Test Bank For Finance Applications and Theory 4th Edition Marcia Cornett Troy Adair John Nofsinger

Test Bank for Finance: Applications and Theory, 4th Edition, Marcia Cornett, Troy Adair John
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Edition, Marcia Cornett, Troy Adair John Nofsinger
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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 Basic
Learning Goal: 06-01 Differentiate between primary and secondary markets and between money and capital markets.
Topic: Primary and 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

Blooms: Remember
Difficulty: 1 Basic
3. Primary market financial instruments include stock issues from firms allowing their equity shares to be publicly traded on
the 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

Blooms: Remember
Difficulty: 1 Basic
Topic: Initial public offerings
4. Once firms issue financial instruments in primary markets, these same stocks and bonds are then traded in which of
these?
A. initial public offerings

B. direct transfers
C. secondary markets

Blooms: Remember
Difficulty: 1 Basic
6-1
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
5. Which of these feature debt securities or instruments with maturities of one year or less?
A. money markets
B. primary markets
C. secondary markets

Blooms: Remember
Difficulty: 1 Basic
Topic: Money and capital markets
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 Basic
Learning Goal: 06-02 List the types of securities traded in money and capital markets.
Topic: Money market 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 Basic
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 Basic
6-2
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 Basic
Topic: Types of loans
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 Basic
Topic: 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

Blooms: Remember
Difficulty: 1 Basic
Topic: Derivatives and other securities
12. Which of these does NOT perform vital functions to securities markets of all sorts by channelling 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 Basic
6-3
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 Basic
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 Basic
Topic: Nominal interest rate factors
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 Intermediate
Learning Goal: 06-06 Analyze specific factors that influence interest rates.
Topic: Nominal and real rates
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
6-4
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 Basic
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 Goal: 06-03 Identify different types of financial institutions and the services that each provides.
Topic: Types of 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 borrowers.
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
Topic: Financial institution functions
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 Basic
6-5
21. Which of these statements is true?
A. The higher the default risk, the higher the interest rate that securities buyers will demand.
B. The lower the default risk, the higher the interest rate that securities buyers will demand.
C. The higher the default risk, the lower the interest rate that securities buyers will demand.
D. The default risk does not impact the interest rate that securities buyers will demand.

Blooms: Remember
Difficulty: 1 Basic
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 Basic
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

Blooms: Remember
Learning Goal: 06-07 Offer different theories that explain the shape of the term structure of interest rates.
Topic: Interest rate theories
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

Blooms: Remember
6-6
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 Goal: 06-08 Demonstrate how forward interest rates derive from the term structure of interest rates.
Topic: Term structure of interest rates
26. Which of these is NOT a theory that explains the shape of the term structure of interest rates?
A. liquidity theory
B. market segmentation theory
C. short-term structure of interest rates theory

Blooms: Remember
Difficulty: 1 Basic
27. 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: Analytical Thinking

Blooms: Apply
Difficulty: 1 Basic
6-7
28. 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
Expected (IP) = i− RIR = 3.50% − 2.50% = 1.00%.

ij* = 1.00% + 2.50% + 1.75% + 0.70% + 1.50% = 7.45%.

Blooms: Apply
Difficulty: 1 Basic
29. 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%.

Blooms: Apply
Difficulty: 1 Basic
6-8
30. 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%.

Blooms: Apply
Difficulty: 1 Basic
31. 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:
1R1 = 5%, E(2r1) = 5.5%, E(3r1) = 6.5%, E(4r1) = 7.0%
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
1R4 = [(1 + 0.05)(1 + 0.055)(1 + 0.065)(1 + 0.07)] 1/4− 1 = 6%.

Blooms: Apply
Difficulty: 1 Basic
6-9
32. 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
1R2 = [(1 + 0.055)(1 + 0.0575)]1/2− 1 = 5.62492604%.

Blooms: Apply
Difficulty: 1 Basic
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
1R2 = [(1 + 0.055)(1 + 0.0575 + 0.00075)] 1/2− 1 = 5.66237504%.

