Let’s Analyze

Activity 1. (Adapted. Brigham & Houston. (2015). Fundamentals of

Financial Management) Choose the letter of the correct answer.

1. Assume that inflation is expected to decline in the future, but that the real
risk-free rate, r*, will remain constant. Which of the following statements
is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield
curve must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve
must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield
curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk
premium.

2. Which of the following factors would be most likely to lead to an increase

in nominal interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the internet has just been introduced,
and it increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.

3. Which of the following statements is CORRECT, other things held

constant?
a. If companies have fewer good investment opportunities, interest
rates are likely to increase.
b. If individuals increase their savings rate, interest rates are
likely to increase.
c. If expected inflation increases, interest rates are likely to increase.
d. Interest rates on all debt securities.

4. In the foreseeable future, the real risk-free rate of interest, r*, is expected to
remain at 3%, inflation is expected to steadily increase, and the maturity risk
premium is expected to be 0.1(t − 1)%, where t is the number of years until the
bond matures. Given this information, which of the following statements is
CORRECT?
a. The yield on 2-year Treasury securities must exceed the yield on 5-year
Treasury securities.
b. The yield on 5-year Treasury securities must exceed the yield on 10-
year corporate bonds.
c. The yield curve must be humped.
d. The yield curve must be upward sloping.
5. If the Treasury yield curve is downward sloping, how should the yield to
maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-
bill?
a. The yield on a 10-year bond would be less than that on a 1-year
bill.
b. The yield on a 10-year bond would have to be higher than that on a 1-
year bill because of the maturity risk premium.
c. It is impossible to tell without knowing the coupon rates of the bonds.
d. The yields on the two securities would be equal.

6. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is
expected to be constant at 3.20% per year. What is the real risk-free rate of
return, r*? Disregard any cross-product terms, i.e., if averaging is required, use
the arithmetic average.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%

7. Suppose the real risk-free rate is 3.50% and the future rate of inflation is
expected to be constant at 2.20%. What rate of return would you expect on a
1-year Treasury security, assuming the pure expectations theory is valid?
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic
average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%

8. Suppose the real risk-free rate is 2.50% and the future rate of inflation is
expected to be constant at 4.10%. What rate of return would you expect on a
5-year Treasury security, assuming the pure expectations theory is valid?
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic
average.
a. 5.38%
b. 5.66%
c. 5.96%
d. 6.60%

9. Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-
year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further
that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a
TIPS, and that no liquidity premium is required on any T-bond. Given this
information, what is the expected rate of inflation over the next 10 years?
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic
 average.
a. 1.81%
b. 1.90%
c. 2.00%
d. 2.10%

10. Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds
yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a
zero liquidity premium for T-bonds, and the maturity risk premium on both
Treasury and corporate 10-year bonds is 1.15%. What is the default risk
premium on corporate bonds?
a. 1.08%
b. 1.20%
c. 1.32%
d. 1.45%