Chapter 4 C) yield to maturity.

Understanding Interest Rates D) real interest rate.

4.1 Measuring Interest Rates Answer: C
1) The concept of ________ is based on the common-sense notion that
a dollar paid to you in the 9) If a security pays $110 next year and $121 the year after that,
future is less valuable to you than a dollar today. what is its yield to maturity if it
A) present value sells for $200?
B) future value A) 9 percent
C) interest B) 10 percent
D) deflation C) 11 percent
Answer: A D) 12 percent
Answer: B
2) With an interest rate of 6 percent, the present value of $100 next
year is approximately 10) A credit market instrument that provides the borrower with an
A) $106. amount of funds that must be
B) $100. repaid at the maturity date along with an interest payment is known
C) $94. as a
D) $92. A) simple loan.
Answer: C B) fixed-payment loan.
C) coupon bond.
3) The present value of an expected future payment ________ as the D) discount bond.
interest rate increases. Answer: A
A) falls
B) rises 11) For simple loans, the simple interest rate is ________ the yield to
C) is constant maturity.
D) is unaffected A) greater than
Answer: A B) less than
C) equal to
4) If a security pays $55 in one year and $133 in three years, its D) not comparable to
present value is $150 if the interest Answer: C
rate is
A) 5 percent. 12) If the amount payable in two years is $2420 for a simple loan at
B) 10 percent. 10 percent interest, the loan
C) 12.5 percent. amount is
D) 15 percent. A) $1000.
Answer: B B) $1210.
C) $2000.
Chapter 4 Understanding Interest Rates 75 D) $2200.
5) An increase in the time to the promised future payment ________ Answer: C
the present value of the
payment. 13) For a 3-year simple loan of $10,000 at 10 percent, the amount to
A) decreases be repaid is
B) increases A) $10,030.
C) has no effect on B) $10,300.
D) is irrelevant to C) $13,000.
Answer: A D) $13,310.
Answer: D
6) To claim that a lottery winner who is to receive $1 million per
year for twenty years has won 14) If $22,050 is the amount payable in two years for a $20,000
$20 million ignores the concept of simple loan made today, the
A) face value. interest rate is
B) par value. A) 5 percent.
C) deflation. B) 10 percent.
D) discounting the future. C) 22 percent.
Answer: D D) 25 percent.
Answer: A
7) The interest rate that equates the present value of payments
received from a debt instrument 15) A credit market instrument that requires the borrower to make
with its value today is the the same payment every
A) simple interest rate. period until the maturity date is known as a
B) current yield. A) simple loan.
C) yield to maturity. B) fixed-payment loan.
D) real interest rate. C) coupon bond.
Answer: C D) discount bond.
Answer: B
8) Economists consider the ________ to be the most accurate measure
of interest rates. 16) Which of the following are true of fixed payment loans?
A) simple interest rate. A) The borrower repays both the principal and interest at the
B) current yield. maturity date.
B) Installment loans and mortgages are frequently of the fixed 24) An $8,000 coupon bond with a $400 coupon payment every
payment type. year has a coupon rate of
C) The borrower pays interest periodically and the principal at the A) 5 percent.
maturity date. B) 8 percent.
D) Commercial loans to businesses are often of this type. C) 10 percent.
Answer: B D) 40 percent.
Answer: A
17) A fully amortized loan is another name for
A) a simple loan. 25) The price of a coupon bond and the yield to maturity are ________
B) a fixed-payment loan. related; that is, as the yield
C) a commercial loan. to maturity ________, the price of the bond ________.
D) an unsecured loan. A) positively; rises; rises
Answer: B B) negatively; falls; falls
C) positively; rises; falls
18) A credit market instrument that pays the owner a fixed coupon D) negatively; rises; falls
payment every year until the Answer: D
maturity date and then repays the face value is called a
A) simple loan. 26) A $10,000 8 percent coupon bond that sells for $10,000 has a
B) fixed-payment loan. yield to maturity of
C) coupon bond. A) 8 percent.
D) discount bond. B) 10 percent.
Answer: C C) 12 percent.
D) 14 percent.
19) A ________ pays the owner a fixed coupon payment every year Answer: A
until the maturity date, when
the ________ value is repaid. 27) Which of the following $1,000 face-value securities has the
A) coupon bond; discount highest yield to maturity?
B) discount bond; discount A) A 5 percent coupon bond selling for $1,000
C) coupon bond; face B) A 10 percent coupon bond selling for $1,000
D) discount bond; face C) A 12 percent coupon bond selling for $1,000
Answer: C D) A 12 percent coupon bond selling for $1,100
Answer: C
20) The ________ is the final amount that will be paid to the holder of
a coupon bond. 28) Which of the following $1,000 face-value securities has the
A) discount value highest yield to maturity?
B) coupon value A) A 5 percent coupon bond with a price of $600
C) face value B) A 5 percent coupon bond with a price of $800
D) present value C) A 5 percent coupon bond with a price of $1,000
Answer: C D) A 5 percent coupon bond with a price of $1,200
Answer: A
21) All of the following are examples of coupon bonds except
A) Corporate bonds 29) Which of the following $1,000 face-value securities has the
B) U.S. Treasury bills lowest yield to maturity?
C) U.S. Treasury notes A) A 5 percent coupon bond selling for $1,000
D) U.S. Treasury bonds B) A 10 percent coupon bond selling for $1,000
Answer: B C) A 15 percent coupon bond selling for $1,000
D) A 15 percent coupon bond selling for $900
22) Which of the following are true for a coupon bond? Answer: A
A) When the coupon bond is priced at its face value, the yield to
maturity equals the coupon 30) Which of the following $5,000 face-value securities has the
rate. highest to maturity?
B) The price of a coupon bond and the yield to maturity are A) A 6 percent coupon bond selling for $5,000
positively related. B) A 6 percent coupon bond selling for $5,500
C) The yield to maturity is greater than the coupon rate when the C) A 10 percent coupon bond selling for $5,000
bond price is above the D) A 12 percent coupon bond selling for $4,500
par value. Answer: D
D) The yield is less than the coupon rate when the bond price is
below the par value. 31) The yield to maturity is ________ than the ________ rate when the
Answer: A bond price is ________ its
face value.
23) If a $5,000 coupon bond has a coupon rate of 13 percent, then A) greater; coupon; above
the coupon payment every year B) greater; coupon; below
is C) greater; perpetuity; above
A) $650. D) less; perpetuity; below
B) $1,300. Answer: B
C) $130.
D) $13. 32) Which of the following bonds would you prefer to be buying?
Answer: A A) A $10,000 face-value security with a 10 percent coupon selling
for $9,000
B) A $10,000 face-value security with a 7 percent coupon selling for Answer: A
$10,000
C) A $10,000 face-value security with a 9 percent coupon selling for 41) The yield to maturity for a one-year discount bond equals the
$10,000 increase in price over the year,
D) A $10,000 face-value security with a 10 percent coupon selling divided by the
for $10,000 A) initial price.
Answer: A B) face value.
C) interest rate.
33) The price of a consol equals the coupon payment D) coupon rate.
A) times the interest rate. Answer: A
B) plus the interest rate.
C) minus the interest rate. 42) Which of the following are true for discount bonds?
D) divided by the interest rate. A) A discount bond is bought at par.
Answer: D B) The purchaser receives the face value of the bond at the maturity
date.
34) The interest rate on a consol equals the C) U.S. Treasury bonds and notes are examples of discount bonds.
A) price times the coupon payment. D) The purchaser receives the par value at maturity plus any capital
B) price divided by the coupon payment. gains.
C) coupon payment plus the price. Answer: B
D) coupon payment divided by the price.
Answer: D 43) If a $10,000 face-value discount bond maturing in one year is
selling for $5,000, then its yield
35) A consol paying $20 annually when the interest rate is 5 percent to maturity is
has a price of A) 5 percent.
A) $100. B) 10 percent.
B) $200. C) 50 percent.
C) $400. D) 100 percent.
D) $800. Answer: D
Answer: C
44) If a $5,000 face-value discount bond maturing in one year is
36) If a consol has a price of $500 and an annual interest payment of selling for $5,000, then its yield to
$25, the interest rate is maturity is
A) 2.5 percent. A) 0 percent.
B) 5 percent. B) 5 percent.
C) 7.5 percent. C) 10 percent.
D) 10 percent. D) 20 percent.
Answer: B Answer: A