Blooms: Apply
Difficulty: 1 Basic
6-10
34. 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 theory, what is the current rate on a four-year Treasury
security?
R1 = 6.65 %
E(r2) = 7.75 % L2 = 0.10 %
E(r3) = 7.85 % L3 = 0.20 %
E(r4) = 8.15 % L4 = 0.25 %
A. 7.736 percent
B. 7.736 percent
C. 7.600 percent
D. 7.600 percent
E. 7.738 percent
F. 7.738 percent
G. 8.400 percent
H. 8.400 percent
1R4 = [(1 + 0.0665)(1 + 0.0775 + 0.0010)(1 + 0.0785 + 0.0020)(1 + 0.0815 + 0.0025)] 1/4− 1 = 7.73548.

Blooms: Apply
Difficulty: 1 Basic
35. One-year Treasury bills currently earn 3.15 percent. You expect 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 Treasury securities?
A. 3.40 percent
B. 3.62 percent
C. 3.75 percent
D. 3.85 percent
1R3 = [(1 + 0.0315)(1 + 0.0365)(1 + 0.0405)] 1/3− 1 = 3.62%.

Blooms: Apply
Difficulty: 1 Basic
6-11
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
1R3 = [(1 + 0.0255)(1 + 0.0285)(1 + 0.0315)] 1/3− 1 = 3.62%.

Blooms: Apply
Difficulty: 1 Basic
37. 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 the expected inflation premium will be
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%

Blooms: Apply
38. 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.

Blooms: Apply
6-12
39. 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
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.

Blooms: Apply
40. 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
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%.

Blooms: Apply
6-13
41. 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 theory, 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%.

Blooms: Apply
42. 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
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%.

Blooms: Apply
6-14
43. 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?
Maturity Yield
One day 3.00 %
One year 5.00
Two years 6.25
Three years 8.00
A. 1.01 percent
B. 1.19 percent
C. 5.625 percent
D. 7.51 percent
1R2 = 0.0625 = [(1 + 0.050)(1 + 2f1)]1/2− 1

 [(1.0625)2/(1.050)] − 1 = 2f1 = 7.51%.

Blooms: Apply
6-15
44. 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:
1R1= 5.25%, 1R2= 5.75%, 1R3 = 6.25%, 1R4= 6.45%
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
4f1 = [(1 + 1R4)4/(1 + 1R3)3] − 1 = [(1 + 0.0645)4/(1 + 0.0625)3] − 1 = 7.05%.

Blooms: Apply
45. 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
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%.

Blooms: Apply
Difficulty: 3 Advanced
6-16
46. 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
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%.

Blooms: Apply
47. 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)
1R1 = 0.10126 = 10.13%.

Blooms: Apply
6-17
48. 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 hypothesis, 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.

Blooms: Analyze
Blooms: Apply
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
1R2 = [(1 + 0.0325)(1 + 0.0345 + 0.0005)(1 + 0.0395 + 0.0015)] 1/3− 1 = 3.62%.

Blooms: Analyze
Blooms: Apply
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
1R2 = [(1 + 0.0295)(1 + 0.0315 + 0.0005)(1 + 0.0335 + 0.0015)] 1/3− 1 = 3.22%.

Blooms: Analyze
Blooms: Apply
6-18
51. 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
1R1 = 5.0%
1/2− 1  f = 6.51%.
1 2 = 5.75% = [(1 + 0.05)(1 + 2f1)]
R 2 1
1/3− 1  f = 7.26.
1R3 = 6.25% = [(1 + 0.05)(1 + 0.0651)(1 + 3f1)] 3 1

Blooms: Analyze
Blooms: Apply
52. 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%.

Blooms: Apply
6-19
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.

Blooms: Apply
Difficulty: 1 Basic
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.

Blooms: Apply
Difficulty: 1 Basic
6-20
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.
Blooms: Apply
Difficulty: 1 Basic
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.

Blooms: Apply
Difficulty: 1 Basic
6-21
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.

