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Chapter 06
Understanding Financial Markets and Institutions
Multiple Choice Questions
6-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
1. Which of these provide a forum in which demanders of funds raise funds by issuing new
financial instruments, such as stocks and bonds?
A. Investment banks
B. Money markets
C. Primary markets
D. Secondary markets
2. In the United States, which of these financial institutions arrange most primary market
transactions for businesses?
A. Investment banks
B. Asset transformer
C. Direct transfer agents
D. Over-the-counter agents
3. Primary market financial instruments include stock issues from firms allowing their equity
shares to be publicly traded on stock market for the first time. We usually refer to these first-
time issues as which of the following?
A. Initial public offerings
B. Direct transfers
C. Money market transfers
D. Over-the-counter stocks
6-2
4. Once firms issue financial instruments in primary markets, these same stocks and bonds are
then traded in which of these?
B. Direct transfers
C. Secondary markets
5. Which of these feature debt securities or instruments with maturities of one year or less?
A. Money markets
B. Primary markets
6. Which of the following is NOT a money market instrument?
A. Treasury bills
B. Commercial paper
C. Corporate bonds
D. Bankers' acceptances
7. Which of these money market instruments are short-term funds transferred between
financial institutions, usually for no more than one day?
A. Treasury bills
B. Federal funds
C. Commercial paper
D. Banker acceptances
6-3
8. Which of the following is NOT a capital market instrument?
A. U.S. Treasury notes and bonds
B. U.S. Treasury bills
C. U.S. government agency bonds
D. Corporate stocks and bonds
9. Which of these capital market instruments are long-term loans to individuals or businesses to
purchase homes, pieces of land, or other real property?
A. Treasury notes and bonds
B. Mortgages
C. Mortgage-backed securities
D. Corporate bonds
10. Which of these markets trade currencies for immediate or for some future stated delivery?
A. Money markets
B. Primary markets
C. Foreign exchange markets
11. Which of these formalizes an agreement between two parties to exchange a standard
quantity of an asset at a predetermined price on a specified date in the future?
A. Derivative security
B. Initial public offering
C. Liquidity asset
D. Trading volume
6-4
12. Which of these does NOT perform vital functions to securities markets of all sorts by
channeling funds from those with surplus funds to those with shortages of funds?
A. Commercial banks
B. Secondary markets
C. Insurance companies
D. Mutual funds
13. Which of these refer to the ease with which an asset can be converted into cash?
A. Direct transfer
B. Liquidity
C. Primary market
D. Secondary market
14. Which of the following is the risk that an asset's sale price will be lower than its purchase
price?
A. Default risk
B. Liquidity risk
C. Price risk
D. Trading risk
15. Which of these is the interest rate that is actually observed in financial markets?
A. Nominal interest rates
B. Real interest rates
C. Real risk free rate
D. Market premium
6-5
16. Which of these is the interest rate that would exist on a default-free security if no inflation
were expected?
A. Nominal interest rate
B. Real interest rate
C. Default premium
D. Market premium
17. Which of the following is the risk that a security issuer will miss an interest or principal
payment or continue to miss such payments?
A. Default risk
B. Liquidity risk
C. Maturity risk
D. Price risk
18. Which of these is NOT a participant in the shadow banking system?
A. Structured investment vehicles (SIVs)
B. Special purpose vehicles (SPVs)
C. Limited-purpose finance companies
D. Credit unions
6-6
19. How is the shadow banking system the same as the traditional banking system?
A. It intermediates the flow of funds between net savers and net borrows.
B. It serves as a middle man.
C. The complete credit intermediation is performed through a series of steps involving many
nonbank financial service firms.
D. The complete credit intermediation is performed by a single bank.
20. Which of the following is the continual increase in the price level of a basket of goods and
services?
A. Deflation
B. Inflation
C. Recession
D. Stagflation
21. Which of these statements is true?
A. The higher the default risk, the higher the interest rate that security buyers will demand.
B. The lower the default risk, the higher the interest rate that security buyers will demand.
C. The higher the default risk, the lower the interest rate that security buyers will demand.
D. The default risk does not impact the interest rate that security buyers will demand.
6-7
22. Which of these is a comparison of market yields on securities, assuming all characteristics
except maturity are the same?
A. Liquidity risk
B. Market risk
C. Maturity risk
D. Term structure of interest rates
23. According to this theory of term structure of interest rates, at any given point in time, the
yield curve reflects the market's current expectations of future short-term rates.
A. Expectations theory
B. Future short-term rates theory
C. Term structure of interest rates theory
D. Unbiased expectations theory
24. Which of the following theories argues that individual investors and financial institutions have
specific maturity preferences, and to encourage buyers to hold securities with maturities
other than their most preferred requires a higher interest rate?
A. Liquidity premium hypothesis
B. Market segmentation theory
C. Supply and demand theory
6-8
25. Which of these is the expected or "implied" rate on a short-term security that will originate at
some point in the future?
A. Current yield
B. Forward rate
C. Spot rate
D. Yield to maturity
26. Which of these is NOT a theory that explains the shape of the term structure of interest
rates?
A. Liquidity theory
C. Short-term structure of interest rates theory
27. Interest rates A particular security's default risk premium is 3 percent. For all securities, the
inflation risk premium is 2 percent and the real interest rate is 2.25 percent. The security's
liquidity risk premium is 0.75 percent and maturity risk premium is 0.90 percent.
The security has no special covenants. What is the security's equilibrium rate of return?
A. 1.78 percent
B. 3.95 percent
C. 8.90 percent
D. 17.8 percent
6-9
28. Interest rates You are considering an investment in 30-year bonds issued by a corporation.
The bonds have no special covenants. The Wall Street Journal reports that one-year T-bills
are currently earning 3.50 percent. Your broker has determined the following information
about economic activity and the corporation bonds:
Real interest rate = 2.50 percent
Default risk premium = 1.75 percent
Liquidity risk premium = 0.70 percent
Maturity risk premium = 1.50 percent
What is the inflation premium? What is the fair interest rate on the corporation's 30-year
bonds?
A. 1 percent and 1.49 percent, respectively
B. 1 percent and 6.45 percent, respectively
C. 1 percent and 7.45 percent, respectively
D. 3.50 percent and 9.95 percent, respectively
29. Interest rates A corporation's 10-year bonds have an equilibrium rate of return of 7 percent.
For all securities, the inflation risk premium is 1.50 percent and the real interest rate is 3.0
percent. The security's liquidity risk premium is 0.15 percent and maturity risk premium is
0.70 percent. The security has no special covenants. What is the bond's default risk
premium?
A. 1.40 percent
B. 1.65 percent
C. 5.35 percent
D. 9.35 percent
6-10
30. Interest rates A two-year Treasury security currently earns 5.25 percent. Over the next two
years, the real interest rate is expected to be 3.00 percent per year and the inflation premium
is expected to be 2.00 percent per year. What is the maturity risk premium on the two-year
Treasury security?
A. 0.25 percent
B. 1.00 percent
C. 1.05 percent
D. 5.00 percent
31. Unbiased Expectations Theory Suppose that the current one-year rate (one-year spot rate)
and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4,
respectively) are as follows:
Using the unbiased expectations theory, what is the current (long-term) rate for four-year-
maturity Treasury securities?
A. 6.00 percent
B. 6.33 percent
C. 6.75 percent
D. 7.00 percent
6-11
32. Unbiased Expectations Theory One-year Treasury bills currently earn 5.50 percent. You
expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent. If
the unbiased expectations theory is correct, what should the current rate be on two-year
Treasury securities?
A. 5.50 percent
B. 5.625 percent
C. 5.75 percent
D. 11.25 percent
33. Liquidity Premium Hypothesis One-year Treasury bills currently earn 5.50 percent. You
expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent. The
liquidity premium on two-year securities is 0.075 percent. If the liquidity theory is correct,
what should the current rate be on two-year Treasury securities?
A. 3.775 percent
B. 5.625 percent
C. 5.662 percent
D. 11.325 percent
6-12
34. Liquidity Premium Hypothesis Based on economists' forecasts and analysis, one-year
Treasury bill rates and liquidity premiums for the next four years are expected to be as
follows:
Using the liquidity premium hypothesis, what is the current rate on a four-year Treasury
security?
A. 7.736 percent
B. 7.600 percent
C. 7.738 percent
D. 8.400 percent
expected that one year from now, 1-year Treasury bill rates will increase to 3.65 percent and
that two years from now, one-year Treasury bill rates will increase to 4.05 percent. If the