37) A bond that is bought at a price below its face value and the face 45) A discount bond selling for $15,000 with a face value of $20,000
value is repaid at a maturity in one year has a yield to
date is called a maturity of
A) simple loan. A) 3 percent.
B) fixed-payment loan. B) 20 percent.
C) coupon bond. C) 25 percent.
D) discount bond. D) 33.3 percent.
Answer: D Answer: D

38) A ________ is bought at a price below its face value, and the 46) In Japan in 1998, interest rates were negative for a short period
________ value is repaid at the of time because investors found
maturity date. it convenient to hold six-month bills as a store of value because
A) coupon bond; discount A) of the high inflation rate.
B) discount bond; discount B) these bills sold at a discount from face value.
C) coupon bond; face C) the bills were denominated in small amounts and could be stored
D) discount bond; face electronically.
Answer: D D) the bills were denominated in large amounts and could be stored
electronically.
39) A discount bond Answer: D
A) pays the bondholder a fixed amount every period and the face
value at maturity. 4.2 Yield on a Discount Basis
B) pays the bondholder the face value at maturity. 1) Dealers in U.S. Treasury securities always refer to prices by
C) pays all interest and the face value at maturity. quoting the
D) pays the face value at maturity plus any capital gain. A) yield to maturity.
Answer: B B) coupon rate.
C) current yield
40) Examples of discount bonds include D) yield on a discount basis.
A) U.S. Treasury bills. Answer: D
B) corporate bonds.
C) U.S. Treasury notes. 2) Which of the following are true of the yield on a discount basis as
D) municipal bonds. a measure of the interest
rate?
A) It uses the percentage gain on the purchase price of the security, 10) If the yield on Treasury bills falls from 5.27 percent to 5.22
rather than the percent, then the yield has
percentage gain on the face value of the security. A) increased by 5 basis points.
B) It puts the yield on the annual basis of a 360-day year. B) increased by 0.5 basis point.
C) It ignores the time to maturity. C) decreased by 0.5 basis point.
D) It overstates the yield to maturity. D) decreased by 5 basis points.
Answer: B Answer: D

3) A problem with the yield on discount basis is that it ________ the 11) If the yield on Treasury bills increases from 6.34 percent to 6.44
yield to maturity, and this percent, the yield has
________ increases, the ________ the maturity of the discount bond. A) increased by 0.01 basis point.
A) understates; understatement; longer B) increased by 0.1 basis point.
B) understates; understatement; shorter C) increased by 1 basis point.
C) overstates; overstatement; longer D) increased by 10 basis points.
D) overstates; overstatement; shorter Answer: D
Answer: A
4.3 The Distinction Between Interest Rates and Returns
4) Dealers in T-bills make profits by selling T-bills at a ________ price 1) The ________ is defined as the payments to the owner plus the
than they pay for them, change in a securityʹs value
thus, the ________ discount yield should be lower than the ________ expressed as a fraction of the securityʹs purchase price.
discount yield. A) yield to maturity
A) higher; bid; asked B) current yield
B) higher; asked; bid C) rate of return
C) lower; bid; asked D) yield rate
D) lower; asked; bid Answer: C
Answer: B
2) What is the return on a 5 percent coupon bond that initially sells
5) The yield on a discount basis of a 90-day, $1,000 Treasury bill for $1,000 and sells for $1,200
selling for $950 is next year?
A) 5 percent. A) 5 percent
B) 10 percent. B) 10 percent
C) 15 percent. C) -5 percent
D) 20 percent. D) 25 percent
Answer: D Answer: D