Blooms: Apply
Difficulty: 1 Basic
1R1= 5 percent,
E(2r1) = 7 percent,
E(3r1) = 7.5 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
1R1 = 5% and 1R2 = [(1 + 0.05)(1 + 0.07)]1/2− 1 = 6.0%.

Blooms: Apply
Difficulty: 1 Basic
6-22
years (i.e., years 2, 3, and 4 respectively) are as follows:
1R1= 5 percent,
E(2r1) = 6 percent,
Using the unbiased expectations theory, calculate the current (long-term) rates for three-year- and four-year-maturity
Treasury securities.
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
1R3 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)]1/3− 1 = 6.16% and

1/4− 1 = 6.58%.
1R4 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)(1 + 0.0785)]

Blooms: Apply
Difficulty: 1 Basic
6-23
1R1= 5 percent,
E(2r1) = 6 percent,
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
1R1 = 5%
1/2− 1 = 5.5%.
1R2 = [(1 + 0.05)(1 + 0.06)]
1/3− 1 = 6.16%.
1R3 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)]
1/4− 1 = 6.33%.
1R4 = [(1 + 0.05)(1 + 0.06)(1 + 0.075)(1 + 0.0685)]

Blooms: Apply
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
1R2 = [(1 + 0.0375)(1 + 0.0415)]0.5− 1 = 3.95%.

Blooms: Apply
Difficulty: 1 Basic
6-24
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
1R2 = [(1 + 0.045)(1 + 0.0665 + 0.0005)] 0.5− 1 = 5.59%.

Blooms: Apply
Difficulty: 1 Basic
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 theory, what should be the current rate on four-year Treasury securities?
A. 6.59 percent
B. 6.75 percent
C. 6.82 percent
D. 7.13 percent
1R4 = [(1 + 0.0595)(1 + 0.0625 + 0.0005)(1 + 0.0675 + 0.0010)(1 + 0.0715 + 0.0012)] 1/4− 1 = 6.59%.

Blooms: Apply
Difficulty: 1 Basic
6-25
rate is 6.20 percent. From discussions with your broker, you have determined that the expected inflation premium will be
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%.

Blooms: Apply
rate is 6.80 percent. From discussions with your broker, you have determined that the expected inflation premium will
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%.

Blooms: Apply
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%.

Blooms: Apply
6-26
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 + 1R2 = {(1 + 1R1)(1 + E(2r1))}1/2

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.

Blooms: Apply
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 hypothesis, 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 + 1R5 = {(1 + 1R4)4(1 + E(5r1))}1/5

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%.

Blooms: Apply
6-27
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 theory, 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 + 1R4 = {(1 + 1R3)(1 + E(4r1) + L4)}1/4

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%.

Blooms: Apply
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 + 1R2 = {(1 + 1R1)(1 + E(2r1) + L2)}1/2

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.

Blooms: Apply
6-28
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?
Maturity Yield
One day 2.00 %
One year 6.00
Two years 7.50
Three years 9.00
A. 7.6 percent
B. 8.6 percent
C. 9.0 percent
D. 10.2 percent
1R2 = 0.075 = [(1 + 0.06)(1 + 2f1)]1/2− 1; [(1.075)2/(1.06)] − 1 = 2f1 = 9.02%.

Blooms: Apply
Topic: Interest rate forecasting
6-29
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:
1R1= 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
2f1 = [(1 + 1R2)2/(1 + 1R1)] − 1 = [(1 + 0.0475)2/(1 + 0.0455)] − 1 = 4.95%

3f1 = [(1 + 1R3) /(1 + 1R2) ] − 1 = [(1 + 0.0525) /(1 + 0.0475) ] − 1 = 6.26%
3 2 3 2
4f1 = [(1 + 1R4) /(1 + 1R3) ] − 1 = [(1 + 0.0595) /(1 + 0.0525) ] − 1 = 8.08%.
4 3 4 3

Blooms: Apply
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%.