unbiased expectations theory is correct, what should the current rate be on three-year
A. 3.40 percent
B. 3.62 percent
C. 3.75 percent
D. 3.85 percent
6-13
expected that one year from now, one-year Treasury bill rates will increase to 2.85 percent
and that two years from now, one-year Treasury bill rates will increase to 3.15 percent. If the
unbiased expectations theory is correct, what should the current rate be on 3-year Treasury
securities?
A. 2.55 percent
B. 2.85 percent
C. 2.93 percent
D. 3.15 percent
37. Interest rates The Wall Street Journal reports that the rate on three-year Treasury securities
is 7.00 percent, and the six-year Treasury rate is 7.25 percent. From discussions with your
broker, you have determined that expected inflation premium is 1.75 percent next year, 2.25
percent in Year 2, and 2.40 percent in Year 3 and beyond. Further, you expect that real
interest rates will be 3.75 percent annually for the foreseeable future. What is the maturity
risk premium on the six-year Treasury security?
A. 0.83 percent
B. 0.983 percent
C. 1.10 percent
D. 1.233 percent
6-14
38. Interest rates A corporation's 10-year bonds are currently yielding a return of 7.75 percent.
The expected inflation premium is 3.0 percent annually and the real interest rate is expected
to be 3.00 percent annually over the next 10 years. The liquidity risk premium on the
corporation's bonds is 0.50 percent. The maturity risk premium is 0.25 percent on two-year
securities and increases by 0.10 percent for each additional year to maturity. What is the
default risk premium on the corporation's 10-year bonds?
A. 0.18 percent
B. 0.20 percent
C. 0.22 percent
D. 0.27 percent
39. Unbiased Expectations Theory Suppose we observe the following rates: 1R1 = 6 percent, 1R2
= 7.5 percent. If the unbiased expectations theory of the term structure of interest rates
holds, what is the one-year interest rate expected one year from now, E(2r1)?
A. 6.75 percent
B. 7.50 percent
C. 9.02 percent
D. 13.5 percent
40. Unbiased Expectations Theory The Wall Street Journal reports that the rate on four-year
Treasury securities is 4.75 percent and the rate on five-year Treasury securities is 5.95
percent. According to the unbiased expectations hypotheses, what does the market expect
the one-year Treasury rate to be four years from today, E(5r1)?
A. 1.11 percent
B. 5.95 percent
C. 10.70 percent
D. 10.89 percent
6-15
41. Liquidity Premium Hypothesis The Wall Street Journal reports that the rate on three-year
Treasury securities is 4.75 percent and the rate on four-year Treasury securities is 5.00
percent. The one-year interest rate expected in three years is E(4r1), 5.25 percent. According
to the liquidity premium hypotheses, what is the liquidity premium on the four-year Treasury
security, L4?
A. 0.0375 percent
B. 0.504 percent
C. 5.01 percent
D. 5.04 percent
42. Liquidity Premium Hypothesis Suppose we observe the following rates: 1R1 = 8 percent, 1R2
= 10 percent, and E(2r1) = 8 percent. If the liquidity premium theory of the term structure of
interest rates holds, what is the liquidity premium for year 2, L2?
A. 1.02 percent
B. 4.04 percent
C. 6.15 percent
D. 12.03 percent
6-16
43. Forecasting Interest Rates You note the following yield curve in The Wall Street Journal.
According to the unbiased expectations hypothesis, what is the one-year forward rate for the
period beginning one year from today, 2f1?
A. 1.01 percent
B. 1.19 percent
C. 5.625 percent
D. 7.51 percent
44. Forecasting Interest Rates On May 23, 20XX, the existing or current (spot) one-year, two-
year, three-year, and four-year zero-coupon Treasury security rates were as follows:
Using the unbiased expectations theory, what is the one-year forward rate on zero-coupon
Treasury bonds for year 4 as of May 23, 20XX?
A. 5.925 percent
B. 6.45 percent
C. 7.05 percent
D. 10.32 percent
6-17
45. Interest rates The Wall Street Journal reports that the current rate on 10-year Treasury
bonds is 6.75 percent, on 20-year Treasury bonds is 7.25 percent, and on a 20-year corporate
bond is 8.50 percent. Assume that the maturity risk premium is zero. If the default risk
premium and liquidity risk premium on a 10-year corporate bond is the same as that on the
20-year corporate bond, what is the current rate on a 10-year corporate bond.
A. 7.50 percent
B. 8.00 percent
C. 8.50 percent
D. 8.75 percent
46. Interest rates The Wall Street Journal reports that the current rate on 5-year Treasury bonds
is 6.50 percent and on 10-year Treasury bonds is 6.75 percent. Assume that the maturity risk
premium is zero. Calculate the expected rate on a 5-year Treasury bond purchased five years
from today, E(5r1).
A. 6.625 percent
B. 6.75 percent
C. 7.00 percent
D. 7.58 percent
6-18
47. Unbiased Expectations Theory Suppose we observe the three-year Treasury security rate
(1R3) to be 6 percent, the expected one-year rate next year E(2r1) to be 3 percent, and the
expected one-year rate the following year E(3r1) to be 5 percent. If the unbiased expectations
theory of the term structure of interest rates holds, what is the one-year Treasury security
rate, 1R1?
A. 3.00 percent
B. 10.13 percent
C. 14.00 percent
D. 19.88 percent
48. Unbiased Expectations Theory The Wall Street Journal reports that the rate on three-year
the two-year Treasury rate to be three years from today, E(4r2)?
A. 6.35 percent
B. 6.75 percent
C. 7.25 percent
D. 7.45 percent
6-19
49. Liquidity Premium Theory One-year Treasury bills currently earn 3.25 percent. You expected
that one year from now, one-year Treasury bill rates will increase to 3.45 percent and that
two years from now, one-year Treasury bill rates will increase to 3.95 percent. The liquidity
premium on two-year securities is 0.05 percent and on three-year securities is 0.15 percent.
If the liquidity theory is correct, what should the current rate be on three-year Treasury
securities?
A. 3.25 percent
B. 3.55 percent
C. 3.62 percent
D. 4.10 percent
50. Liquidity Premium Theory One-year Treasury bills currently earn 2.95 percent. You expected
that one year from now, one-year Treasury bill rates will increase to 3.15 percent and that
two years from now, one-year Treasury bill rates will increase to 3.35 percent. The liquidity
premium on two-year securities is 0.05 percent and on three-year securities is 0.15 percent.
If the liquidity theory is correct, what should the current rate be on three-year Treasury
securities?
A. 2.95 percent
B. 3.15 percent
C. 3.22 percent
D. 3.35 percent
6-20
51. Forecasting Interest Rates Assume the current interest rate on a one-year Treasury bond
(1R1) is 5.00 percent, the current rate on a two-year Treasury bond (1R2) is 5.75 percent, and
the current rate on a three-year Treasury bond (1R3) is 6.25 percent. If the unbiased
expectations theory of the term structure of interest rates is correct, what is the one-year
interest rate expected on Treasury bills during year 3, 3f1?
A. 5.00 percent
B. 5.67 percent
C. 7.26 percent
D. 8.00 percent
52. Forecasting Interest Rates A recent edition of The Wall Street Journal reported interest
rates of 3.10 percent, 3.50 percent, 3.75 percent, and 3.95 percent for three-year, four-year,
five-year, and six-year Treasury security yields, respectively, According to the unbiased
expectation theory of the term structure of interest rates, what are the expected one-year
rates for year 6?
A. 3.575 percent
B. 3.95 percent
C. 4.96 percent
D. 5.33 percent
6-21
53. A particular security's default risk premium is 3 percent. For all securities, the inflation risk
premium is 1.75 percent and the real interest rate is 4.2 percent. The security's liquidity risk
premium is 0.35 percent and maturity risk premium is 0.95 percent. The security has no
special covenants. Calculate the security's equilibrium rate of return.
A. 8.50 percent
B. 6.05 percent
C. 10.25 percent
D. 9.90 percent
54. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds
have no special covenants. The Wall Street Journal reports that one-year T-bills are currently
earning 3.55 percent. Your broker has determined the following information about economic
activity and Moore Corporation bonds:
What is the inflation premium?
A. 0.80 percent
B. 1.25 percent
C. 6.25 percent
D. 8.00 percent
6-22
55. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds
have no special covenants. The Wall Street Journal reports that one-year T-bills are currently
earning 3.55 percent. Your broker has determined the following information about economic
activity and Moore Corporation bonds:
What is the fair interest rate on Moore Corporation 30-year bonds?
A. 3.80 percent
B. 6.45 percent
C. 6.95 percent
D. 9.70 percent
56. Dakota Corporation 15-year bonds have an equilibrium rate of return of 9 percent. For all
securities, the inflation risk premium is 1.95 percent and the real interest rate is 3.65 percent.
The security's liquidity risk premium is 0.35 percent and maturity risk premium is 0.95
percent. The security has no special covenants. Calculate the bond's default risk premium.
A. 2.10 percent
B. 3.05 percent
C. 3.40 percent
D. 2.45 percent
6-23
57. A two-year Treasury security currently earns 5.13 percent. Over the next two years, the real
interest rate is expected to be 2.15 percent per year and the inflation premium is expected to
be 1.75 percent per year. Calculate the maturity risk premium on the two-year Treasury
security.
A. 5.13 percent
B. 3.38 percent
C. 2.98 percent
D. 1.23 percent
58. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill
rates over the following three years (i.e., years 2, 3 and 4, respectively) are as follows:
1 R1 = 5 percent, E(2r1) = 7 percent, E(3r1) = 7.5 percent E(4r1) = 7.85 percent