86 3) What is the return on a 5 percent coupon bond that initially sells

Chapter 4 Understanding Interest Rates 87 for $1,000 and sells for $900
6) The yield on a discount basis of a 180-day $1,000 Treasury bill next year?
selling for $900 is A) 5 percent
A) 10 percent. B) 10 percent
B) 20 percent. C) -5 percent
C) 25 percent. D) -10 percent
D) 40 percent. Answer: C
Answer: B
4) The return on a 5 percent coupon bond that initially sells for
7) The yield to maturity on a $10,000 Treasury bill selling for $1,000 and sells for $950 next year
$9,800 with 73 days to maturity is is
approximately A) -10 percent.
A) 2 percent. B) -5 percent.
B) 5 percent. C) 0 percent.
C) 10 percent. D) 5 percent.
D) 20 percent. Answer: C
Answer: C
5) Suppose you are holding a 5 percent coupon bond maturing in
8) When referring to changes in yields, a basis point equals one year with a yield to
A) 10 percent. maturity of 15 percent. If the interest rate on one-year bonds rises
B) 1 percent. from 15 percent to 20
C) 0.1 percent. percent over the course of the year, what is the yearly return on the
D) 0.01 percent. bond you are holding?
Answer: D A) 5 percent
B) 10 percent
9) To say that a yield increased by twenty basis points means the C) 15 percent
interest rate increased by D) 20 percent
A) 20 percent. Answer: C
B) 2 percent.
C) 0.2 percent. 6) If the interest rates on all bonds rise from 5 to 6 percent over the
D) 0.02 percent. course of the year, which
Answer: C bond would you prefer to have been holding?
A) A bond with one year to maturity 12) The riskiness of an assetʹs returns due to changes in interest
B) A bond with five years to maturity rates is
C) A bond with ten years to maturity A) exchange-rate risk.
D) A bond with twenty years to maturity B) price risk.
Answer: A C) asset risk.
D) interest-rate risk.
7) An equal decrease in all bond interest rates Answer: D
A) increases the price of a five-year bond more than the price of a
ten-year bond. 13) Interest-rate risk is the riskiness of an assetʹs returns due to
B) increases the price of a ten-year bond more than the price of a A) interest-rate changes.
five-year bond. B) changes in the coupon rate.
C) decreases the price of a five-year bond more than the price of a C) default of the borrower.
ten-year bond. D) changes in the assetʹs maturity.
D) decreases the price of a ten-year bond more than the price of a Answer: A
five-year bond.
Answer: B 14) Prices and returns for ________ bonds are more volatile than
those for ________ bonds,
8) An equal increase in all bond interest rates everything else held constant.
A) increases the return to all bond maturities by an equal amount. A) long-term; long-term
B) decreases the return to all bond maturities by an equal amount. B) long-term; short-term
C) has no effect on the returns to bonds. C) short-term; long-term
D) decreases long-term bond returns more than short-term bond D) short-term; short-term
returns. Answer: B
Answer: D
4.4 The Distinction Between Real and Nominal Interest Rates
9) Which of the following are true concerning the distinction 1) The ________ states that the nominal interest rate equals the real
between interest rates and returns? interest rate plus the expected
A) The rate of return on a bond will not necessarily equal the rate of inflation.
interest rate on that bond. A) Fisher equation
B) The return can be expressed as the difference between the B) Keynesian equation
current yield and the rate of C) Monetarist equation
capital gains. D) Marshall equation
C) The rate of return will be greater than the interest rate when the Answer: A
price of the bond falls
between time t and time t + 1. 2) The nominal interest rate minus the expected rate of inflation
D) The return can be expressed as the sum of the discount yield and A) defines the real interest rate.
the rate of capital gains. B) is a less accurate measure of the incentives to borrow and lend
Answer: A than is the nominal
interest rate.
10) Which of the following are generally true of bonds? C) is a less accurate indicator of the tightness of credit market
A) The only bond whose return equals the initial yield to maturity is conditions than is the nominal
one whose time to interest rate.
maturity is the same as the holding period. D) defines the discount rate.
B) A rise in interest rates is associated with a fall in bond prices, Answer: A
resulting in capital gains on
bonds whose terms to maturity are longer than the holding periods. 3) The ________ interest rate more accurately reflects the true cost of
C) The longer a bondʹs maturity, the smaller is the size of the price borrowing.
change associated with A) nominal
an interest rate change. B) real
D) Prices and returns for short-term bonds are more volatile than C) discount
those for longer-term D) market
bonds. Answer: B
Answer: A
4) If you expect the inflation rate to be 15 percent next year and a
11) Which of the following are generally true of all bonds? one -year bond has a yield to
A) The longer a bondʹs maturity, the greater is the rate of return maturity of 7 percent, then the real interest rate on this bond is
that occurs as a result of the A) 7 percent.
increase in the interest rate. B) 22 percent.
B) Even though a bond has a substantial initial interest rate, its C) -15 percent.
return can turn out to be D) -8 percent.
negative if interest rates rise. Answer: D
C) Prices and returns for short-term bonds are more volatile than
those for longer term 5) When the ________ interest rate is low, there are greater incentives
bonds. to ________ and fewer
D) A fall in interest rates results in capital losses for bonds whose incentives to ________.
terms to maturity are A) nominal; lend; borrow
longer than the holding period. B) real; lend; borrow
Answer: B C) real; borrow; lend
D) market; lend; borrow
Answer: C A) the nominal interest rate.
B) the real interest rate.
6) In which of the following situations would you prefer to be the C) the nominal exchange rate.
lender? D) the expected inflation rate.
A) The interest rate is 9 percent and the expected inflation rate is 7 Answer: D
percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 13) Assuming the same coupon rate and maturity length, when the
percent. interest rate on a Treasury
C) The interest rate is 13 percent and the expected inflation rate is Inflation Protected Security is 3 percent, and the yield on a
15 percent. nonindexed Treasury bond is 8
D) The interest rate is 25 percent and the expected inflation rate is percent, the expected rate of inflation is
50 percent. A) 3 percent.
Answer: B B) 5 percent.
C) 8 percent.
· D) 11 percent.
7) In which of the following situations would you prefer to be Answer: B
borrowing?
A) The interest rate is 9 percent and the expected inflation rate is 7 4.5 Web Appendix 1: Measuring Interest-Rate Risk: Duration
percent. 1) Duration is
B) The interest rate is 4 percent and the expected inflation rate is 1 A) an assetʹs term to maturity.
percent. B) the time until the next interest payment for a coupon bond.
C) The interest rate is 13 percent and the expected inflation rate is C) the average lifetime of a debt securityʹs stream of payments.
15 percent. D) the time between interest payments for a coupon bond.
D) The interest rate is 25 percent and the expected inflation rate is Answer: C
50 percent.
Answer: D 2) Comparing a discount bond and a coupon bond with the same
maturity,
8) If you expect the inflation rate to be 12 percent next year and a A) the coupon bond has the greater effective maturity.
one -year bond has a yield to B) the discount bond has the greater effective maturity.
maturity of 7 percent, then the real interest rate on this bond is C) the effective maturity cannot be calculated for a coupon bond.
A) -5 percent. D) the effective maturity cannot be calculated for a discount bond.
B) -2 percent. Answer: B
C) 2 percent.
D) 12 percent. 3) The duration of a coupon bond increases
Answer: A A) the longer is the bondʹs term to maturity.
B) when interest rates increase.
9) If you expect the inflation rate to be 4 percent next year and a one C) the higher the coupon rate on the bond.
year bond has a yield to D) the higher the bond price.
maturity of 7 percent, then the real interest rate on this bond is Answer: A
A) -3 percent.
B) -2 percent. 4) All else equal, the ________ the coupon rate on a bond, the ________
C) 3 percent. the bondʹs duration.
D) 7 percent. A) higher; longer
Answer: C B) higher; shorter
C) lower; shorter
10) If the nominal rate of interest is 2 percent, and the expected D) greater; longer
inflation rate is -10 percent, the Answer: B
real rate of interest is
A) 2 percent. 5) If a financial institution has 50% of its portfolio in a bond with a
B) 8 percent. five-year duration and 50% of
C) 10 percent. its portfolio in a bond with a seven-year duration, what is the
D) 12 percent. duration of the portfolio?
Answer: D A) 12 years
B) 7 years
94 C) 6 years
Chapter 4 Understanding Interest Rates 95 D) 5 years
11) The interest rate on Treasury Inflation Protected Securities is a Answer: C
direct measure of
A) the real interest rate. 6) An assetʹs interest rate risk ________ as the duration of the asset
B) the nominal interest rate. ________.
C) the rate of inflation. A) increases; decreases
D) the rate of deflation. B) decreases; decreases
Answer: A C) decreases; increases
D) remains constant; increases
12) Assuming the same coupon rate and maturity length, the Answer: B
difference between the yield on a
Treasury Inflation Protected Security and the yield on a nonindexed
Treasury security Chapter 6
provides insight into
The Risk and Term Structure of Interest Rates C) negative; raise
6.1 Risk Structure of Interest Rates D) negative; lower
1) The risk structure of interest rates is Answer: A
A) the structure of how interest rates move over time.
B) the relationship among interest rates of different bonds with the 9) If a corporation begins to suffer large losses, then the default risk
same maturity. on the corporate bond will
C) the relationship among the term to maturity of different bonds. A) increase and the bondʹs return will become more uncertain,
D) the relationship among interest rates on bonds with different meaning the expected return
maturities. on the corporate bond will fall.
Answer: B B) increase and the bondʹs return will become less uncertain,
meaning the expected return
2) The risk that interest payments will not be made, or that the face on the corporate bond will fall.
value of a bond is not repaid C) decrease and the bondʹs return will become less uncertain,
when a bond matures is meaning the expected return
A) interest rate risk. on the corporate bond will fall.
B) inflation risk. D) decrease and the bondʹs return will become less uncertain,
C) moral hazard. meaning the expected return
D) default risk. on the corporate bond will rise.
Answer: D Answer: A