Blooms: Apply
6-30
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
A. 7.25 percent
B. 8.12 percent
C. 9.07 percent
D. 10.16 percent
1 + 1R10 = {(1 + 1R5)5(1 + E(5r5))5}1/10 = 1.0775 = {(1 + 0.0645)5(1 + E(5r5))5}1/10

E(5r5) = {(1.0775)10/(1 + 0.0645)5}1/5− 1 = 9.07%.

Blooms: Apply
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
1.11 = {(1 + 1R1)(1 + E(2r1))(1 + E(3r1))}1/3

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)
1R1 = 0.2524 = 25.24%.

Blooms: Apply
6-31
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
1R1 = 5.5%
1/2− 1; f = 6.40%.
1 2 = 5.95% = [(1 + 0.055)(1 + 2f1)]
R 2 1
1/3− 1; f = 13.79%.
1R3 = 8.50% = [(1 + 0.055)(1 + 0.064)(1 + 3f1)] 3 1

Blooms: Apply
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: Treasury yield curve
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%.

Blooms: Apply
Topic: Fisher effect
6-32
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
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 bond 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
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.

Blooms: Apply
Difficulty: 1 Basic
6-33
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
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 choices are correct.
Blooms: Remember
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.

Blooms: Remember
Difficulty: 1 Basic
Learning Goal: 06-05 Understand how equilibrium interest rates are determined.
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.

Blooms: Apply
Difficulty: 1 Basic
6-34
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.

Blooms: Remember
87. All of the following are types of financial institutions EXCEPT
A. insurance companies.
B. pension funds.
C. thrifts.
D. Federal reserve

Blooms: Remember
Difficulty: 1 Basic
Topic: Types of financial institutions
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.

Blooms: Remember
Difficulty: 1 Basic
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.

Blooms: Remember
Difficulty: 1 Basic
6-35
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.

Blooms: Remember
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.

Blooms: Remember
Difficulty: 1 Basic
Topic: Exchange rates
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.

Blooms: Remember
Difficulty: 1 Basic
93. The theory that states that the yield curve reflects the market's current expectations of future short-term rates is called the
A. market segmentation theory.

B. liquidity premium theory.
C. unbiased expectations theory.
D. inverted forward theory.

Blooms: Remember
Difficulty: 1 Basic
6-36
94. Which of the following statements is incorrect?
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.

Blooms: Remember
Difficulty: 1 Basic
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.

Blooms: Remember
Difficulty: 1 Basic
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.

Blooms: Remember
Difficulty: 1 Basic
Topic: Derivatives and other securities
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.

Blooms: Remember
Difficulty: 1 Basic
6-37
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.

Blooms: Remember
Difficulty: 1 Basic
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.

Blooms: Remember
Difficulty: 1 Basic
100. All of the following special provisions benefit security holders EXCEPT
A. tax-free status.
B. convertibility.
C. callability.

Blooms: Remember
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.

Blooms: Remember
Difficulty: 1 Basic
6-38
102. All of the following are common shapes for the yield curve EXCEPT
A. elliptical.
B. upward-sloping.
C. flat.
D. inverted.

Blooms: Remember
Difficulty: 1 Basic
103. 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
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%.

Blooms: Remember
104. 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 10 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%.

Blooms: Remember
6-39
105. Which of the following are suppliers of loanable funds?
A. households
B. government units
C. foreign investors

Blooms: Remember
Difficulty: 1 Basic
Learning Goal: 06-04 Know the main suppliers and demanders of loanable funds.
106. Which of the following do foreign suppliers of funds in the U.S. financial market assess?
A. interest rates offered on financial securities

B. their total wealth
C. foreign investors

Blooms: Remember
Difficulty: 1 Basic
107. Which of the following are demanders of loanable funds?
A. households
B. businesses
C. governments

Blooms: Remember
Difficulty: 1 Basic
108. Why would foreign participants borrow from U.S. financial markets?
A. They look for the cheapest source of funds.

