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If 1-year rates are 5 percent, 1-year rates one year from now are expected to be 5.75 percent, and 1-year rates two
years from now are expected to be 6.25 percent, then the unbiased expectations theory of interest rates would
indicate current 3-year rates should be closest to:
✗ A) 6.37%.
✓ B) 5.67%.
✗ C) 8.75%.
✗ D) 5.29%.
Explanation
Current 3-year rates have to equal current 1-year rates compounded by 1-year forward rates. Thus [1 + r(3)]3 =
(1.05)(1.0575)(1.0625), which generates a current 3-year rate of 5.67 percent.
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The Treasury spot rate yield curve is closest to which of the following curves?
Explanation
The spot rate yield curve shows the appropriate rates for discounting single cash flows occuring at different times in
the future. Conceptually, these rates are equivalent to yields on zero-coupon bonds. The par bond yield curve shows
the YTMs on coupon bonds by maturity. Forward rates are expected future short-term rates. Reinvestment rates are
not part of the spot rate yield curve.
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Risk management:
Explanation
A company with liquid assets sufficient to fund all of its positive NPV projects would not be exposed to the
underinvestment problem when it encountered cash flow deficits. Alternatively, the company can institute a risk
management program to insure (at some level of statistical significance) that its operating cash flow will not fall below
the level needed to fund valuable projects. Thus, risk management can be viewed as a substitute for investing equity
capital in liquid assets.
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Questions #4-5 of 17
Maturity
STRIPS Price Spot Rate Forward Rate
(Years)
The 6-month forward rate in 1.5 years (ending in year 2.0) is closest to:
✗ A) 4.11%.
✓ B) 4.26%.
✗ C) 4.57%.
✗ D) 4.04%.
Explanation
2 * [(100/93.2775)^(1/4) - 1] = 3.51%
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The value of a 1.5-year, 6 percent semiannual coupon, $100 par value bond is closest to:
✗ A) $102.19.
✗ B) $105.66.
✗ C) $103.42.
✓ D) $104.00.
Explanation
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✗ A)
1.53.87%. 95.2652 3.26% 3.78%
✗ B) 3.42%.
2.0 93.2775 ?.??% ?.??%
✗ C) 4.02%.
✓ D) 3.51%.
Explanation
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Questions #7-10 of 17
Use the following Treasury bond prices to answer the next four questions. Assume the prices are for settlement on
June 1, 2005, today's date. Assume semiannual coupon payments:
The discount factors associated with the bonds maturing in December 2005 and June 2006, are closest to:
✗ A) 0.9546/0.9696.
✗ B) 0.9696/0.9858.
✓ C) 0.9858/0.9546.
✗ D) 0.9778/0.9696.
Explanation
We must calculate the 6-month discount factor first. This is done by dividing today's price by the final payment's par
+ coupon:
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The spot rates associated with the discount factors determined in the previous question are closest to:
✗ A) 1.82%/7.56%.
✗ B) 3.26%/5.87%.
✗ C) 2.25%/4.87%.
✓ D) 2.88%/4.70%.
Explanation
The easiest way to do this given the discount factors is to use the formula:
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✗ A) 6.04%.
✗ B) 7.28%.
✗ C) 5.86%.
✓ D) 6.54%.
Explanation
The key to calculating forward rates is to understand that the longer spot rate has to be equivalent to the product of
the two shorter rates. In this case, an investment in a 1-year rate held over the year has to generate the same cash
flow as investing for the first six months and then reinvesting in another 6-month bond. Therefore, the forward rate
implied by the annual and the 6-month spot rates is equal to:
This value would then be multiplied by 2 to get the 6-month forward rate 6-months from now of 6.54%.
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The yield to maturity (YTM) for the bond maturing June 2007 is closest to:
✗ A) 3.02%.
✗ B) 3.27%.
✓ C) 3.79%.
✗ D) 2.93%.
Explanation
The YTM is the rate that sets the price of the bond equal to the present value of the payments. This calculation can
be done easily with a financial calculator. For the bond maturing June 2005 (two years from now):
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Assume the one-year spot rate is 4 percent, the two-year spot rate is 4.5 percent, and the three-year spot rate is 5
percent. Which of the following statements is TRUE?
✓ A) The two-year rate that will exist one year from today is 5.5 percent.