3) Bonds with no default risk are called 10) If the possibility of a default increases because corporations
A) flower bonds. begin to suffer losses, then the
B) no-risk bonds. default risk on corporate bonds will ________, and the bondsʹ returns
C) default-free bonds. will become ________
D) zero-risk bonds. uncertain, meaning that the expected return on these bonds will
Answer: C decrease, everything else held
constant.
4) Which of the following bonds are considered to be default-risk A) increase; less
free? B) increase; more
A) municipal bonds C) decrease; less
B) investment-grade bonds D) decrease; more
C) U.S. Treasury bonds Answer: B
D) junk bonds
Answer: C 11) Other things being equal, an increase in the default risk of
corporate bonds shifts the demand
Chapter 6 The Risk and Term Structure of Interest Rates 135 curve for corporate bonds to the ________ and the demand curve for
5) U.S. government bonds have no default risk because Treasury bonds to the
A) they are backed by the full faith and credit of the federal ________.
government. A) right; right
B) the federal government can increase taxes to pay its obligations. B) right; left
C) they are backed with gold reserves. C) left; right
D) they can be exchanged for silver at any time. D) left; left
Answer: B Answer: C

6) The spread between the interest rates on bonds with default risk 12) An increase in the riskiness of corporate bonds will ________ the
and default-free bonds is price of corporate bonds and
called the ________ the price of Treasury bonds, everything else held constant.
A) risk premium. A) increase; increase
B) junk margin. B) reduce; reduce
C) bond margin. C) reduce; increase
D) default premium. D) increase; reduce
Answer: A Answer: C

7) If the probability of a bond default increases because 136

corporations begin to suffer large losses, Chapter 6 The Risk and Term Structure of Interest Rates 137
then the default risk on corporate bonds will ________ and the 13) An increase in the riskiness of corporate bonds will ________ the
expected return on these bonds yield on corporate bonds and
will ________, everything else held constant. ________ the yield on Treasury securities, everything else held
A) decrease; increase constant.
B) decrease; decrease A) increase; increase
C) increase; increase B) reduce; reduce
D) increase; decrease C) increase; reduce
Answer: D D) reduce; increase
Answer: C
8) A bond with default risk will always have a ________ risk premium
and an increase in its 14) An increase in default risk on corporate bonds ________ the
default risk will ________ the risk premium. demand for these bonds, but
A) positive; raise ________ the demand for default-free bonds, everything else held
B) positive; lower constant.
A) increases; lowers 21) Which of the following bonds would have the highest default
B) lowers; increases risk?
C) does not change; greatly increases A) Municipal bonds
D) moderately lowers; does not change B) Investment-grade bonds
Answer: B C) U.S. Treasury bonds
D) Junk bonds
15) As default risk increases, the expected return on corporate Answer: D
bonds ________, and the return
becomes ________ uncertain, everything else held constant. 22) Which of the following long-term bonds has the highest interest
A) increases; less rate?
B) increases; more A) Corporate Baa bonds
C) decreases; less B) U.S. Treasury bonds
D) decreases; more C) Corporate Aaa bonds
Answer: D D) Municipal bonds
Answer: A
16) As their relative riskiness ________, the expected return on
corporate bonds ________ relative 23) Which of the following short-term securities has the lowest
to the expected return on default-free bonds, everything else held interest rate?
constant. A) Bankerʹs acceptances
A) increases; increases B) U.S. Treasury bills
B) increases; decreases C) Negotiable certificates of deposit
C) decreases; decreases D) Commercial paper
D) decreases; does not change Answer: B
Answer: B
24) The bankruptcy of the Enron Corporation
17) Which of the following statements are true? A) did not affect the corporate bond market.
A) A decrease in default risk on corporate bonds lowers the demand B) increased the perceived riskiness of Treasury securities.
for these bonds, but C) reduced the Baa-Aaa spread.
increases the demand for default-free bonds. D) increased the Baa-Aaa spread.
B) The expected return on corporate bonds decreases as default risk Answer: D
increases.
C) A corporate bondʹs return becomes less uncertain as default risk ·
increases. 25) The bankruptcy of the Enron Corporation increased the spread
D) As their relative riskiness increases, the expected return on between Baa and Aaa rated
corporate bonds increases bonds. This is due to
relative to the expected return on default-free bonds. A) a reduction in risk.
Answer: B B) a reduction in maturity.
C) a flight to quality.
18) Everything else held constant, if the federal government were to D) a flight to liquidity.
guarantee today that it will Answer: C
pay creditors if a corporation goes bankrupt in the future, the
interest rate on corporate bonds 26) During a ʺflight to qualityʺ
will ________ and the interest rate on Treasury securities will ________. A) the spread between Aaa and Baa bonds increases.
A) increase; increase B) the spread between Aaa and Baa bonds decreases.
B) increase; decrease C) the spread between Aaa and Baa bonds is not affected.
C) decrease; increase D) the change in the spread between Aaa and Baa bonds cannot be
D) decrease; decrease predicted.
Answer: C Answer: A