B. They look at the economic conditions of their home country.
C. All of these choices are correct.
Blooms: Remember
Difficulty: 1 Basic
6-40
109. Which of the following factors cause the supply of funds curve to shift?
A. total wealth risk of the financial security

B. future spending needs
C. All of these choices are correct.

Blooms: Remember
Difficulty: 1 Basic
110. When monetary policy objectives are to contract the economic growth, which of the following occurs?
A. The Federal Reserve decreases the supply of funds available in the financial markets.
B. At every interest rate the supply of loanable funds increases.
C. The supply curve shifts down and to the right.
D. The equilibrium interest rate rises.

Blooms: Remember
111. Which of the following factors cause the demand for funds curve to shift?
A. utility derived from asset purchased with borrowed funds

B. restrictiveness of nonprice conditions of borrowing
C. domestic and foreign economic conditions

Blooms: Remember
Difficulty: 1 Basic
112. Which of the following occurs as the utility derived from an asset purchased with borrowed funds increases?
A. The willingness of market participants to borrow decreases.

B. The absolute dollar value borrowed increases.
C. At every interest rate the demand for loanable funds decrease.

Blooms: Remember
6-41
Test Bank for Finance: Applications and Theory, 4th Edition, Marcia Cornett, Troy Adair John
113. Which of the following occurs as the nonprice restrictions put on borrowers as a condition of borrowing increase?
A. The willingness of market participants to borrow decreases.

B. The absolute dollar value borrowed increases.
C. At every interest rate the demand for loanable funds increases.

Blooms: Remember
114. Which of the following occurs as domestic economic conditions experience a period of growth especially relative to other
countries?
A. Market participants are willing to borrow more heavily.

B. At every interest rate the supply of loanable funds increases.
C. At every interest rate the demand for loanable funds increases.

Blooms: Remember
6-42
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Test Bank For Finance Applications and Theory 4th Edition Marcia Cornett Troy Adair John Nofsinger

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Multiple Choice Questions

AACSB: Reflective Thinking

AACSB: Reflective Thinking

A. initial public offerings

AACSB: Reflective Thinking

A. initial public offerings

AACSB: Reflective Thinking

AACSB: Reflective Thinking

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

AACSB: Reflective Thinking

AACSB: Reflective Thinking

8. Which of the following is NOT a capital market instrument?

A. U.S. Treasury notes and bonds

AACSB: Reflective Thinking

A. treasury notes and bonds

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

A. nominal interest rates

AACSB: Reflective Thinking

A. nominal interest rate

AACSB: Reflective Thinking

AACSB: Reflective Thinking

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

A. structured investment vehicles (SIVs)

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

A. liquidity premium hypothesis

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Analytical Thinking

Real interest rate = 2.50 percent

Default risk premium = 1.75 percent

Liquidity risk premium = 0.70 percent

Maturity risk premium = 1.50 percent

A. 1 percent and 1.49 percent, respectively

Expected (IP) = i− RIR = 3.50% − 2.50% = 1.00%.

AACSB: Analytical Thinking

7.00% = 1.5% + 3% + DRP + 0.15% + 0.70%

=> DRP = 7.00% − (1.5% + 3% + 0.15% + 0.70%) = 1.65%.

AACSB: Analytical Thinking

AACSB: Analytical Thinking

1R1 = 5%, E(2r1) = 5.5%, E(3r1) = 6.5%, E(4r1) = 7.0%

1R4 = [(1 + 0.05)(1 + 0.055)(1 + 0.065)(1 + 0.07)] 1/4− 1 = 6%.

AACSB: Analytical Thinking

1R2 = [(1 + 0.055)(1 + 0.0575)]1/2− 1 = 5.62492604%.

AACSB: Analytical Thinking

1R2 = [(1 + 0.055)(1 + 0.0575 + 0.00075)] 1/2− 1 = 5.66237504%.

AACSB: Analytical Thinking

AACSB: Analytical Thinking

1R3 = [(1 + 0.0315)(1 + 0.0365)(1 + 0.0405)] 1/3− 1 = 3.62%.

AACSB: Analytical Thinking

1R3 = [(1 + 0.0255)(1 + 0.0285)(1 + 0.0315)] 1/3− 1 = 3.62%.