Using the unbiased expectations theory, calculate the current (long-term) rates for one-year
and two-year -maturity Treasury securities.
A. One-year: 5.00 percent; Two-year: 5.50 percent
B. One-year: 5.00 percent; Two-year: 6.00 percent
C. One-year: 5.50 percent; Two-year: 6.15 percent
D. One-year: 5.50 percent; Two-year: 5.75 percent
6-24
rates over the following three years (i.e., years 2, 3 and 4 respectively) are as follows:

Using the unbiased expectations theory, calculate the current (long-term) rates for three-
year- and four-year-maturity Treasury securities.
rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
Using the unbiased expectations theory, calculate the current (long-term) rates for one-, two-
, three-, and four-year-maturity Treasury securities.
A. 5.00 percent; 5.50 percent; 6.16 percent; 6.33 percent
B. 5.00 percent; 5.25 percent; 6.10 percent; 6.27 percent
C. 5.00 percent; 5.50 percent; 6.10 percent; 6.23 percent
D. 5.00 percent; 5.25 percent; 6.16 percent; 6.49 percent
6-25
61. One-year Treasury bills currently earn 3.75 percent. You expect that one year from now, one-
year Treasury bill rates will increase to 4.15 percent. If the unbiased expectations theory is
correct, what should the current rate be on two-year Treasury securities?
A. 4.25 percent
B. 3.85 percent
C. 3.95 percent
D. 4.35 percent
62. One-year Treasury bills currently earn 4.5 percent. You expect that one year from now, one-
year Treasury bill rates will increase to 6.65 percent. The liquidity premium on two-year
securities is 0.05 percent. If the liquidity theory is correct, what should the current rate be on
two-year Treasury securities?
A. 5.24 percent
B. 5.59 percent
C. 5.65 percent
D. 5.95 percent
6-26
63. Based on economists' forecasts and analysis, one-year Treasury bill rates and liquidity
premiums for the next four years are expected to be as follows:
R1 = 5.95 percent
E(r2) = 6.25 percent L2 = 0.05 percent
Using the liquidity premium hypothesis, what should be the current rate on four-year
A. 6.59 percent
B. 6.75 percent
C. 6.82 percent
D. 7.13 percent
64. The Wall Street Journal reports that the rate on three-year Treasury securities is 7.00
percent, and the six-year Treasury rate is 6.20 percent. From discussions with your broker,
you have determined that expected inflation premium is 2.25 percent next year, 2.50 percent
in Year 2, and 2.50 percent in Year 3 and beyond. Further, you expect that real interest rates
will be 4.4 percent annually for the foreseeable future. Calculate the maturity risk premium on
the 3-year Treasury security.
A. 0.00 percent
B. 0.10 percent
C. 4.50 percent
D. 2.60 percent
6-27
you have determined that expected inflation premium is 2.25 percent next year, 2.50 percent
in Year 2, and 2.60 percent in Year 3 and beyond. Further, you expect that real interest rates
will be 3.4 percent annually for the foreseeable future. Calculate the maturity risk premium on
the three-year and the six-year Treasury security.
A. 3-year: 0.6 percent; 6-year: 0.80 percent
B. 3-year: 0.5 percent; 6-year: 0.90 percent
C. 3-year: 0.6 percent; 6-year: 1.20 percent
D. 3-year: 0.5 percent; 6-year: 0.80 percent
66. Nikki G's Corporation's 10-year bonds are currently yielding a return of 9.25 percent. The
expected inflation premium is 2.0 percent annually and the real interest rate is expected to be
3.10 percent annually over the next 10 years. The liquidity risk premium on Nikki G's bonds is
0.1 percent. The maturity risk premium is 0.10 percent on two-year securities and increases
by 0.05 percent for each additional year to maturity. Calculate the default risk premium on
Nikki G's 10-year bonds.
A. 2.55 percent
B. 5.65 percent
C. 3.55 percent
D. 1.85 percent
6-28
67. Suppose we observe the following rates: 1R1 = 12 percent, 1R2 = 15 percent. If the unbiased
expectations theory of the term structure of interest rates holds, what is the one-year interest
rate expected one year from now, E(2r1)?
A. 13.5 percent
B. 14.2 percent
C. 15.6 percent
D. 18.0 percent
68. The Wall Street Journal reports that the rate on four-year Treasury securities is 7.50 percent
and the rate on five-year Treasury securities is 9.15 percent. According to the unbiased
expectations hypotheses, what does the market expect the one-year Treasury rate to be four
years from today, E(5r1)?
A. 16.0 percent
B. 18.4 percent
C. 15.9 percent
D. 13.7 percent
69. The Wall Street Journal reports that the rate on three-year Treasury securities is 7.25 percent
and the rate on four-year Treasury securities is 8.50 percent. The one-year interest rate
expected in three years is E(4r1), 4.10 percent. According to the liquidity premium hypotheses,
what is the liquidity premium on the four-year Treasury security, L4?
A. 6.7 percent
B. 7.1 percent
C. 8.2 percent
D. 9.6 percent
6-29
70. Suppose we observe the following rates: 1R1 = 13 percent, 1R2 = 16 percent, and E(2r1) = 10
percent. If the liquidity premium theory of the term structure of interest rates holds, what is
the liquidity premium for year 2, L2?
A. 8.7 percent
B. 9.1 percent
C. 9.7 percent
D. 10.0 percent
71. You note the following yield curve in The Wall Street Journal. According to the unbiased
expectations hypothesis, what is the one-year forward rate for the period beginning one year
from today, 2f1?
A. 7.6 percent
B. 8.6 percent
C. 9.0 percent
D. 10.2 percent
6-30
72. On May 23, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year
zero-coupon Treasury security rates were as follows:
1 R1 = 4.55 percent, 1R2 = 4.75 percent, 1R3 = 5.25 percent, 1R4 = 5.95 percent
Using the unbiased expectations theory, calculate the one-year forward rates on zero-coupon
Treasury bonds for years two, three, and four as of May 23, 20XX.
A. Year 1: 4.95 percent; Year 2: 6.26 percent; Year 3: 8.08 percent
B. Year 1: 3.75 percent; Year 2: 6.02 percent; Year 3: 9.00 percent
C. Year 1: 4.95 percent; Year 2: 7.26 percent; Year 3: 8.08 percent
D. Year 1: 3.65 percent; Year 2: 6.32 percent; Year 3: 11.08 percent
73. The Wall Street Journal reports that the current rate on 10-year Treasury bonds is 6.25
percent, on 20-year Treasury bonds is 7.95 percent, and on a 20-year corporate bond is 10.75
percent. Assume that the maturity risk premium is zero. If the default risk premium and
liquidity risk premium on a 10-year corporate bond is the same as that on the 20-year
corporate bond, calculate the current rate on a 10-year corporate bond.
A. 9.05 percent
B. 6.15 percent
C. 7.60 percent
D. 8.70 percent
6-31
74. The Wall Street Journal reports that the current rate on five-year Treasury bonds is 6.45
percent and on 10-year Treasury bonds is 7.75 percent. Assume that the maturity risk
premium is zero. Calculate the expected rate on a five-year Treasury bond purchased five
years from today, E(5r5).
A. 7.25 percent
B. 8.12 percent
C. 9.07 percent
D. 10.16 percent
75. Suppose we observe the three-year Treasury security rate (1R3) to be 11 percent, the
expected one-year rate next year E(2r1) to be 4 percent, and the expected one-year rate the
following year E(3r1) to be 5 percent. If the unbiased expectations theory of the term structure
of interest rates holds, what is the one-year Treasury security rate, 1R1?
A. 18.57 percent
B. 10.19 percent
C. 23.19 percent
D. 25.24 percent
76. Assume the current interest rate on a one-year Treasury bond (1R1) is 5.50 percent, the
current rate on a two-year Treasury bond (1R2) is 5.95 percent, and the current rate on a
three-year Treasury bond (1R3) is 8.50 percent. If the unbiased expectations theory of the
term structure of interest rates is correct, what is the one-year interest rate expected on
Treasury bills during year 3, 3f1?
A. 13.79 percent
B. 12.29 percent
C. 11.69 percent
D. 10.29 percent
6-32
77. If the yield curve is downward sloping, what is the yield to maturity on a 30-year Treasury
bond relative to a 10-year Treasury bond?
A. The yield on the 10-year bond must be greater than the yield on the 30-year bond.
B. The yield on the 10-year bond must be less than the yield on the 30-year bond.
C. The yields on the two bonds are equal.
D. We need to know the other risk premiums to answer this question.
78. One-year Treasury bill rates in 20XX averaged 5.15 percent and inflation for the year was 7.3
percent. If investors had expected the same inflation rate as that realized, calculate the real
interest rate for 20XX according to the Fisher effect.
A. 0.00 percent
B. -2.15 percent
C. 2.15 percent
D. 3.95 percent
79. Assume that you observe the following rates on long-term bonds:
U.S. Treasury bonds = 4.15 percent
AAA Corporate bonds = 6.2 percent
BBB Corporate bonds = 7.15 percent
The main reason for the differences in the interest rates is:
A. Maturity risk premium
B. Inflation premium
C. Default risk premium
D. Convertibility premium
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80. Which of the following statements is correct?
A. According to the unbiased expectations theory, the return for holding a two-year bond to
maturity is equal to the nominal rate divided by the real interest rate.
B. The rate on a 10-year Corporate can never be less than the rate on a 10-year Treasury.
C. We usually observe the inverted yield curve.
D. The rate on a three-year Treasury can never be less than the rate on a 15-year Treasury.
81. One-year interest rates are 3 percent. The market expects one-year rates to be 5 percent one
year from now. The market also expects one-year rates to be 7 percent two years from now.
Assume that the unbiased expectations theory holds. Which of the following is correct?
A. The yield curve is downward sloping.
B. The yield curve is flat.
C. The yield curve is upward sloping.
D. We need the maturity risk premiums to be able to answer this question.
A. If the unbiased expectations theory is correct, we could see an inverted yield curve.
B. If a yield curve is inverted, long-term bonds have higher yields than short-term bonds.
C. If the maturity risk premium is zero, the yield curve would be flat.
D. If the unbiased expectations theory is correct, the maturity risk premium is zero.
6-34
83. The Wall Street Journal states that the yield curve for Treasuries is downward sloping and
there is no liquidity premium or maturity risk premium. Given this information, which of the
following statements is correct?
A. A 30-year corporate bond must have a higher yield than a five-year corporate bond.
B. A five-year corporate bond must have a higher yield than a 30-year Treasury bond.
C. A five-year Treasury bond must have a higher yield than a five-year corporate bond.
D. All of these statements are correct.
A. An IPO is an example of a primary market transaction.
B. Money markets are subject to wider price fluctuations and are therefore more risky than
capital market instruments.
C. A direct transfer of funds is more efficient than utilizing financial institutions.
D. The market segmentation theory argues that the different investors have different risk
preferences which determine the shape of the yield curve.
85. In 20XX, the 10-year Treasury rate was 4.5 percent while the average 10-year Aaa corporate
bond debt carried an interest rate of 6.0 percent. What is the average default risk premium on
Aaa corporate bonds?
A. 0.75 percent
B. 1.5 percent
C. 1.95 percent
D. 2.25 percent
6-35
A. The default risk premium of Baa 20-year corporate bonds over Aaa 20-year corporate
bonds does not vary.
B. The market segmentation theory assumes that borrowers and investors do not want to
shift from one maturity sector to another without an interest rate premium.
C. Real interest rates are the rates that are quoted in the news.
87. All of the following are types of financial institutions EXCEPT:
A. insurance companies.
B. pension funds.
C. thrifts.
D. federal reserve bank.
88. All of the following are benefits that financial institutions provide to our economy EXCEPT:
A. increased liquidity.
B. increased monitoring.
C. increased dollar amount of funds flowing from suppliers to fund users.
D. increased price risk.
89. All of the following are factors that affect nominal interest rates EXCEPT:
A. time to maturity.
B. real interest rate.
C. convertibility features.
D. foreign exchange.
6-36
A. A flat yield curve occurs when the yield-to-maturity is virtually unaffected by the term-to-
maturity.
B. Real interest rates are generally lower than nominal interest rates.
C. Liquidity risk is the risk that a security may be difficult to sell on short notice for its true
value.
91. Which of the following statements is incorrect?
A. Governments affect foreign exchange rates indirectly by altering prevailing interest rates
within their own countries.
B. Foreign currency exchange rates vary with the day-to-day demand and supply of the two
foreign currencies.
C. Central governments can intervene in foreign exchange markets directly and value their
currency at high rates relative to another currency.
92. The theory that argues that individual investors and financial institutions have specific
maturity preferences is called the:
A. market segmentation theory.
B. unbiased expectations theory.
C. liquidity preference theory.
D. inverted forward theory.
6-37
93. The theory that states that the yield curve reflects the market's current expectations of future
short-term rates is called the:
B. liquidity premium theory.
C. unbiased expectations theory.
A. The over-the-counter market operates in a fixed location to conduct trades for local
stocks.
B. Liquidity is the ease with which an asset can be converted into cash.
C. An initial public offering is an example of a primary market transaction.
D. Money market instruments have maturities of less than one year.
95. All of the following are secondary market transactions EXCEPT:
A. GE sells $30 million of new preferred stock.
B. Microsoft sells $2 million of IBM preferred stock out of its marketable securities portfolio.
C. the Magellan Fund buys $100 million of Apple previously issued bonds.
D. Allstate Insurance Co. sells $5 million in IBM bonds.
96. Which of the following is NOT correct with respect to derivative securities?
A. They are among the riskiest of securities in the financial securities markets.
B. They can be used for hedging purposes.
C. Examples of derivatives include futures, options and swaps.
D. All of these are correct statements about derivatives.
6-38
97. Which of the following is NOT correct with respect to financial institutions?
A. Financial institutions channel funds from those with shortages to those with surplus funds.
B. Commercial banks, insurance companies, and mutual funds are examples of financial
institutions.
C. Financial institutions reduce monitoring costs and liquidity costs.
D. Financial institutions reduce price risk.
98. All of the following are factors that influence interest rates for individual securities EXCEPT:
A. the security's term to maturity.
B. inflation.
C. special provisions regarding the use of funds raised by a particular security issuer.
D. the home mortgage rate.
99. The real interest rate is:
A. the rate charged to the corporations with the best credit rating or least amount of default
risk.
B. the rate that a security would pay if no inflation were expected over its holding period.
C. the rate that a security would pay if the security had no maturity risk.
D. None of these statements is a correct definition.
100.All of the following special provisions benefit security holders EXCEPT:
A. tax-free status.
B. convertibility.
C. callability.
D. All of these provisions are beneficial to security holders.
6-39
101.An example of an illiquid asset is:
A. U.S. Treasury bill.
B. bonds issued by GM.
C. common stock issued by Apple Inc.
D. common stock issued by a small but financially strong firm.
102.All of the following are common shapes for the yield curve EXCEPT:
A. elliptical.
B. upward-sloping.
C. flat.
D. inverted.
103.Determinants of Interest Rates for Individual Securities The Wall Street Journal reports
that the current rate on five-year Treasury bonds is 2.85 percent and on 10-year Treasury
bonds is 4.35 percent. Assume that the maturity risk premium is zero. Calculate the expected
rate on a five-year Treasury bond purchased five years from today, E(5r5).
A. 3.60 percent
B. 5.85 percent
C. 7.20 percent
D. 8.28 percent
6-40
104.Determinants of Interest Rates for Individual Securities The Wall Street Journal reports
that the current rate on 10-year Treasury bonds is 3.25 percent and on 20-year Treasury
bonds is 5.50 percent. Assume that the maturity risk premium is zero. Calculate the expected
rate on a 10-year Treasury bond purchased ten years from today, E(10r10).
A. 2.25 percent
B. 4.38 percent
C. 7.80 percent
D. 8.75 percent
Essay Questions
105.What is a derivative security and what determines its value?
6-41
106.What shape does the term structure usually take? Why?
107.What does the "term structure of interest rates" mean?
108.Why is it useful to calculate forward rates?
6-42
109.George Washington wants to invest in one of two corporate bonds issued by separate firms.
One bond yields 7 percent with a 10-year maturity; the other offers a 10 percent yield with a
nine-year maturity. George thinks the nine-year bond is the better deal since the rate is
higher. Is this necessarily so? Explain what factors George should consider before making a
choice.
110.How do Financial Intermediaries (FIs) act as asset transformers?
6-43
111.Who are some of the participants in the shadow banking system?
112.Explain how the shadow banking system works.
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113.Classify the following transactions as taking place in the primary or secondary markets:
a. A company issues new common stock.

