choicequestion 2flag questionquestion textniendorf corporation B u s i n e s s F i n a n c e

I’m working on a business test / quiz prep and need an explanation and answer to help me learn.

Which of the following statements is CORRECT?

Select one:

a. The real risk-free rate should increase if people expect inflation to increase.

b. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.

c. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

d. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.

e. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

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Question 2

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Niendorf Corporation’s 5-year bonds yield 7.75%, and 5-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for 5-year bonds is IP = 1.65%, the default risk premium for Niendorf’s bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf’s bonds?

Select one:

a. 1.42%

b. 2.17%

c. 1.56%

d. 2.10%

e. 1.75%

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Question 3

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Which of the following statements is CORRECT?

Select one:

a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond.

b. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond.

c. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond.

d. The following represents a “possibly reasonable” formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

e. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond.

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Question 4

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Multiple Choice: Problems

Interest rates are important in finance, and it is important for all students to understand the basics of how they are determined. However, the chapter really has two aspects that become clear when we try to write test questions and problems for the chapter. First, the material on the fundamental determinants of interest rates – the real risk-free rate plus a set of premiums – is logical and intuitive, and easy in a testing sense. However, the second set of material, that dealing with the yield curve and the relationship between 1-year rates and longer-term rates, is more mathematical and less intuitive, and test questions dealing with it tend to be more difficult, especially for students who are not good at math.

As a result, problems on the chapter tend to be either relatively easy or relatively difficult, with the difficult ones being as much exercises in algebra as in finance. In the test bank for prior editions, we tended to use primarily difficult problems that addressed the problem of forecasting forward rates based on yield curve data. In this edition, we leaned more toward easy problems that address intuitive aspects of interest rate theory.

We should note one issue that can be confusing if it is not handled carefully – the use of arithmetic versus geometric averages when bringing inflation into interest rate determination in yield curve related problems. It is easy to explain why a 2-year rate is an average of two 1-year rates, and it is logical to use a compounding process that is essentially a geometric average that includes the effects of cross-product terms. It is also easy to explain that average inflation rates should be calculated as geometric averages. However, when we combine inflation with interest rates, rather than using the formulation rRF = [(1 + r*)(1 + IP)] – 1, almost everyone, from Federal Reserve officials down to textbook authors, uses the approximation rRF = r* + IP. Understandably, this can confuse students when they start working problems. In both the text and test bank problems we make it clear to students which procedure to use.

Quite a few of the problems are based on this basic equation: r = r* + IP + MRP + DRP + LP. We tell our students to keep this equation in mind, and that they will have to do some transposing of terms to solve some of the problems.

The other key equation used in the problems is the one for finding the 1-year forward rate, given the current 1-year and 2-year rates: (1 + 2-year rate)2 = (1 + 1-year rate)(1 + X), which converts to X = (1 + 2yr)2/(1 + 1yr) – 1, where X is the 1-year forward rate. This equation, which is used in a number of problems, assumes that the pure expectations theory is correct and thus the maturity risk premium is zero.

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 6.00% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

Select one:

a. 1.15%

b. 0.82%

c. 1.00%

d. 0.97%

e. 0.85%

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Question 5

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Keys Corporation’s 5-year bonds yield 5.10% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the liquidity premium for Keys’ bonds is LP = 0.5% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Keys’ bonds?

Select one:

a. 0.17%

b. 0.20%

c. 0.22%

d. 0.19%

e. 0.24%

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Question 6

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Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.65%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds?

Select one:

a. 1.34%

b. 1.10%

c. 1.22%

d. 0.86%

e. 1.20%

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Question 7

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Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 5.90%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

Select one:

a. 9.00%

b. 7.29%

c. 8.91%

d. 10.35%

e. 9.27%

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Question 8

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Kern Corporation’s 5-year bonds yield 7.50% and 5-year T-bonds yield 4.30%. The real risk-free rate is r* = 2.5%, the default risk premium for Kern’s bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern’s bonds is LP = 1.3%, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds?

Select one:

a. 1.64%

b. 1.19%

c. 1.06%

d. 1.32%

e. 1.40%

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Question 9

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If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

Select one:

a. The yields on the two securities would be equal.

b. The yield on a 10-year bond would be less than that on a 1-year bill.

c. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium.

d. It is impossible to tell without knowing the coupon rates of the bonds.

e. It is impossible to tell without knowing the relative risks of the two securities.

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Question 10

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The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?

Select one:

a. The yield on a 2-year T-bond must exceed that on a 5-year T-bond.

b. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

c. The conditions in the problem cannot all be true–they are internally inconsistent.

d. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.

e. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.