19) Bonds with relatively high risk of default are called 27) If you have a very low tolerance for risk, which of the following
A) Brady bonds. bonds would you be least
B) junk bonds. likely to hold in your portfolio?
C) zero coupon bonds. A) a U.S. Treasury bond
D) investment grade bonds. B) a municipal bond
Answer: B C) a corporate bond with a rating of Aaa
D) a corporate bond with a rating of Baa
20) Bonds with relatively low risk of default are called ________ Answer: D
securities and have a rating of Baa
(or BBB) and above; bonds with ratings below Baa (or BBB) have a 28) The spread between interest rates on low quality corporate
higher default risk and are bonds and U.S. government bonds
called ________. A) widened significantly during the Great Depression.
A) investment grade; lower grade B) narrowed significantly during the Great Depression.
B) investment grade; junk bonds C) narrowed moderately during the Great Depression.
C) high quality; lower grade D) did not change during the Great Depression.
D) high quality; junk bonds Answer: A
Answer: B
140
138 Chapter 6 The Risk and Term Structure of Interest Rates 141
Chapter 6 The Risk and Term Structure of Interest Rates 139
29) During the Great Depression years 1930-1933 there was a very Answer: A
high rate of business failures
and defaults, we would expect the risk premium for ________ bonds to 36) The risk premium on corporate bonds reflects the fact that
be very high. corporate bonds have a higher
A) U.S. Treasury default risk and are ________ U.S. Treasury bonds.
B) corporate Aaa A) less liquid than
C) municipal B) less speculative than
D) corporate Baa C) tax-exempt unlike
Answer: D D) lower-yielding than
Answer: A
30) Risk premiums on corporate bonds tend to ________ during
business cycle expansions and 37) Everything else held constant, an increase in marginal tax rates
________ during recessions, everything else held constant. would likely have the effect of
A) increase; increase ________ the demand for municipal bonds, and ________ the demand for
B) increase; decrease U.S. government
C) decrease; increase bonds.
D) decrease; decrease A) increasing; increasing
Answer: C B) increasing; decreasing
C) decreasing; increasing
31) Which of the following statements are true? D) decreasing; decreasing
A) A liquid asset is one that can be quickly and cheaply converted Answer: B
into cash.
B) The demand for a bond declines when it becomes less liquid, 38) Which of the following statements are true?
decreasing the interest rate A) An increase in tax rates will increase the demand for Treasury
spread between it and relatively more liquid bonds. bonds, lowering their
C) The differences in bond interest rates reflect differences in interest rates.
default risk only. B) Because the tax-exempt status of municipal bonds was of little
D) The corporate bond market is the most liquid bond market. benefit to bond holders
Answer: A when tax rates were low, they had higher interest rates than U.S.
government bonds
32) Corporate bonds are not as liquid as government bonds because before World War II.
A) fewer corporate bonds for any one corporation are traded, C) Interest rates on municipal bonds will be higher than comparable
making them more costly to bonds without the tax
sell. exemption.
B) the corporate bond rating must be calculated each time they are D) Because coupon payments on municipal bonds are exempt from
traded. federal income tax, the
C) corporate bonds are not callable. expected after-tax return on them will be higher for individuals in
D) corporate bonds cannot be resold. lower income tax
Answer: A brackets.
Answer: B
33) When the Treasury bond market becomes more liquid, other
things equal, the demand curve 39) Everything else held constant, the interest rate on municipal
for corporate bonds shifts to the ________ and the demand curve for bonds rises relative to the interest
Treasury bonds shifts to rate on Treasury securities when
the ________. A) income tax rates are lowered.
A) right; right B) income tax rates are raised.
B) right; left C) municipal bonds become more widely traded.
C) left; right D) corporate bonds become riskier.
D) left; left Answer: A
Answer: C
40) Everything else held constant, if income tax rates were lowered,
34) A decrease in the liquidity of corporate bonds, other things then
being equal, shifts the demand A) the interest rate on municipal bonds would fall.
curve for corporate bonds to the ________ and the demand curve for B) the interest rate on Treasury bonds would rise.
Treasury bonds shifts to C) the interest rate on municipal bonds would rise.
the ________. D) the price of Treasury bonds would fall.
A) right; right Answer: C
B) right; left
C) left; left 41) Everything else held constant, abolishing all taxes will
D) left; right A) increase the interest rate on corporate bonds.
Answer: D B) reduce the interest rate on municipal bonds.
C) increase the interest rate on municipal bonds.
35) An increase in the liquidity of corporate bonds will ________ the D) increase the interest rate on Treasury bonds.
price of corporate bonds and Answer: C
________ the yield of Treasury bonds, everything else held constant.
A) increase; increase 42) Municipal bonds have default risk, yet their interest rates are
B) reduce; reduce lower than the rates on
C) increase; reduce default-free Treasury bonds. This suggests that
D) reduce; increase
A) the benefit from the tax-exempt status of municipal bonds is less A) gently upward sloping.
than their default risk. B) mound shaped.
B) the benefit from the tax-exempt status of municipal bonds equals C) flat.
their default risk. D) bowl shaped.
C) the benefit from the tax-exempt status of municipal bonds Answer: A
exceeds their default risk.
D) Treasury bonds are not default-free. 5) When yield curves are steeply upward sloping,
Answer: C A) long-term interest rates are above short-term interest rates.
B) short-term interest rates are above long-term interest rates.
43) Everything else held constant, if the tax-exempt status of C) short-term interest rates are about the same as long-term
municipal bonds were eliminated, interest rates.
then D) medium-term interest rates are above both short-term and long-
A) the interest rates on municipal bonds would still be less than the term interest rates.
interest rate on Treasury Answer: A
bonds.
B) the interest rate on municipal bonds would equal the rate on 6) When yield curves are downward sloping,
Treasury bonds. A) long-term interest rates are above short-term interest rates.
C) the interest rate on municipal bonds would exceed the rate on B) short-term interest rates are above long-term interest rates.
Treasury bonds. C) short-term interest rates are about the same as long-term
D) the interest rates on municipal, Treasury, and corporate bonds interest rates.
would all increase. D) medium-term interest rates are above both short-term and long-
Answer: C term interest rates.
Answer: B
44) Which of the following statements is true?
A) State and local governments cannot default on their bonds. 7) When yield curves are flat,
B) Bonds issued by state and local governments are called A) long-term interest rates are above short-term interest rates.
municipal bonds. B) short-term interest rates are above long-term interest rates.
C) All government issued bonds  local, state, and federal  are C) short-term interest rates are about the same as long-term
federal income tax exempt. interest rates.
D) The coupon payment on municipal bonds is usually higher than D) medium-term interest rates are above both short-term and long-
the coupon payment on term interest rates.
Treasury bonds. Answer: C
Answer: B
8) An inverted yield curve
45) Three factors explain the risk structure of interest rates: A) slopes up.
A) liquidity, default risk, and the income tax treatment of a security. B) is flat.
B) maturity, default risk, and the income tax treatment of a security. C) slopes down.
C) maturity, liquidity, and the income tax treatment of a security. D) has a U shape.
D) maturity, default risk, and the liquidity of a security. Answer: C
Answer: A
9) According to the expectations theory of the term structure
6.2 Term Structure of Interest Rates A) the interest rate on long-term bonds will exceed the average of
1) The term structure of interest rates is short-term interest rates
A) the relationship among interest rates of different bonds with the that people expect to occur over the life of the long-term bonds,
same maturity. because of their
B) the structure of how interest rates move over time. preference for short-term securities.
C) the relationship among the term to maturity of different bonds. B) interest rates on bonds of different maturities move together
D) the relationship among interest rates on bonds with different over time.
maturities. C) buyers of bonds prefer short-term to long-term bonds.
Answer: D D) buyers require an additional incentive to hold long-term bonds.
Answer: B
2) A plot of the interest rates on default-free government bonds
with different terms to maturity 10) According to the expectations theory of the term structure
is called A) when the yield curve is steeply upward sloping, short-term
A) a risk-structure curve. interest rates are expected to
B) a default-free curve. remain relatively stable in the future.
C) a yield curve. B) when the yield curve is downward sloping, short-term interest
D) an interest-rate curve. rates are expected to
Answer: C remain relatively stable in the future.
C) investors have strong preferences for short-term relative to long-
3) Differences in ________ explain why interest rates on Treasury term bonds, explaining
securities are not all the same. why yield curves typically slope upward.
A) risk D) yield curves should be equally likely to slope downward as slope
B) liquidity upward.
C) time to maturity Answer: D
D) tax characteristics
Answer: C 11) If the expected path of one-year interest rates over the next five
years is 4 percent, 5 percent, 7
4) Typically, yield curves are
percent, 8 percent, and 6 percent, then the expectations theory interest rates on bonds of different maturities move together over
predicts that todayʹs interest time.
rate on the five-year bond is B) the interest rate for each maturity bond is determined by supply
A) 4 percent. and demand for that
B) 5 percent. maturity bond.
C) 6 percent. C) investorsʹ strong preferences for short-term relative to long-term
D) 7 percent. bonds explains why
Answer: C yield curves typically slope downward.
D) because of the positive term premium, the yield curve will not be
12) If the expected path of 1-year interest rates over the next four observed to be
years is 5 percent, 4 percent, 2 downward-sloping.
percent, and 1 percent, then the expectations theory predicts that Answer: B
todayʹs interest rate on the
four-year bond is 18) According to the liquidity premium theory of the term structure
A) 1 percent. A) because buyers of bonds may prefer bonds of one maturity over
B) 2 percent. another, interest rates on
C) 3 percent. bonds of different maturities do not move together over time.
D) 4 percent. B) the interest rate on long-term bonds will equal an average of
Answer: C short-term interest rates
that people expect to occur over the life of the long-term bonds plus
13) If the expected path of 1-year interest rates over the next five a term premium.
years is 1 percent, 2 percent, 3 C) because of the positive term premium, the yield curve will not be
percent, 4 percent, and 5 percent, the expectations theory predicts observed to be
that the bond with the downward sloping.
highest interest rate today is the one with a maturity of D) the interest rate for each maturity bond is determined by supply
A) two years. and demand for that
B) three years. maturity bond.
C) four years. Answer: B
D) five years.
Answer: D 19) According to the liquidity premium theory of the term structure
A) bonds of different maturities are not substitutes.
14) If the expected path of 1-year interest rates over the next five B) if yield curves are downward sloping, then short-term interest
years is 2 percent, 4 percent, 1 rates are expected to fall
percent, 4 percent, and 3 percent, the expectations theory predicts by so much that, even when the positive term premium is added,
that the bond with the long-term rates fall
lowest interest rate today is the one with a maturity of below short-term rates.
A) one year. C) yield curves should never slope downward.
B) two years. D) interest rates on bonds of different maturities do not move
C) three years. together over time.
D) four years. Answer: B
Answer: A
20) The additional incentive that the purchaser of a Treasury
15) Over the next three years, the expected path of 1-year interest security requires to buy a long -term
rates is 4, 1, and 1 percent. The security rather than a short-term security is called the
expectations theory of the term structure predicts that the current A) risk premium.
interest rate on 3-year bond B) term premium.
is C) tax premium.
A) 1 percent. D) market premium.
B) 2 percent. Answer: B
C) 3 percent.
D) 4 percent. 21) If 1-year interest rates for the next three years are expected to
Answer: B be 4, 2, and 3 percent, and the
3-year term premium is 1 percent, than the 3-year bond rate will be
16) According to the segmented markets theory of the term A) 1 percent.
structure B) 2 percent.
A) the interest rate on long-term bonds will equal an average of C) 3 percent.
short-term interest rates D) 4 percent.
that people expect to occur over the life of the long-term bonds. Answer: D
B) buyers of bonds do not prefer bonds of one maturity over
another. 22) If 1-year interest rates for the next five years are expected to be
C) interest rates on bonds of different maturities do not move 4, 2, 5, 4, and 5 percent, and
together over time. the 5-year term premium is 1 percent, than the 5-year bond rate
D) buyers require an additional incentive to hold long-term bonds. will be
Answer: C A) 2 percent.
B) 3 percent.
17) According to the segmented markets theory of the term C) 4 percent.
structure D) 5 percent.
A) bonds of one maturity are close substitutes for bonds of other Answer: D
maturities, therefore,
23) If the yield curve is flat for short maturities and then slopes
downward for longer maturities, 28) According to the liquidity premium theory of the term structure,
the liquidity premium theory (assuming a mild preference for a flat yield curve indicates
shorter-term bonds) indicates that short-term interest rates are expected to
that the market is predicting. A) rise in the future.
A) a rise in short-term interest rates in the near future and a decline B) remain unchanged in the future.
further out in the C) decline moderately in the future.
future. D) decline sharply in the future.
B) constant short-term interest rates in the near future and a Answer: C
decline further out in the
future. 29) According to the liquidity premium theory of the term structure,
C) a decline in short-term interest rates in the near future and a rise a downward sloping yield
further out in the curve indicates that short-term interest rates are expected to
future. A) rise in the future.
D) a decline in short-term interest rates in the near future and an B) remain unchanged in the future.
even steeper decline C) decline moderately in the future.
further out in the future. D) decline sharply in the future.
Answer: D Answer: D