b. A company issues common stock in an IPO.
c. A shareholder sells preferred stock out of its marketable securities portfolio.
d. A mutual fund buys previously issued bonds.
e. An insurance company sells another company's common stock.
f. A company buys another company's stock from a mutual fund.
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114.Classify the following financial instruments as money market securities or capital market
securities:
a. Common stock
b. Corporate bonds
c. Mortgages
d. U.S. Treasury bills
e. U.S. Treasury notes
f. U.S. Treasury bonds
g. State and government bonds
6-46
Chapter 06 Understanding Financial Markets and Institutions Answer
Key
Multiple Choice Questions
1. Which of these provide a forum in which demanders of funds raise funds by issuing new
financial instruments, such as stocks and bonds?
A. Investment banks
B. Money markets
C. Primary markets
D. Secondary markets
AACSB: Reflective Thinking

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-01 Differentiate between primary and secondary markets and between money and capital
markets.
Topic: Primary and Secondary Markets
6-47
2. In the United States, which of these financial institutions arrange most primary market
transactions for businesses?
A. Investment banks
B. Asset transformer
C. Direct transfer agents
D. Over-the-counter agents

Blooms: Remember
Difficulty: 1 Easy
markets.
3. Primary market financial instruments include stock issues from firms allowing their equity
shares to be publicly traded on stock market for the first time. We usually refer to these
first-time issues as which of the following?
B. Direct transfers
C. Money market transfers

Blooms: Remember
Difficulty: 1 Easy
markets.
6-48
4. Once firms issue financial instruments in primary markets, these same stocks and bonds
are then traded in which of these?
B. Direct transfers

Blooms: Remember
Difficulty: 1 Easy
markets.
5. Which of these feature debt securities or instruments with maturities of one year or less?
A. Money markets
B. Primary markets

Blooms: Remember
Difficulty: 1 Easy
markets.
6-49
6. Which of the following is NOT a money market instrument?
A. Treasury bills
B. Commercial paper
C. Corporate bonds
D. Bankers' acceptances

Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 06-02 List the types of securities traded in money and capital markets.
Topic: Types of Securities
7. Which of these money market instruments are short-term funds transferred between
financial institutions, usually for no more than one day?
A. Treasury bills
B. Federal funds
C. Commercial paper
D. Banker acceptances

Blooms: Remember
Difficulty: 1 Easy
6-50
8. Which of the following is NOT a capital market instrument?
A. U.S. Treasury notes and bonds
B. U.S. Treasury bills
C. U.S. government agency bonds
D. Corporate stocks and bonds

Blooms: Remember
Difficulty: 1 Easy
9. Which of these capital market instruments are long-term loans to individuals or

businesses to purchase homes, pieces of land, or other real property?
A. Treasury notes and bonds
B. Mortgages
C. Mortgage-backed securities
D. Corporate bonds

Blooms: Remember
Difficulty: 1 Easy
6-51
10. Which of these markets trade currencies for immediate or for some future stated
delivery?
A. Money markets
B. Primary markets
C. Foreign exchange markets

Blooms: Remember
Difficulty: 1 Easy
11. Which of these formalizes an agreement between two parties to exchange a standard
quantity of an asset at a predetermined price on a specified date in the future?
A. Derivative security
B. Initial public offering
C. Liquidity asset
D. Trading volume

Blooms: Remember
Difficulty: 1 Easy
6-52
12. Which of these does NOT perform vital functions to securities markets of all sorts by
channeling funds from those with surplus funds to those with shortages of funds?
A. Commercial banks
B. Secondary markets
C. Insurance companies
D. Mutual funds

Blooms: Remember
Difficulty: 1 Easy
13. Which of these refer to the ease with which an asset can be converted into cash?
A. Direct transfer
B. Liquidity
C. Primary market
D. Secondary market

Blooms: Remember
Difficulty: 1 Easy
6-53
14. Which of the following is the risk that an asset's sale price will be lower than its purchase
price?
A. Default risk
B. Liquidity risk
C. Price risk
D. Trading risk

Blooms: Remember
Difficulty: 1 Easy
15. Which of these is the interest rate that is actually observed in financial markets?
A. Nominal interest rates
B. Real interest rates
C. Real risk free rate
D. Market premium

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 06-04 Analyze specific factors that influence interest rates.
Topic: Interest Rates
6-54
16. Which of these is the interest rate that would exist on a default-free security if no inflation
were expected?
A. Nominal interest rate
B. Real interest rate
C. Default premium
D. Market premium

Blooms: Remember
17. Which of the following is the risk that a security issuer will miss an interest or principal
payment or continue to miss such payments?
A. Default risk
B. Liquidity risk
C. Maturity risk
D. Price risk

Blooms: Remember
Difficulty: 1 Easy
6-55
18. Which of these is NOT a participant in the shadow banking system?
A. Structured investment vehicles (SIVs)
B. Special purpose vehicles (SPVs)
C. Limited-purpose finance companies
D. Credit unions

Blooms: Remember
Learning Objective: 06-03 Identify different types of financial institutions and the services that each provides.
Topic: Financial Institutions
19. How is the shadow banking system the same as the traditional banking system?
A. It intermediates the flow of funds between net savers and net borrows.
B. It serves as a middle man.
C. The complete credit intermediation is performed through a series of steps involving

many nonbank financial service firms.
D. The complete credit intermediation is performed by a single bank.

Blooms: Remember
6-56
20. Which of the following is the continual increase in the price level of a basket of goods and
services?
A. Deflation
B. Inflation
C. Recession
D. Stagflation

Blooms: Remember
Difficulty: 1 Easy
21. Which of these statements is true?
A. The higher the default risk, the higher the interest rate that security buyers will
demand.
B. The lower the default risk, the higher the interest rate that security buyers will demand.
C. The higher the default risk, the lower the interest rate that security buyers will demand.
D. The default risk does not impact the interest rate that security buyers will demand.

Blooms: Remember
Difficulty: 1 Easy
6-57
22. Which of these is a comparison of market yields on securities, assuming all characteristics
except maturity are the same?
A. Liquidity risk
B. Market risk
C. Maturity risk
D. Term structure of interest rates

Blooms: Remember
Difficulty: 1 Easy
23. According to this theory of term structure of interest rates, at any given point in time, the
yield curve reflects the market's current expectations of future short-term rates.
A. Expectations theory
B. Future short-term rates theory
C. Term structure of interest rates theory

Blooms: Remember
Learning Objective: 06-05 Offer different theories that explain the shape of the term structure of interest rates.
Topic: Term Structure Shape
6-58
24. Which of the following theories argues that individual investors and financial institutions
have specific maturity preferences, and to encourage buyers to hold securities with
maturities other than their most preferred requires a higher interest rate?
A. Liquidity premium hypothesis
C. Supply and demand theory

Blooms: Remember
25. Which of these is the expected or "implied" rate on a short-term security that will originate
at some point in the future?
A. Current yield
B. Forward rate
C. Spot rate
D. Yield to maturity

Blooms: Remember
Learning Objective: 06-06 Demonstrate how forward interest rates derive from the term structure of interest rates.
Topic: Forward Interest Rates
6-59
26. Which of these is NOT a theory that explains the shape of the term structure of interest
rates?
A. Liquidity theory
C. Short-term structure of interest rates theory

Blooms: Remember
Difficulty: 1 Easy
27. Interest rates A particular security's default risk premium is 3 percent. For all securities,
the inflation risk premium is 2 percent and the real interest rate is 2.25 percent. The
security's liquidity risk premium is 0.75 percent and maturity risk premium is 0.90 percent.
The security has no special covenants. What is the security's equilibrium rate of return?
A. 1.78 percent
B. 3.95 percent
C. 8.90 percent
D. 17.8 percent
ij* = 2.00% + 2.25% + 3.00% + 0.75% + 0.90% = 8.90%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-60
28. Interest rates You are considering an investment in 30-year bonds issued by a
corporation. The bonds have no special covenants. The Wall Street Journal reports that
one-year T-bills are currently earning 3.50 percent. Your broker has determined the
following information about economic activity and the corporation bonds:
What is the inflation premium? What is the fair interest rate on the corporation's 30-year
bonds?
A. 1 percent and 1.49 percent, respectively
B. 1 percent and 6.45 percent, respectively
C. 1 percent and 7.45 percent, respectively
D. 3.50 percent and 9.95 percent, respectively
Expected (IP) = i - RIR = 3.50% - 2.50% = 1.00%

ij* = 1.00% + 2.50% + 1.75% + 0.70% + 1.50% = 7.45%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-61
29. Interest rates A corporation's 10-year bonds have an equilibrium rate of return of 7
percent. For all securities, the inflation risk premium is 1.50 percent and the real interest
rate is 3.0 percent. The security's liquidity risk premium is 0.15 percent and maturity risk
premium is 0.70 percent. The security has no special covenants. What is the bond's
default risk premium?
A. 1.40 percent
B. 1.65 percent
C. 5.35 percent
D. 9.35 percent
7.00% = 1.5% + 3% + DRP + 0.15% + 0.70%

=> DRP = 7.00% - (1.5% + 3% + 0.15% + 0.70%) = 1.65%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-62
30. Interest rates A two-year Treasury security currently earns 5.25 percent. Over the next
two years, the real interest rate is expected to be 3.00 percent per year and the inflation
premium is expected to be 2.00 percent per year. What is the maturity risk premium on the
two-year Treasury security?
A. 0.25 percent
B. 1.00 percent
C. 1.05 percent
D. 5.00 percent
5.25% = 2.00% + 3.00% + 0.00% + 0.00% + MP

=> MP = 5.25% - (2.00% + 3.00% + 0.00% + 0.00%) = 0.25%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-63
31. Unbiased Expectations Theory Suppose that the current one-year rate (one-year spot
rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and
4, respectively) are as follows:
Using the unbiased expectations theory, what is the current (long-term) rate for four-year-
maturity Treasury securities?
A. 6.00 percent
B. 6.33 percent
C. 6.75 percent
D. 7.00 percent
1 R4 = [(1 + 0.05)(1 + 0.055)(1 + 0.065)(1 + 0.07)]1/4 - 1 = 6%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-64
expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent. If
the unbiased expectations theory is correct, what should the current rate be on two-year
A. 5.50 percent
B. 5.625 percent
C. 5.75 percent
D. 11.25 percent
1 R2 = [(1 + 0.055)(1 + 0.0575)]1/2 - 1 = 5.62492604%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-65
33. Liquidity Premium Hypothesis One-year Treasury bills currently earn 5.50 percent. You
expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent.
The liquidity premium on two-year securities is 0.075 percent. If the liquidity theory is
correct, what should the current rate be on two-year Treasury securities?
A. 3.775 percent
B. 5.625 percent
C. 5.662 percent
D. 11.325 percent
1 R2 = [(1 + 0.055)(1 + 0.0575 + 0.00075)]1/2 - 1 = 5.66237504%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-66
34. Liquidity Premium Hypothesis Based on economists' forecasts and analysis, one-year
Treasury bill rates and liquidity premiums for the next four years are expected to be as
follows:
Using the liquidity premium hypothesis, what is the current rate on a four-year Treasury
security?
A. 7.736 percent
B. 7.600 percent
C. 7.738 percent
D. 8.400 percent
1 R4 = [(1 + 0.0665)(1 + 0.0775 + 0.0010)(1 + 0.0785 + 0.0020)(1 + 0.0815 + 0.0025)] 1/4 - 1