✗ B) The one-year rate that will exist one year from today is 5.5 percent.
✗ C) The rate that an investor can earn on a sum invested today for the next three years is 5.5
percent.
✗ D) The one-year rate that will exist two years from today is 5 percent.
Explanation
The one-year rate that will exist one year from today is:
The one-year rate that will exist two years from today is:
The two-year rate that will exist one year from today is:
Note that the rate that an investor could earn on a sum invested today for the next three years would be equal to the
three-year spot rate of 5%.
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Which of the following statements concerning a forward rate is FALSE? A forward rate is:
✗ A) the interest rate that makes an investor indifferent to investing over a long time period or
investing over two or more shorter time periods.
✗ B) the market's best guess as to an interest rate that will exist in the future.
✗ C) an interest rate that can be locked in for some future time period.
✓ D) the rate of interest an investor would earn from now until some point in the future.
Explanation
The rate of interest an investor could invest at today until some point in the future is the spot rate. The other three
statements correctly identify the three possible interpretations of a forward rate. A forward rate can be interpreted as
a break even rate, a locked-in rate for some future period, or an expectation of future spot interest rates.
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If the five-year spot rate is 6.1 percent and the four-year spot rate is 5.9 percent, what is the only rate that can be
computed?
✓ A) The one-year forward rate starting four years from today is 6.9%.
✗ B) The four-year forward rate starting one year from today is 7.4%.
✗ C) The one-year forward rate starting four years from today is 7.4%.
✗ D) The four-year forward rate starting one year from today is 6.9%.
Explanation
Using the current five-year spot rate and the current four-year spot rate, we can derive the one-year forward rate
starting four years from today. The formula is: (1.061)5/(1.059)4 - 1 = R = 0.069, or 6.9 percent.
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Questions #14-16 of 17
Use the Treasury bond prices given below for the following four problems. Assume the prices are for settlement on
June 1, 2005, today's date. Assume semiannual coupon payments:
Coupon Maturity Price
6.00% 12/1/2005 99-15
7.00% 6/1/2006 98-27+
8.00% 12/1/2006 101-29
9.00% 6/1/2007 102-9
The discount factors associated with the bonds maturing in December 2005 and June 2006, respectively, are closest
to:
✗ A) 0.9458; 0.9013.
✓ B) 0.9657; 0.9225.
✗ C) 0.9319; 0.8769.
✗ D) 0.9587; 0.9157.
Explanation
We must calculate the discount factor for the December bond first. This is done by dividing today's price by the final
payment's par + coupon:
(99 + 15/32)/(100 + 6/2) = 0.9657. The 12-month discount factor d2 solves the following equation: [(7/2)(0.9657)]+
[(100+7/2)(d2)] = 98+(27.5/32); d2=0.9225.
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The spot rates associated with the discount factors of the previous problem are closest to:
✗ A) 5.48%; 6.78%.
✓ B) 7.10%; 8.23%.
✗ C) 6.26%; 7.05%.
✗ D) 4.87%; 6.23%.
Explanation
The easiest way to do this given the discount factors is to use the formula
where z(t) is the spot rate associated with the discount factors d(t). The first spot rate, which pertains to the bond
maturing in December 2003, is equal to (1/0.9657 - 1) × 2 = 7.10%. The second spot rate, which pertains to the
payment being made in June 2004, is equal to ((1/0.9225)0.5 - 1) × 2 = 8.23%.
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Given the spot rates for the 6-month and 1-year maturing bond, the forward rate inherent in those figures is closest
to:
✗ A) 4.68%.
✗ B) 5.74%.
✓ C) 9.37%.
✗ D) 6.96%.
Explanation
The key to calculating forward rates is to understand that the longer spot rate has to be equivalent to the product of
the two shorter rates. In this case, an investment in a 1-year rate held over the year has to generate the same cash
flow as investing for the first six months and then reinvesting in another 6-month bond. Therefore, the forward rate
implied by the annual and the 6-month spot rate is equal to:
= 4.6831%
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If the one-year spot rate is 7 percent and the one-year forward rate is 7.4 percent, what is the two-year spot rate?
✓ A) 7.20%.
✗ B) 7.12 %.
✗ C) 7.27%.
✗ D) 7.40%.
Explanation
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