24) If the yield curve slope is flat, the liquidity premium theory 30) The preferred habitat theory of the term structure is closely
(assuming a mild preference for related to the
shorter-term bonds) indicates that the market is predicting A) expectations theory of the term structure.
A) a mild rise in short-term interest rates in the near future and a B) segmented markets theory of the term structure.
mild decline further out in C) liquidity premium theory of the term structure.
the future. D) the inverted yield curve theory of the term structure.
B) constant short-term interest rates in the near future and further Answer: C
out in the future.
C) a mild decline in short-term interest rates in the near future and 31) The expectations theory and the segmented markets theory do
a continuing mild not explain the facts very well,
decline further out in the future. but they provide the groundwork for the most widely accepted
D) constant short-term interest rates in the near future and a mild theory of the term structure of
decline further out in the interest rates,
future. A) the Keynesian theory.
Answer: C B) separable markets theory.
C) liquidity premium theory.
25) If the yield curve has a mild upward slope, the liquidity D) the asset market approach.
premium theory (assuming a mild Answer: C
preference for shorter-term bonds) indicates that the market is
predicting 32) The ________ of the term structure of interest rates states that the
A) a rise in short-term interest rates in the near future and a decline interest rate on a long -term
further out in the bond will equal the average of short-term interest rates that
future. individuals expect to occur over
B) constant short-term interest rates in the near future and further the life of the long-term bond, and investors have no preference for
out in the future. short-term bonds relative
C) a decline in short-term interest rates in the near future and a rise to long-term bonds.
further out in the A) segmented markets theory
future. B) expectations theory
D) a decline in short-term interest rates in the near future and an C) liquidity premium theory
even steeper decline D) separable markets theory
further out in the future. Answer: B
Answer: B
33) In actual practice, short-term interest rates and long-term
26) According to the liquidity premium theory of the term structure, interest rates usually move
a steeply upward sloping together; this is the major shortcoming of the
yield curve indicates that short-term interest rates are expected to A) segmented markets theory.
A) rise in the future. B) expectations theory.
B) remain unchanged in the future. C) liquidity premium theory.
C) decline moderately in the future. D) separable markets theory.
D) decline sharply in the future. Answer: A
Answer: A
34) According to this theory of the term structure, bonds of
27) According to the liquidity premium theory of the term structure, different maturities are not substitutes
a slightly upward sloping for one another.
yield curve indicates that short-term interest rates are expected to A) Segmented markets theory
A) rise in the future. B) Expectations theory
B) remain unchanged in the future. C) Liquidity premium theory
C) decline moderately in the future. D) Separable markets theory
D) decline sharply in the future. Answer: A
Answer: B
35) The ________ of the term structure states the following: the A) rise in the near-term and fall later on.
interest rate on a long-term bond B) fall sharply in the near-term and rise later on.
will equal an average of short-term interest rates expected to occur C) fall moderately in the near-term and rise later on.
over the life of the D) remain unchanged in the near-term and rise later on.
long-term bond plus a term premium that responds to supply and Answer: B
demand conditions for that
bond. 42) The U-shaped yield curve in the figure above indicates that the
A) segmented markets theory inflation rate is expected to
B) expectations theory A) remain constant in the near-term and fall later on.
C) liquidity premium theory B) fall sharply in the near-term and rise later on.
D) separable markets theory C) rise moderately in the near-term and fall later on.
Answer: C D) remain constant in the near-term and rise later on.
Answer: B
36) A particularly attractive feature of the ________ is that it tells you
what the market is 43) The inverted U-shaped yield curve in the figure above indicates
predicting about future short-term interest rates by just looking at that short-term interest rates
the slope of the yield curve. are expected to
A) segmented markets theory A) rise in the near-term and fall later on.
B) expectations theory B) fall moderately in the near-term and rise later on.
C) liquidity premium theory C) fall sharply in the near-term and rise later on.
D) separable markets theory D) remain unchanged in the near-term and fall later on.
Answer: C Answer: A