= 7.73548
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-67
expected that one year from now, 1-year Treasury bill rates will increase to 3.65 percent
and that two years from now, one-year Treasury bill rates will increase to 4.05 percent. If
the unbiased expectations theory is correct, what should the current rate be on three-year
A. 3.40 percent
B. 3.62 percent
C. 3.75 percent
D. 3.85 percent
1 R3 = [(1 + 0.0315)(1 + 0.0365)(1 + 0.0405)]1/3 - 1 = 3.62%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Topic: Unbiased Expectations Theory
6-68
and that two years from now, one-year Treasury bill rates will increase to 3.15 percent. If
the unbiased expectations theory is correct, what should the current rate be on 3-year
A. 2.55 percent
B. 2.85 percent
C. 2.93 percent
D. 3.15 percent
1 R3 = [(1 + 0.0255)(1 + 0.0285)(1 + 0.0315)]1/3 - 1 = 3.62%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-69
37. Interest rates The Wall Street Journal reports that the rate on three-year Treasury
securities is 7.00 percent, and the six-year Treasury rate is 7.25 percent. From discussions
with your broker, you have determined that expected inflation premium is 1.75 percent
next year, 2.25 percent in Year 2, and 2.40 percent in Year 3 and beyond. Further, you
expect that real interest rates will be 3.75 percent annually for the foreseeable future.
What is the maturity risk premium on the six-year Treasury security?
A. 0.83 percent
B. 0.983 percent
C. 1.10 percent
D. 1.233 percent
7.25% = 2.40% + 3.75% + MP => MP = 7.25% - (2.40% + 3.75%) = 1.10%
AACSB: Analytic
Blooms: Apply
6-70
38. Interest rates A corporation's 10-year bonds are currently yielding a return of 7.75
percent. The expected inflation premium is 3.0 percent annually and the real interest rate
is expected to be 3.00 percent annually over the next 10 years. The liquidity risk premium
on the corporation's bonds is 0.50 percent. The maturity risk premium is 0.25 percent on
two-year securities and increases by 0.10 percent for each additional year to maturity.
What is the default risk premium on the corporation's 10-year bonds?
A. 0.18 percent
B. 0.20 percent
C. 0.22 percent
D. 0.27 percent
7.75% = 3.00% + 3.00% + DRP + 0.50% + (0.25% + (0.10% × 8))

=> DRP = 7.75% - (3.00% + 3.00% + 0.50% + (0.25% + (0.10% × 8))) = 0.20%
AACSB: Analytic
Blooms: Apply
6-71
39. Unbiased Expectations Theory Suppose we observe the following rates: 1R1 = 6 percent,
1 R2 = 7.5 percent. If the unbiased expectations theory of the term structure of interest
rates holds, what is the one-year interest rate expected one year from now, E(2r1)?
A. 6.75 percent
B. 7.50 percent
C. 9.02 percent
D. 13.5 percent
1 + 1R2 = {(1 + 1R1)(1 + E(2r1))}1/2

1.075 = {1.06(1 + E(2r1))}1/2
1.155625 = 1.06 (1 + E(2r1))
1.155625/1.06 = 1 + E(2r1)
1 + E(2r1) = 1.090212264
E(2r1) = 0.0902 = 9.02%
AACSB: Analytic
Blooms: Apply
6-72
40. Unbiased Expectations Theory The Wall Street Journal reports that the rate on four-year
the one-year Treasury rate to be four years from today, E(5r1)?
A. 1.11 percent
B. 5.95 percent
C. 10.70 percent
D. 10.89 percent
1 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}1/5

1.0595 = {(1.0475)4(1 + E(5r1))}1/5
(1.0595)5 = (1.0475)4 (1 + E(5r1))
(1.0595)5/(1.0475)4 = 1 + E(5r1)
1 + E(5r1) = 1.108890541
E(5r1) = 10.89%
AACSB: Analytic
Blooms: Apply
6-73
41. Liquidity Premium Hypothesis The Wall Street Journal reports that the rate on three-year
Treasury securities is 4.75 percent and the rate on four-year Treasury securities is 5.00
percent. The one-year interest rate expected in three years is E(4r1), 5.25 percent.
According to the liquidity premium hypotheses, what is the liquidity premium on the four-
year Treasury security, L4?
A. 0.0375 percent
B. 0.504 percent
C. 5.01 percent
D. 5.04 percent
1 + 1R4 = {(1 + 1R3)(1 + E(4r1) + L4)}1/4

1.0500 = {(1.0475)3(1 + 0.0525 + L4)}1/4
(1.0500)4 = (1.0475)3(1 + 0.0525 + L4)
(1.0500)4/(1.0475)3 = 1 + 0.0525 + L4
(1.0500)4/(1.0475)3 - 1.0525 = L4 = 0.0050358564 = 0.504%
AACSB: Analytic
Blooms: Apply
6-74
42. Liquidity Premium Hypothesis Suppose we observe the following rates: 1R1 = 8 percent,
1 R2 = 10 percent, and E(2r1) = 8 percent. If the liquidity premium theory of the term
structure of interest rates holds, what is the liquidity premium for year 2, L2?
A. 1.02 percent
B. 4.04 percent
C. 6.15 percent
D. 12.03 percent
1 + 1R2 = {(1 + 1R1)(1 + E(2r1) + L2)}1/2

1.10 = {(1.08)(1 + 0.08 + L2)}1/2
(1.10)2 = (1.08)(1 + 0.08 + L2)
(1.10)2/(1.08) = 1 + 0.08 + L2
(1.10)2/(1.08) - 1.08 = L2 = 0.04037 = 4.04%
AACSB: Analytic
Blooms: Apply
6-75
43. Forecasting Interest Rates You note the following yield curve in The Wall Street Journal.
According to the unbiased expectations hypothesis, what is the one-year forward rate for
the period beginning one year from today, 2f1?
A. 1.01 percent
B. 1.19 percent
C. 5.625 percent
D. 7.51 percent
AACSB: Analytic
Blooms: Apply
6-76
44. Forecasting Interest Rates On May 23, 20XX, the existing or current (spot) one-year,
two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:
Using the unbiased expectations theory, what is the one-year forward rate on zero-coupon
Treasury bonds for year 4 as of May 23, 20XX?
A. 5.925 percent
B. 6.45 percent
C. 7.05 percent
D. 10.32 percent
f = [(1 + 1R4)4/(1 + 1R3)3] - 1 = [(1 + 0.0645)4/(1 + 0.0625)3] - 1 = 7.05%

4 1
AACSB: Analytic
Blooms: Apply
6-77
bonds is 6.75 percent, on 20-year Treasury bonds is 7.25 percent, and on a 20-year
corporate bond is 8.50 percent. Assume that the maturity risk premium is zero. If the
default risk premium and liquidity risk premium on a 10-year corporate bond is the same
as that on the 20-year corporate bond, what is the current rate on a 10-year corporate
bond.
A. 7.50 percent
B. 8.00 percent
C. 8.50 percent
D. 8.75 percent
20-year corporate bond: 8.5% = 7.25% + DRP + LRP + 0.00% => DRP + LRP = 8.5% -
7.25% = 1.25%
10-year corporate bond: ij* = 6.75% + 1.25% = 8.00%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-78
bonds is 6.50 percent and on 10-year Treasury bonds is 6.75 percent. Assume that the
maturity risk premium is zero. Calculate the expected rate on a 5-year Treasury bond
purchased five years from today, E(5r1).
A. 6.625 percent
B. 6.75 percent
C. 7.00 percent
D. 7.58 percent
1 + 1R10 = {(1 + 1R5)5(1 + E(5r1))5}1/10 = 1.0675 = {(1 + 0.065)5(1 + E(5r1))5}1/10

=> E(5r1) = {(1.0675)10/(1 + 0.065)5}1/5 - 1 = 7.00%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-79
47. Unbiased Expectations Theory Suppose we observe the three-year Treasury security
rate (1R3) to be 6 percent, the expected one-year rate next year E(2r1) to be 3 percent, and
the expected one-year rate the following year E(3r1) to be 5 percent. If the unbiased
expectations theory of the term structure of interest rates holds, what is the one-year
Treasury security rate, 1R1?
A. 3.00 percent
B. 10.13 percent
C. 14.00 percent
D. 19.88 percent
1.06 = {(1 + 1R1)(1 + E(2r1))(1 + E(3r1))}1/3

1.06 = {(1 + 1R1) × 1.03 × 1.05}1/3
(1.06)3 = (1 + 1R1) × 1.03 × 1.05
1 + 1R1 = 1.191016/(1.03 × 1.05)
1 R1 = 0.10126 = 10.13%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-80
48. Unbiased Expectations Theory The Wall Street Journal reports that the rate on three-
year Treasury securities is 6.25 percent and the rate on five-year Treasury securities is
6.45 percent. According to the unbiased expectations hypotheses, what does the market
expect the two-year Treasury rate to be three years from today, E(4r2)?
A. 6.35 percent
B. 6.75 percent
C. 7.25 percent
D. 7.45 percent
1 + 1R5 = {(1 + 1R3)3(1 + E(3r2))2}1/5 = 1.0645 = {(1 + 0.0625)3(1 + E(3r2))2}1/5

