer: c Diff: M N

8se k? H *.0D and +,

0

H 1.0D #rom previous problem.

Step 1> Solve #or the sum o# the de#ault and li-uidity risk premiums.

k

(1&

H k? M +,

1&

M 'B, M 5B, M <,

:D H *.0D M !.0D M & M 5B, M <,

!D H 5B, M <,.

Step !> Solve #or the yield on the 0year corporate bond.

k

(0

H k? M +,

0

M 'B, M 5B, M <,

H *.0D M 1.0D M & M 5B, M <,

H *.0D M 1.0D M & M !D

H 7D.

1&*' E"pected interest rates Answer: c Diff: E N

+,

*

H A*D M .D M 0DCN* H .D. So k

*

H k? M +,

*

H *D M .D H 7D.

1&. ' E"pected inflation

Answer: e Diff: E N

k

T.

H :D. +,

.

H :D *D H 0D) which is the average in#lation premium over the .

year period. So) 0D H A*D M .D M 0D M KCN.. So) K H :D) or +

.

H :D.

1&0 ' E"pected interest rates

Answer: a Diff: M N

10 × 7.!D H 1& × 7.0D M 0 × K

1&:D H 70D M 0K

**D H 0K

3.3D H K.

1&3 ' E"pected interest rates

Answer: d Diff: M N

! × 3.0D M 1 × 3.:D H 1 × 3D M ! × K

1=.:D H 3D M !K

1*.:D H !K

3.=D H K.

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