37) According to the liquidity premium theory, a yield curve that is 44) The inverted U-shaped yield curve in the figure above indicates
flat means that that the inflation rate is
A) bond purchasers expect interest rates to rise in the future. expected to
B) bond purchasers expect interest rates to stay the same. A) remain constant in the near-term and fall later on.
C) bond purchasers expect interest rates to fall in the future. B) fall moderately in the near-term and rise later on.
D) the yield curve has nothing to do with expectations of bond C) rise moderately in the near-term and fall later on.
purchasers. D) remain unchanged in the near-term and rise later on.
Answer: C Answer: C
45) An inverted yield curve predicts that short-term interest rates
38) Economistsʹ attempts to explain the term structure of interest A) are expected to rise in the future.
rates B) will rise and then fall in the future.
A) illustrate how economists modify theories to improve them C) will remain unchanged in the future.
when they are inconsistent D) will fall in the future.
with the empirical evidence. Answer: D
B) illustrate how economists continue to accept theories that fail to
explain observed 46) When short-term interest rates are expected to fall sharply in
behavior of interest rate movements. the future, the yield curve will
C) prove that the real world is a special case that tends to get short A) slope up.
shrift in theoretical B) be flat.
models. C) be inverted.
D) have proved entirely unsatisfactory to date. D) be an inverted U shape.
Answer: A Answer: C

39) The steeply upward sloping yield curve in the figure above 47) If investors expect interest rates to fall significantly in the
indicates that future, the yield curve will be
A) short-term interest rates are expected to rise in the future. inverted. This means that the yield curve has a ________ slope.
B) short-term interest rates are expected to fall moderately in the A) steep upward
future. B) slight upward
C) short-term interest rates are expected to fall sharply in the C) flat
future. D) downward
D) short-term interest rates are expected to remain unchanged in Answer: D
the future.
Answer: A Chapter 7
The Stock Market, the Theory of Rational Expectations,
40) The steeply upward sloping yield curve in the figure above and the Efficient Market Hypothesis
indicates that ________ interest 7.1 Computing the Price of Common Stock
rates are expected to ________ in the future. 1) Stockholders are residual claimants, meaning that they
A) short-term; rise A) have the first priority claim on all of a companyʹs assets.
B) short-term; fall moderately B) are liable for all of a companyʹs debts.
C) short-term; remain unchanged C) will never share in a companyʹs profits.
D) long-term; fall moderately D) receive the remaining cash flow after all other claims are paid.
Answer: A Answer: D

41) The U-shaped yield curve in the figure above indicates that 2) A stockholderʹs ownership of a companyʹs stock gives her the
short-term interest rates are right to
expected to A) vote and be the primary claimant of all cash flows.
B) vote and be the residual claimant of all cash flows. C) it is equally important with dividends in determining the stockʹs
C) manage and assume responsibility for all liabilities. price.
D) vote and assume responsibility for all liabilities. D) it is less important than dividends but still affects a stockʹs price.
Answer: B Answer: A