=> E(3r2) = {(1.0645)5/(1 + 0.0625)3}1/2 - 1 = 6.75%
AACSB: Analytic
Blooms: Analyze
Blooms: Apply
Difficulty: 3 Hard
6-81
49. Liquidity Premium Theory One-year Treasury bills currently earn 3.25 percent. You
and that two years from now, one-year Treasury bill rates will increase to 3.95 percent.
The liquidity premium on two-year securities is 0.05 percent and on three-year securities
is 0.15 percent. If the liquidity theory is correct, what should the current rate be on three-
year Treasury securities?
A. 3.25 percent
B. 3.55 percent
C. 3.62 percent
D. 4.10 percent
1 R2 = [(1 + 0.0325)(1 + 0.0345 + 0.0005)(1 + 0.0395 + 0.0015)]1/3 - 1 = 3.62%
AACSB: Analytic
Blooms: Analyze
Blooms: Apply
Topic: Liquidity Premium Theory
6-82
50. Liquidity Premium Theory One-year Treasury bills currently earn 2.95 percent. You
and that two years from now, one-year Treasury bill rates will increase to 3.35 percent.
The liquidity premium on two-year securities is 0.05 percent and on three-year securities
is 0.15 percent. If the liquidity theory is correct, what should the current rate be on three-
year Treasury securities?
A. 2.95 percent
B. 3.15 percent
C. 3.22 percent
D. 3.35 percent
1 R2 = [(1 + 0.0295)(1 + 0.0315 + 0.0005)(1 + 0.0335 + 0.0015)]1/3 - 1 = 3.22%
AACSB: Analytic
Blooms: Analyze
Blooms: Apply
Topic: Liquidity Premium Theory
6-83
51. Forecasting Interest Rates Assume the current interest rate on a one-year Treasury bond
(1R1) is 5.00 percent, the current rate on a two-year Treasury bond (1R2) is 5.75 percent,
and the current rate on a three-year Treasury bond (1R3) is 6.25 percent. If the unbiased
expectations theory of the term structure of interest rates is correct, what is the one-year
interest rate expected on Treasury bills during year 3, 3f1?
A. 5.00 percent
B. 5.67 percent
C. 7.26 percent
D. 8.00 percent
1 R1 = 5.0%
AACSB: Analytic
Blooms: Analyze
Blooms: Apply
Difficulty: 3 Hard
6-84
52. Forecasting Interest Rates A recent edition of The Wall Street Journal reported interest
rates of 3.10 percent, 3.50 percent, 3.75 percent, and 3.95 percent for three-year, four-
year, five-year, and six-year Treasury security yields, respectively, According to the
unbiased expectation theory of the term structure of interest rates, what are the expected
one-year rates for year 6?
A. 3.575 percent
B. 3.95 percent
C. 4.96 percent
D. 5.33 percent
1 + 1R6 = {(1 + 1R5)5(1 + E(6r1))}1/6

1.0395 = {(1.0375)5(1 + E(6r1))}1/6
(1.0395)6 = (1.0375)5(1 + E(6r1))
(1.0395)6/(1.0375)5 = 1 + E(6r1)
1 + E(6r1) = 1.04955798
E(6r1) = 4.96%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-85
53. A particular security's default risk premium is 3 percent. For all securities, the inflation risk
premium is 1.75 percent and the real interest rate is 4.2 percent. The security's liquidity
risk premium is 0.35 percent and maturity risk premium is 0.95 percent. The security has
no special covenants. Calculate the security's equilibrium rate of return.
A. 8.50 percent
B. 6.05 percent
C. 10.25 percent
D. 9.90 percent
3 + 1.75 + 4.2 + 0.35 + 0.95 = 10.25
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-86
54. You are considering an investment in 30-year bonds issued by Moore Corporation. The
bonds have no special covenants. The Wall Street Journal reports that one-year T-bills are
currently earning 3.55 percent. Your broker has determined the following information
about economic activity and Moore Corporation bonds:
What is the inflation premium?
A. 0.80 percent
B. 1.25 percent
C. 6.25 percent
D. 8.00 percent
3.55 - 2.75 = 0.80
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-87
55. You are considering an investment in 30-year bonds issued by Moore Corporation. The
bonds have no special covenants. The Wall Street Journal reports that one-year T-bills are
currently earning 3.55 percent. Your broker has determined the following information
about economic activity and Moore Corporation bonds:
What is the fair interest rate on Moore Corporation 30-year bonds?
A. 3.80 percent
B. 6.45 percent
C. 6.95 percent
D. 9.70 percent
1.05 + 0.5 + 1.85 + 3.55 = 6.95
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-88
56. Dakota Corporation 15-year bonds have an equilibrium rate of return of 9 percent. For all
securities, the inflation risk premium is 1.95 percent and the real interest rate is 3.65
percent. The security's liquidity risk premium is 0.35 percent and maturity risk premium is
0.95 percent. The security has no special covenants. Calculate the bond's default risk
premium.
A. 2.10 percent
B. 3.05 percent
C. 3.40 percent
D. 2.45 percent
9 - 1.95 - 3.65 - 0.35 - 0.95 = 2.1
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-89
57. A two-year Treasury security currently earns 5.13 percent. Over the next two years, the
real interest rate is expected to be 2.15 percent per year and the inflation premium is
expected to be 1.75 percent per year. Calculate the maturity risk premium on the two-year
Treasury security.
A. 5.13 percent
B. 3.38 percent
C. 2.98 percent
D. 1.23 percent
5.13 - 1.75 - 2.15 = 1.23
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-90
rates over the following three years (i.e., years 2, 3 and 4, respectively) are as follows:

Using the unbiased expectations theory, calculate the current (long-term) rates for one-
year and two-year -maturity Treasury securities.
1 R1 = 5% and 1R2 = [(1 + 0.05)(1 + 0.07)]1/2 - 1 = 6.0%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-91
rates over the following three years (i.e., years 2, 3 and 4 respectively) are as follows:

Using the unbiased expectations theory, calculate the current (long-term) rates for three-
year- and four-year-maturity Treasury securities.
1 R3 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)]1/3 - 1 = 6.16% and
1 R4 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)(1 + 0.0785)]1/4 - 1 = 6.58%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-92
rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
Using the unbiased expectations theory, calculate the current (long-term) rates for one-,
two-, three-, and four-year-maturity Treasury securities.
A. 5.00 percent; 5.50 percent; 6.16 percent; 6.33 percent
B. 5.00 percent; 5.25 percent; 6.10 percent; 6.27 percent
C. 5.00 percent; 5.50 percent; 6.10 percent; 6.23 percent
D. 5.00 percent; 5.25 percent; 6.16 percent; 6.49 percent
1 R1 = 5%
1 R2 = [(1 + 0.05)(1 + 0.06)]1/2 - 1 = 5.5%
1 R3 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)]1/3 - 1 = 6.16%
1 R4 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)(1 + 0.0685)]1/4 - 1 = 6.33%
AACSB: Analytic
Blooms: Apply
6-93
61. One-year Treasury bills currently earn 3.75 percent. You expect that one year from now,
one-year Treasury bill rates will increase to 4.15 percent. If the unbiased expectations
theory is correct, what should the current rate be on two-year Treasury securities?
A. 4.25 percent
B. 3.85 percent
C. 3.95 percent
D. 4.35 percent
1 R2 = [(1 + 0.0375)(1 + 0.0415)]0.5 - 1 = 3.95%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-94
62. One-year Treasury bills currently earn 4.5 percent. You expect that one year from now,
one-year Treasury bill rates will increase to 6.65 percent. The liquidity premium on two-
year securities is 0.05 percent. If the liquidity theory is correct, what should the current
rate be on two-year Treasury securities?
A. 5.24 percent
B. 5.59 percent
C. 5.65 percent
D. 5.95 percent
1 R2 = [(1 + 0.045)(1 + 0.0665 + 0.0005)]0.5 - 1 = 5.59%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Topic: Liquidity Premium Hypothesis
6-95
63. Based on economists' forecasts and analysis, one-year Treasury bill rates and liquidity
premiums for the next four years are expected to be as follows:
R1 = 5.95 percent
Using the liquidity premium hypothesis, what should be the current rate on four-year
A. 6.59 percent
B. 6.75 percent
C. 6.82 percent
D. 7.13 percent
1 R4 = [(1 + 0.0595)(1 + 0.0625 + 0.0005)(1 + 0.0675 + 0.0010)(1 + 0.0715 + 0.0012)] 1/4 - 1

= 6.59%
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-96
you have determined that expected inflation premium is 2.25 percent next year, 2.50
interest rates will be 4.4 percent annually for the foreseeable future. Calculate the
maturity risk premium on the 3-year Treasury security.
A. 0.00 percent
B. 0.10 percent
C. 4.50 percent
D. 2.60 percent
7.00% = 2.50% + 4.40% + MP => MP = 7.00% - (2.50% + 4.40%) = 0.10%
AACSB: Analytic
Blooms: Apply
6-97
you have determined that expected inflation premium is 2.25 percent next year, 2.50
interest rates will be 3.4 percent annually for the foreseeable future. Calculate the
maturity risk premium on the three-year and the six-year Treasury security.
A. 3-year: 0.6 percent; 6-year: 0.80 percent
B. 3-year: 0.5 percent; 6-year: 0.90 percent
C. 3-year: 0.6 percent; 6-year: 1.20 percent
D. 3-year: 0.5 percent; 6-year: 0.80 percent
Step 1: 6.50% = 2.60% + 3.40% + MP => MP = 6.50% - (2.60% + 3.40%) = 0.50% Step 2:
6.80% = 2.60% + 3.40% + MP => MP = 6.80% - (2.60% + 3.40%) = 0.80%
AACSB: Analytic
Blooms: Apply
6-98
66. Nikki G's Corporation's 10-year bonds are currently yielding a return of 9.25 percent. The
expected inflation premium is 2.0 percent annually and the real interest rate is expected to
be 3.10 percent annually over the next 10 years. The liquidity risk premium on Nikki G's
bonds is 0.1 percent. The maturity risk premium is 0.10 percent on two-year securities and
increases by 0.05 percent for each additional year to maturity. Calculate the default risk
premium on Nikki G's 10-year bonds.
A. 2.55 percent
B. 5.65 percent
C. 3.55 percent
D. 1.85 percent
9.25% = 2.0% + 3.10% + DRP + 0.1% + (0.10% + (0.05% × 8))

DRP = 9.25% - (2.0% + 3.10% + 0.1% + 0.5%) = 3.55%
AACSB: Analytic
Blooms: Apply
6-99
67. Suppose we observe the following rates: 1R1 = 12 percent, 1R2 = 15 percent. If the
unbiased expectations theory of the term structure of interest rates holds, what is the
one-year interest rate expected one year from now, E(2r1)?
A. 13.5 percent
B. 14.2 percent
C. 15.6 percent
D. 18.0 percent
1/2
1 + 1R2 = {(1 + 1R1)(1 + E(2r1))}
1.15 = {1.12(1 + E(2r1))}1/2

1.32 = 1.12 (1 + E(2r1))
1.32/1.12 = 1 + E(2r1)
1 + E(2r1) = 1.18
E(2r1) = 0.18
AACSB: Analytic
Blooms: Apply
6-100
68. The Wall Street Journal reports that the rate on four-year Treasury securities is 7.50
percent and the rate on five-year Treasury securities is 9.15 percent. According to the
unbiased expectations hypotheses, what does the market expect the one-year Treasury
rate to be four years from today, E(5r1)?
A. 16.0 percent
B. 18.4 percent
C. 15.9 percent
D. 13.7 percent
1/5
1 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}
1.0915 = {(1.075)4(1 + E(5r1))}1/5

(1.0915)5 = (1.075)4(1 + E(5r1))
(1.0915)5/(1.075)4 = 1 + E(5r1)
1 + E(5r1) = 1.1601
E(5r1) = 16.01%
AACSB: Analytic
Blooms: Apply
6-101
percent and the rate on four-year Treasury securities is 8.50 percent. The one-year
interest rate expected in three years is E(4r1), 4.10 percent. According to the liquidity
premium hypotheses, what is the liquidity premium on the four-year Treasury security, L4?
A. 6.7 percent
B. 7.1 percent
C. 8.2 percent
D. 9.6 percent
1/4
1 + 1R4 = {(1 + 1R3)(1 + E(4r1) + L4)}
1.0850 = {(1.0725)3(1 + 0.0410 + L4)}1/4

