Chapter 6 - BUS 361 Sample Test
1. The default risk premium:
a. compensates investors for
interest rate risk, which is that long-term securities are more price sensitive
to interest changes than short-term securities.
b. is equal to expected inflation over the life of the security
c. is added to the equilibrium interest rate on a security if the security cannot be converted to cash quickly at close to “fair market value.”
d. is the difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability
2. The NYSE does not exist as a physical location; rather it represents a loose collection of dealers who trade stock electronically.
3. Suppose that the real risk-free rate is 3.5%, the average future inflation rate is 2.25%, and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 5-year Treasury security?
4. Assume that the expectations theory holds, and that liquidity and maturity risk premiums are zero. If the annual rate of interest on a 2-year Treasury bond is 9 percent and the rate on a 1-year Treasury bond is 11 percent, what rate of interest should you expect on a 1-year Treasury bond one year from now?
5. Federal Reserve policy rarely affects interest rates.
6. If the yield curve is downward sloping, what is the yield to maturity on a 10-year Treasury coupon bond, relative to that on a 1-year T-bond?
a. The yield on the 10-year
bond is less than the yield on a 1-year bond.
b. The yield on a 10-year bond will always be higher than the yield on a 1-year bond because of maturity risk premiums.
c. It is impossible to tell without knowing the coupon rates of the bonds.
d. The yields on the two bonds are equal.
e. It is impossible to tell without knowing the relative risks of the two bonds.
7. The real risk-free rate of interest is:
a. static, it does not change
b. changes over time depending on economic conditions
c. is always zero
d. none of the above are correct
8. Investing overseas adds:
a. country risk which refers
to the risk that arises from investing or doing business in a particular country
b. exchange rate risk which is the risk that changes in the relative value of the currencies will reduce the value of the investment in terms of the home currency.
c. both a and b are true
d. neither a nor b are true
9. Assume that inflation is expected to steadily decline in the years ahead, but that the real risk-free rate, k*, is expected to remain constant. Which of the following statements is most correct?
a. If the expectations theory
holds, the Treasury yield curve must be downward sloping.
b. If the expectations theory holds, the Treasury yield curve must be upward sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
d. Statements a and c are correct.
10. A large liquidity premium:
a. is required for assets that
can be converted into cash on short notice at a reasonable price.
b. is required for assets that cannot be converted into cash on short notice at a reasonable price.
c. is required for assets with high default risk
d. is required for assets when inflation was high in the past
11. Investment banking firms:
a. facilitate the issue of new
b. are secondary market participants.
c. are primary market participants.
d. a and b are true
e. a and c are true
12. Suppose the rate of return on a 10-year T-bond is 5% and the rate of return on a Treasury Inflation Protected Security (TIPS) is 2.10%. Suppose also that the MRP on a 10-year T-bond is 0.90%, but than no MRP is required on TIPS, and that neither type of T-bond has any liquidity premium. Given these data, what is the expected rate of inflation over the next 10 years?
13. Prices for capital:
a. remain stable over time.
b. change in response to shifts in supply and demand conditions
c. are always zero
d. none of the above are true
14. Suppose that the risk-free rate of interest is 3.50%, the average future inflation rate is 2.25%, a maturity risk per year to maturity applies, i.e., MRP = 0.08%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.85% applies to A-rated corporate bonds. Calculate the yields for both bonds. How much higher would return be on a 10-year A-rate corporate bond than on a 5-year treasury bond?