Ch6 Finance

One of the four most fundamental factors that affect the cost of money as discussed in the text is the risk inherent in agiven security. The higher the risk, the higher the security’s required return, other things held constant. True
The four most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferencesfor consumption, (3) risk, and (4) inflation. True
If the demand curve for funds increased but the supply curve remained constant, we would expect to see the totalamount of funds supplied and demanded increase and interest rates in general also increase. True
During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall wheninflation is declining. True
If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bondshould be equal to the real risk-free rate, r*. True
If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see anupward sloping yield curve. true
The risk that interest rates will increase, and that increase will lead to a decline in the prices of outstanding bonds, iscalled “interest rate risk,” or “price risk.” true
The risk that interest rates will decline, and that decline will lead to a decline in the income provided by a bondportfolio as interest and maturity payments are reinvested, is called “reinvestment rate risk.” True
The “yield curve” shows the relationship between bonds’ maturities and their yields. True
Because the maturity risk premium is normally positive, the yield curve is normally upward sloping. True
If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected todecline in the future. True
An upward-sloping yield curve is often call a “normal” yield curve, while a downward-sloping yield curve is called”abnormal.” True
The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decreaserates when the economy is weak. True
One of the four most fundamental factors that affect the cost of money as discussed in the text is the availability ofproduction opportunities and their expected rates of return. If production opportunities are relatively good, then interestrates will tend to be relatively high, other things held constant. True
Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remainconstant. Which of the following statements is CORRECT, other things held constant? a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
Which of the following factors would be most likely to lead to an increase in nominal interest rates? A new technology like the Internet has just been introduced, and it increases investment opportunities.
If expected inflation increases, interest rates are likely to increase. True
Which of the following would be most likely to lead to a higher level of interest rates in the economy? b. Corporations step up their expansion plans and thus increase their demand for capital.
Suppose the U.S. Treasury issued $50 billion of short-term securities and sold them to the public. Other things heldconstant, what would be the most likely effect on short-term securities’ prices and interest rates? Prices would decline and interest rates would rise.
Assume that interest rates on 20-year Treasury and corporate bonds are as follows:T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%The differences in these rates were probably caused primarily by: b. Default and liquidity risk differences.
In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected tosteadily increase, and the maturity risk premium is expected to be 0.1(t 1)%, where t is the number of years until thebond matures. Given this information, which of the following statements is CORRECT? The yield curve must be upward sloping.
If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bondcompare to that on a 1-year T-bill? The yield on a 10-year bond would be less than that on a 1-year bill.
Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3%next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information,which of the following statements is CORRECT? This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.
If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, theTreasury bond yield curve must be upward sloping. True
A bond trader observes the following information:The Treasury yield curve is downward sloping.Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquiditypremium is built into corporate bond yields. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond
The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increaseswith years to maturity. Given these conditions, which of the following statements is CORRECT? The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. True
If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero,then the Treasury yield curve will have an upward slope. True
Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we could be sure that Maturity risk premiums could help to explain the yield curve’s upward slope.
The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. True
Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, we could besure that Maturity risk premiums could help to explain the yield curve’s upward slope.
Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which ofthe following statements is CORRECT? The maturity risk premium is assumed to be zero.
Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from nowand then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity riskpremium equals zero. Which of the following statements is CORRECT? The interest rate today on a 3-year bond should be approximately 7%.
The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation isexpected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that thepure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements isCORRECT? The 10-year corporate bond must have a higher yield than the 5-year corporate bond.
If the pure expectations theory of the term structure is correct, which of the following statements would beCORRECT? Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds
If the pure expectations theory of the term structure is correct, which of the following statements would beCORRECT? If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise
If the pure expectations theory holds, which of the following statements is CORRECT? The maturity risk premium would be zero.
The pure expectations theory states that the maturity risk premium for long-term Treasury bonds is zero andthat differences in interest rates across different Treasury maturities are driven by expectations about futureinterest rates. True
Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds. True
If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following isCORRECT? The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. True
Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on bothTreasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the followingstatements is CORRECT? The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.
If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. True
Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years.Both bonds promise to pay a semiannual coupon, they are not callable or corvertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT? If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short’s bonds must under all conditions have a lower yield than Long’s bonds.

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