(1.0850)4 = (1.0725)3(1 + 0.0410 + L4)
(1.0850)4/(1.0725)3 = 1 + 0.0410 + L4
(1.0850)4/(1.0725)3 - 1.0410 = L4 = 0.0824 = 8.24%
AACSB: Analytic
Blooms: Apply
6-102
70. Suppose we observe the following rates: 1R1 = 13 percent, 1R2 = 16 percent, and E(2r1) =
10 percent. If the liquidity premium theory of the term structure of interest rates holds,
what is the liquidity premium for year 2, L2?
A. 8.7 percent
B. 9.1 percent
C. 9.7 percent
D. 10.0 percent
1/2
1 + 1R2 = {(1 + 1R1)(1 + E(2r1) + L2)}
1.16 = {(1.13)(1 + 0.10 + L2)}1/2

(1.16)2 = (1.13)(1 + 0.10 + L2)
(1.16)2/(1.13) = 1 + 0.10 + L2
(1.16)2/(1.13) - 1.10 = L2 = 0.0908
AACSB: Analytic
Blooms: Apply
6-103
71. You note the following yield curve in The Wall Street Journal. According to the unbiased
expectations hypothesis, what is the one-year forward rate for the period beginning one
year from today, 2f1?
A. 7.6 percent
B. 8.6 percent
C. 9.0 percent
D. 10.2 percent
1 R2 = 0.075 = [(1 + 0.06)(1 + 2f1)]1/2 - 1; [(1.075)2/(1.06)] - 1 = 2f1 = 9.02%
AACSB: Analytic
Blooms: Apply
Topic: Forecasting Interest Rates
6-104
72. On May 23, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-
year zero-coupon Treasury security rates were as follows:
1 R1 = 4.55 percent, 1R2 = 4.75 percent, 1R3 = 5.25 percent, 1R4 = 5.95 percent
Using the unbiased expectations theory, calculate the one-year forward rates on zero-
coupon Treasury bonds for years two, three, and four as of May 23, 20XX.
A. Year 1: 4.95 percent; Year 2: 6.26 percent; Year 3: 8.08 percent
B. Year 1: 3.75 percent; Year 2: 6.02 percent; Year 3: 9.00 percent
C. Year 1: 4.95 percent; Year 2: 7.26 percent; Year 3: 8.08 percent
D. Year 1: 3.65 percent; Year 2: 6.32 percent; Year 3: 11.08 percent
2 1 f = [(1 + 1R2)2/(1 + 1R1)] - 1 = [(1 + 0.0475)2/(1 + 0.0455)] - 1 = 4.95%
3 1 f = [(1 + 1R3)3/(1 + 1R2)2] - 1 = [(1 + 0.0525)3/(1 + 0.0475)2] - 1 = 6.26%
4 1 f = [(1 + 1R4)4/(1 + 1R3)3] - 1 = [(1 + 0.0595)4/(1 + 0.0525)3] - 1 = 8.08%
AACSB: Analytic
Blooms: Apply
6-105
73. The Wall Street Journal reports that the current rate on 10-year Treasury bonds is 6.25
percent, on 20-year Treasury bonds is 7.95 percent, and on a 20-year corporate bond is
10.75 percent. Assume that the maturity risk premium is zero. If the default risk premium
and liquidity risk premium on a 10-year corporate bond is the same as that on the 20-year
corporate bond, calculate the current rate on a 10-year corporate bond.
A. 9.05 percent
B. 6.15 percent
C. 7.60 percent
D. 8.70 percent
20-year bond: 10.75% = 7.95% + DRP + LRP + 0.00% => DRP + LRP = 2.8%
10-year bond: ij* = 6.25% + 2.8% = 9.05%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-106
74. The Wall Street Journal reports that the current rate on five-year Treasury bonds is 6.45
percent and on 10-year Treasury bonds is 7.75 percent. Assume that the maturity risk
premium is zero. Calculate the expected rate on a five-year Treasury bond purchased five
years from today, E(5r5).
A. 7.25 percent
B. 8.12 percent
C. 9.07 percent
D. 10.16 percent
1/10
1 + 1R10 = {(1 + 1R5)5(1 + E(5r5))5}1/10 = 1.0775 = {(1 + 0.0645)5(1 + E(5r5))5}
E(5r5) = {(1.0775)10/(1 + 0.0645)5}1/5 - 1 = 9.07%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-107
75. Suppose we observe the three-year Treasury security rate (1R3) to be 11 percent, the
expected one-year rate next year E(2r1) to be 4 percent, and the expected one-year rate
the following year E(3r1) to be 5 percent. If the unbiased expectations theory of the term
structure of interest rates holds, what is the one-year Treasury security rate, 1R1?
A. 18.57 percent
B. 10.19 percent
C. 23.19 percent
D. 25.24 percent
1/3
1.11 = {(1 + 1R1)(1 + E(2r1))(1 + E(3r1))}
1.11 = {(1 + 1R1) × 1.04 × 1.05}1/3

(1.11)3 = (1 + 1R1) × 1.04 × 1.05
1 + 1R1 = 1.3676/(1.04 × 1.05)
1 R1 = 0.2524 = 25.24%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-108
76. Assume the current interest rate on a one-year Treasury bond (1R1) is 5.50 percent, the
current rate on a two-year Treasury bond (1R2) is 5.95 percent, and the current rate on a
three-year Treasury bond (1R3) is 8.50 percent. If the unbiased expectations theory of the
term structure of interest rates is correct, what is the one-year interest rate expected on
Treasury bills during year 3, 3f1?
A. 13.79 percent
B. 12.29 percent
C. 11.69 percent
D. 10.29 percent
1 R1 = 5.5%
1 R2 = 5.95% = [(1 + 0.055)(1 + 2f1)]1/2 - 1; 2f1 = 6.40%
1 R3 = 8.50% = [(1 + 0.055)(1 + 0.064)(1 + 3f1)]1/3 - 1; 3f1 = 13.79%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
6-109
77. If the yield curve is downward sloping, what is the yield to maturity on a 30-year Treasury
bond relative to a 10-year Treasury bond?
A. The yield on the 10-year bond must be greater than the yield on the 30-year bond.
B. The yield on the 10-year bond must be less than the yield on the 30-year bond.
C. The yields on the two bonds are equal.
D. We need to know the other risk premiums to answer this question.

Blooms: Understand
Topic: Yield Curves
78. One-year Treasury bill rates in 20XX averaged 5.15 percent and inflation for the year was
7.3 percent. If investors had expected the same inflation rate as that realized, calculate the
real interest rate for 20XX according to the Fisher effect.
A. 0.00 percent
B. -2.15 percent
C. 2.15 percent
D. 3.95 percent
5.15 - 7.3 = -2.15%
AACSB: Analytic
Blooms: Apply
Topic: Fisher Effect
6-110
79. Assume that you observe the following rates on long-term bonds:
U.S. Treasury bonds = 4.15 percent
AAA Corporate bonds = 6.2 percent
BBB Corporate bonds = 7.15 percent
The main reason for the differences in the interest rates is:
A. Maturity risk premium
B. Inflation premium
C. Default risk premium
D. Convertibility premium

Blooms: Remember
Topic: Factors that Influence Interest Rates for Individual Securities
6-111
A. According to the unbiased expectations theory, the return for holding a two-year bond
to maturity is equal to the nominal rate divided by the real interest rate.
B. The rate on a 10-year Corporate can never be less than the rate on a 10-year Treasury.
C. We usually observe the inverted yield curve.
D. The rate on a three-year Treasury can never be less than the rate on a 15-year
Treasury.

Blooms: Remember
Difficulty: 3 Hard
Topic: Yield Curves
81. One-year interest rates are 3 percent. The market expects one-year rates to be 5 percent
one year from now. The market also expects one-year rates to be 7 percent two years from
now. Assume that the unbiased expectations theory holds. Which of the following is
correct?
A. The yield curve is downward sloping.
B. The yield curve is flat.
C. The yield curve is upward sloping.
D. We need the maturity risk premiums to be able to answer this question.
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-112
A. If the unbiased expectations theory is correct, we could see an inverted yield curve.
B. If a yield curve is inverted, long-term bonds have higher yields than short-term bonds.
C. If the maturity risk premium is zero, the yield curve would be flat.
D. If the unbiased expectations theory is correct, the maturity risk premium is zero.

Blooms: Remember
Topic: Yield Curves
83. The Wall Street Journal states that the yield curve for Treasuries is downward sloping and
there is no liquidity premium or maturity risk premium. Given this information, which of the
following statements is correct?
A. A 30-year corporate bond must have a higher yield than a five-year corporate bond.
B. A five-year corporate bond must have a higher yield than a 30-year Treasury bond.
C. A five-year Treasury bond must have a higher yield than a five-year corporate bond.

Blooms: Remember
Topic: Yield Curves
6-113
A. An IPO is an example of a primary market transaction.
B. Money markets are subject to wider price fluctuations and are therefore more risky
than capital market instruments.
C. A direct transfer of funds is more efficient than utilizing financial institutions.
D. The market segmentation theory argues that the different investors have different risk
preferences which determine the shape of the yield curve.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
markets.
Topic: Money Markets, Primary Markets, Term Structure Theory
6-114
85. In 20XX, the 10-year Treasury rate was 4.5 percent while the average 10-year Aaa
corporate bond debt carried an interest rate of 6.0 percent. What is the average default
risk premium on Aaa corporate bonds?
A. 0.75 percent
B. 1.5 percent
C. 1.95 percent
D. 2.25 percent
6.0 - 4.5 = 1.5
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
6-115
A. The default risk premium of Baa 20-year corporate bonds over Aaa 20-year corporate
bonds does not vary.
B. The market segmentation theory assumes that borrowers and investors do not want to
shift from one maturity sector to another without an interest rate premium.
C. Real interest rates are the rates that are quoted in the news.
AACSB: Analytic
Blooms: Remember
Topic: Theories Explaining the Shape of the Term Structure of Interest Rates
87. All of the following are types of financial institutions EXCEPT:
A. insurance companies.
B. pension funds.
C. thrifts.
D. federal reserve bank.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
6-116
88. All of the following are benefits that financial institutions provide to our economy
EXCEPT:
A. increased liquidity.
B. increased monitoring.
C. increased dollar amount of funds flowing from suppliers to fund users.
D. increased price risk.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Economic Functions Provided by Financial Institutions
89. All of the following are factors that affect nominal interest rates EXCEPT:
A. time to maturity.
B. real interest rate.
C. convertibility features.
D. foreign exchange.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
6-117
A. A flat yield curve occurs when the yield-to-maturity is virtually unaffected by the term-
to-maturity.
B. Real interest rates are generally lower than nominal interest rates.
C. Liquidity risk is the risk that a security may be difficult to sell on short notice for its
true value.
AACSB: Analytic
Blooms: Remember
Topic: Yield Curves
A. Governments affect foreign exchange rates indirectly by altering prevailing interest

rates within their own countries.
B. Foreign currency exchange rates vary with the day-to-day demand and supply of the
two foreign currencies.
C. Central governments can intervene in foreign exchange markets directly and value their
currency at high rates relative to another currency.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Foreign Exchange Rates
6-118
92. The theory that argues that individual investors and financial institutions have specific
maturity preferences is called the:
B. unbiased expectations theory.
C. liquidity preference theory.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Term Structure of Interest Rates
93. The theory that states that the yield curve reflects the market's current expectations of
future short-term rates is called the:
B. liquidity premium theory.
C. unbiased expectations theory.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
6-119
A. The over-the-counter market operates in a fixed location to conduct trades for local
stocks.
B. Liquidity is the ease with which an asset can be converted into cash.
C. An initial public offering is an example of a primary market transaction.
D. Money market instruments have maturities of less than one year.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
markets.
Topic: Money Market
95. All of the following are secondary market transactions EXCEPT:
A. GE sells $30 million of new preferred stock.
B. Microsoft sells $2 million of IBM preferred stock out of its marketable securities
portfolio.
C. the Magellan Fund buys $100 million of Apple previously issued bonds.
D. Allstate Insurance Co. sells $5 million in IBM bonds.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
markets.
Topic: Secondary Market
6-120
96. Which of the following is NOT correct with respect to derivative securities?
A. They are among the riskiest of securities in the financial securities markets.
B. They can be used for hedging purposes.
C. Examples of derivatives include futures, options and swaps.
D. All of these are correct statements about derivatives.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Derivatives
97. Which of the following is NOT correct with respect to financial institutions?
A. Financial institutions channel funds from those with shortages to those with surplus
funds.
B. Commercial banks, insurance companies, and mutual funds are examples of financial
institutions.
C. Financial institutions reduce monitoring costs and liquidity costs.
D. Financial institutions reduce price risk.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
6-121
98. All of the following are factors that influence interest rates for individual securities
EXCEPT:
A. the security's term to maturity.
B. inflation.
C. special provisions regarding the use of funds raised by a particular security issuer.
D. the home mortgage rate.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Factors Affecting Interest Rates
99. The real interest rate is:
A. the rate charged to the corporations with the best credit rating or least amount of
default risk.
B. the rate that a security would pay if no inflation were expected over its holding period.
C. the rate that a security would pay if the security had no maturity risk.
D. None of these statements is a correct definition.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Real Interest Rate
6-122
100. All of the following special provisions benefit security holders EXCEPT:
A. tax-free status.
B. convertibility.
C. callability.
D. All of these provisions are beneficial to security holders.
AACSB: Analytic
Blooms: Remember
Topic: Special Provisions
101. An example of an illiquid asset is:
A. U.S. Treasury bill.
B. bonds issued by GM.
C. common stock issued by Apple Inc.
D. common stock issued by a small but financially strong firm.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Liquidity Risk
6-123
102. All of the following are common shapes for the yield curve EXCEPT:
A. elliptical.
B. upward-sloping.
C. flat.
D. inverted.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Topic: Yield Curves
103. Determinants of Interest Rates for Individual Securities The Wall Street Journal reports
that the current rate on five-year Treasury bonds is 2.85 percent and on 10-year Treasury
bonds is 4.35 percent. Assume that the maturity risk premium is zero. Calculate the
expected rate on a five-year Treasury bond purchased five years from today, E(5r5).
A. 3.60 percent
B. 5.85 percent
C. 7.20 percent
D. 8.28 percent
1 + 1R10 = {(1 + 1R5)5(1 + E(5r5))5}1/10 = 1.0435 = {(1 + 0.0285)5(1 + E(5r5))5}1/10

=> E(5r5) = {(1.0435)10/(1 + 0.0285)5}1/5 - 1 = 5.85%
AACSB: Analytic
Blooms: Remember
Difficulty: 3 Hard
Topic: Determinants of Interest Rates for Individual Securities
6-124
104. Determinants of Interest Rates for Individual Securities The Wall Street Journal reports
that the current rate on 10-year Treasury bonds is 3.25 percent and on 20-year Treasury
bonds is 5.50 percent. Assume that the maturity risk premium is zero. Calculate the
expected rate on a 10-year Treasury bond purchased ten years from today, E(10r10).
A. 2.25 percent
B. 4.38 percent
C. 7.80 percent
D. 8.75 percent
1 + 1R20 = {(1 + 1R10)10(1 + E(10r10))10}1/20 = 1.0550 = {(1 + 0.0325)10(1 + E(10r10))10}1/20

=> E(10r10) = {(1.0550)20/(1 + 0.0325)10}1/10 - 1 = 7.80%
AACSB: Analytic
Blooms: Remember
Difficulty: 3 Hard
Topic: Determinants of Interest Rates for Individual Securities
Essay Questions
6-125
105. What is a derivative security and what determines its value?
This is a financial security linked to another, underlying security, such as a stock traded in
capital markets or British Pounds Sterling traded in foreign exchange markets. These
generally involve an agreement between two parties to exchange a standard quantity of an
asset or cash flow at a predetermined price and at a specified date in the future. As the
value and/or riskiness of the underlying security changes, the value of the derivative
security changes.

Blooms: Remember
106. What shape does the term structure usually take? Why?
The yield curve for U.S. Treasury securities has taken many shapes over the years, but the
three most common shapes are: (1) the upward-sloping yield curve where yields rise
steadily with maturity; (2) an inverted or downward-sloping yield curve in which yields
decline as maturity increases; and (3) a flat yield curve, when the yield to maturity is
virtually unaffected by the term-to-maturity.
AACSB: Analytic
Blooms: Remember
6-126
107. What does the "term structure of interest rates" mean?
It compares interest rates on debt securities based on their time to maturity, assuming
that all characteristics (default risk, liquidity risk) are equal.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
108. Why is it useful to calculate forward rates?
As interest rates change, so do the values of financial securities. Accordingly, both

individual investors and public corporations want to be able to predict or forecast interest
rates if they wish to trade profitably.
AACSB: Analytic
Blooms: Remember
Topic: Forward Rates
6-127
109. George Washington wants to invest in one of two corporate bonds issued by separate
firms. One bond yields 7 percent with a 10-year maturity; the other offers a 10 percent
yield with a nine-year maturity. George thinks the nine-year bond is the better deal since
the rate is higher. Is this necessarily so? Explain what factors George should consider
before making a choice.
George should consider factors that affect differences in interest rates on debt. These
include the general level of inflation, the real interest rate, default risk, liquidity risk and
any special provisions associated with the bond and the term to maturity.
AACSB: Analytic
Blooms: Apply
110. How do Financial Intermediaries (FIs) act as asset transformers?
Financial intermediaries act as asset transformers as follows: FIs purchase the financial
claims that fund users issue―primary securities such as mortgages, bonds, and
stocks―and finance these purchases by selling financial claims to household investors
and other fund suppliers as deposits, insurance policies, or other secondary securities.
The secondary securities—packages or pools of primary claims—that FIs issue are often
more liquid than are the primary securities themselves.

Blooms: Evaluate
6-128
111. Who are some of the participants in the shadow banking system?
Participants in the shadow banking system include structured investment vehicles (SIVs),
special purpose vehicles (SPVs), asset-backed paper vehicles, asset-backed commercial
paper (ABCP) conduits, limited-purpose finance companies, money market mutual funds
(MMMFs), and credit hedge funds.

Blooms: Remember
112. Explain how the shadow banking system works.
In the shadow banking system, savers place their funds with money market mutual and
similar funds, which invest these funds in the liabilities of other shadow banks. Borrowers
get loans and leases from shadow banks such as finance companies rather than from
banks. Like the traditional banking system, the shadow banking system intermediates the
flow of funds between net savers and net borrowers. However, instead of the bank serving
as middleman, it is the nonbank financial service firm, or shadow bank, that intermediates.
Further, unlike the traditional banking system, where the complete credit intermediation is
performed by a single bank, in the shadow banking system it is performed through a series
of steps involving many nonbank financial service firms.

Blooms: Remember
Difficulty: 3 Hard
6-129
113. Classify the following transactions as taking place in the primary or secondary markets:
a. A company issues new common stock.

b. A company issues common stock in an IPO.
c. A shareholder sells preferred stock out of its marketable securities portfolio.
d. A mutual fund buys previously issued bonds.
e. An insurance company sells another company's common stock.
f. A company buys another company's stock from a mutual fund.
a. primary market
b. primary market
c. secondary market
d. secondary market
e. secondary market
f. secondary market

Blooms: Remember
Difficulty: 1 Easy
markets.
6-130
114. Classify the following financial instruments as money market securities or capital market
securities:
a. Common stock
b. Corporate bonds
c. Mortgages
d. U.S. Treasury bills
e. U.S. Treasury notes
f. U.S. Treasury bonds
g. State and government bonds
a. capital market security

b. capital market security
c. capital market security
d. money market security
e. capital market security
f. capital market security
g. capital market security

Blooms: Remember
Difficulty: 1 Easy
6-131

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Understanding Financial Markets and Institutions

Multiple Choice Questions

C. Direct transfer agents

A. Initial public offerings

C. Money market transfers

A. Initial public offerings

6. Which of the following is NOT a money market instrument?

A. U.S. Treasury notes and bonds

B. U.S. Treasury bills

C. U.S. government agency bonds

D. Corporate stocks and bonds

A. Treasury notes and bonds

C. Foreign exchange markets

B. Initial public offering

A. Nominal interest rates

B. Real interest rates

C. Real risk free rate

A. Nominal interest rate

B. Real interest rate

18. Which of these is NOT a participant in the shadow banking system?

A. Structured investment vehicles (SIVs)

B. Special purpose vehicles (SPVs)

C. Limited-purpose finance companies

B. It serves as a middle man.

D. The complete credit intermediation is performed by a single bank.

21. Which of these statements is true?

D. Term structure of interest rates

B. Future short-term rates theory

C. Term structure of interest rates theory

D. Unbiased expectations theory

A. Liquidity premium hypothesis

B. Market segmentation theory

C. Supply and demand theory

D. Unbiased expectations theory

B. Market segmentation theory

C. Short-term structure of interest rates theory

D. Unbiased expectations theory

A. 1 percent and 1.49 percent, respectively

B. 1 percent and 6.45 percent, respectively

C. 1 percent and 7.45 percent, respectively

D. 3.50 percent and 9.95 percent, respectively

1 R1 = 5 percent, E(2r1) = 7 percent, E(3r1) = 7.5 percent E(4r1) = 7.85 percent

A. One-year: 5.00 percent; Two-year: 5.50 percent

B. One-year: 5.00 percent; Two-year: 6.00 percent

C. One-year: 5.50 percent; Two-year: 6.15 percent

D. One-year: 5.50 percent; Two-year: 5.75 percent

1 R1 = 5 percent, E(2r1) = 6 percent, E(3r1) = 7.5 percent E(4r1) = 7.85 percent

A. One-year: 6.16 percent; Two-year: 6.58 percent

B. One-year: 6.16 percent; Two-year: 6.78 percent

C. One-year: 6.25 percent; Two-year: 6.45 percent

D. One-year: 5.95 percent; Two-year: 6.45 percent

1 R1 = 5 percent, E(2r1) = 6 percent, E(3r1) = 7.5 percent E(4r1) = 6.85 percent

A. 5.00 percent; 5.50 percent; 6.16 percent; 6.33 percent

B. 5.00 percent; 5.25 percent; 6.10 percent; 6.27 percent

C. 5.00 percent; 5.50 percent; 6.10 percent; 6.23 percent

D. 5.00 percent; 5.25 percent; 6.16 percent; 6.49 percent

A. 3-year: 0.6 percent; 6-year: 0.80 percent

B. 3-year: 0.5 percent; 6-year: 0.90 percent

C. 3-year: 0.6 percent; 6-year: 1.20 percent

D. 3-year: 0.5 percent; 6-year: 0.80 percent

A. Year 1: 4.95 percent; Year 2: 6.26 percent; Year 3: 8.08 percent