3) Periodic payments of net earnings to shareholders are known as 11) In the generalized dividend model, a future sales price far in the
A) capital gains. future does not affect the
B) dividends. current stock price because
C) profits. A) the present value cannot be computed.
D) interest. B) the present value is almost zero.
Answer: B C) the sales price does not affect the current price.
D) the stock may never be sold.
4) The value of any investment is found by computing the Answer: B
A) present value of all future sales.
B) present value of all future liabilities. 12) In the generalized dividend model, the current stock price is the
C) future value of all future expenses. sum of
D) present value of all future cash flows. A) the actual value of the future dividend stream.
Answer: D B) the present value of the future dividend stream.
C) the present value of the future dividend stream plus the actual
5) In the one-period valuation model, the value of a share of stock future sales price.
depends upon D) the present value of the future sales price.
A) the present value of both dividends and the expected sales price. Answer: B
B) only the present value of the future dividends.
C) the actual value of the dividends and expected sales price ·
received in one year. 13) Using the Gordon growth model, a stockʹs price will increase if
D) the future value of dividends and the actual sales price. A) the dividend growth rate increases.
Answer: A B) the growth rate of dividends falls.
C) the required rate of return rises.
6) In the one-period valuation model, the current stock price D) the expected sales price rises.
increases if Answer: A
A) the expected sales price increases.
B) the expected sales price falls. 14) In the Gordon growth model, a decrease in the required rate of
C) the required return increases. return
D) dividends are cut. A) increases the current stock price.
Answer: A B) increases the future stock price.
C) reduces the future stock price.
7) In the one-period valuation model, an increase in the required D) reduces the current stock price.
return Answer: A
A) increases the expected sales price of a stock.
B) increases the current price of a stock. 15) Using the Gordon growth formula, if D1 is $2.00, ke is 12% or
C) reduces the expected sales price of a stock. 0.12, and g is 10% or 0.10, then
D) reduces the current price of a stock. the current stock price is
Answer: D A) $20.
B) $50.
8) Using the one-period valuation model, assuming a year-end C) $100.
dividend of $0.11, an expected D) $150.
sales price of $110, and a required rate of return of 10%, the current Answer: C
price of the stock would be
A) $110.11. 16) Using the Gordon growth formula, if D1 is $1.00, ke is 10% or
B) $121.12. 0.10, and g is 5% or 0.05, then
C) $100.10. the current stock price is
D) $100.11 A) $10.
Answer: C B) $20.
C) $30.
9) Using the one-period valuation model, assuming a year-end D) $40.
dividend of $1.00, an expected Answer: B
sales price of $100, and a required rate of return of 5%, the current
price of the stock would be 162
A) $110.00. Chapter 7 The Stock Market, Theory of Rational Expectations, &
B) $101.00. Efficient Market Hypothesis 163
C) $100.00. 17) One of the assumptions of the Gordon Growth Model is that
D) $96.19. dividends will continue growing
Answer: D at ________ rate.
A) an increasing
10) In the generalized dividend model, if the expected sales price is B) a fast
in the distant future C) a constant
A) it does not affect the stock price. D) an escalating
B) it is more important than dividends in determining a stockʹs Answer: C
price.
18) In the Gordon Growth Model, the growth rate is assumed to be Answer: A
________ the required return
on equity. 8) Everything else held constant, an increase in uncertainty due to
A) greater than threat of war will
B) equal to A) increase stock prices due to a higher required return.
C) less than B) depress stock prices due to a lower required return.
D) proportional to C) increase stock prices due to a lower required return.
Answer: C D) depress stock prices due to a higher required return.
Answer: D
7.2 How the Market Sets Stock Prices
1) In asset markets, an assetʹs price is 9) Dishonest corporate accounting procedures caused stock prices
A) set equal to the highest price a seller will accept. to
B) set equal to the highest price a buyer is willing to pay. A) increase due to higher expected dividend growth and higher
C) set equal to the lowest price a seller is willing to accept. future sales price.
D) set by the buyer willing to pay the highest price. B) decrease due to lower expected dividend growth and lower
Answer: D required return.
C) decrease due to lower expected dividend growth and higher
2) New information about an asset can result in a decrease in the required return.
assetʹs price due to D) increase due to higher expected dividend growth and lower
A) an expected decrease in the level of future dividends. required return.
B) a decrease in the required rate of return. Answer: C
C) an expected increase in the dividend growth rate.
D) an expected increase in the future sales price. 7.3 The Theory of Rational Expectations
Answer: A 1) Economists have focused more attention on the formation of
expectations in recent years. This
3) Information plays an important role in asset pricing because it increase in interest can probably best be explained by the
allows the buyer to more recognition that
accurately judge ________. A) expectations influence the behavior of participants in the
A) liquidity economy and thus have a major
B) risk impact on economic activity.
C) capital B) expectations influence only a few individuals, have little impact
D) policy on the overall economy,
Answer: B but can have important effects on a few markets.
C) expectations influence many individuals, have little impact on the
4) A change in perceived risk of a stock changes overall economy, but
A) the expected dividend growth rate. can have distributional effects.
B) the expected sales price. D) models that ignore expectations have little predictive power,
C) the required rate of return. even in the short run.
D) the current dividend. Answer: A
Answer: C
2) The view that expectations change relatively slowly over time in
5) A stockʹs price will fall if there is response to new information
A) a decrease in perceived risk. is known in economics as
B) an increase in the required rate of return. A) rational expectations.
C) an increase in the future sales price. B) irrational expectations.
D) current dividends are high. C) slow-response expectations.
Answer: B D) adaptive expectations.
Answer: D
164
Chapter 7 The Stock Market, Theory of Rational Expectations, & 3) If expectations of the future inflation rate are formed solely on
Efficient Market Hypothesis 165 the basis of a weighted average
6) A monetary expansion ________ stock prices due to a decrease in of past inflation rates, then economics would say that expectation
the ________ and an increase formation is
in the ________, everything else held constant. A) irrational.
A) reduces; future sales price; expected rate of return B) rational.
B) reduces; current dividend; expected rate of return C) adaptive.
C) increases; required rate of return; future sales price D) reasonable.
D) increases; required rate of return; dividend growth rate Answer: C
Answer: D
4) The major criticism of the view that expectations are formed
7) Terrorist attacks on the United States caused adaptively is that
A) a decrease in stock prices due to lower expected growth and A) this view ignores that people use more information than just past
greater risk. data to form their
B) a decrease in stock prices due to lower expected dividend growth expectations.
and reduced B) it is easier to model adaptive expectations than it is to model
uncertainty. rational expectations.
C) an increase in stock prices due to an increased required return. C) adaptive expectations models have no predictive power.
D) an increase in stock prices due to higher expected dividend D) people are irrational and therefore never learn from past
growth. mistakes.
Answer: A 12) People have a strong incentive to form rational expectations
because
166 A) they are guaranteed of success in the stock market.
Chapter 7 The Stock Market, Theory of Rational Expectations, & B) it is costly not to do so.
Efficient Market Hypothesis 167 C) it is costly to do so.
5) If expectations are formed adaptively, then people D) everyone wants to be rational.
A) use more information than just past data on a single variable to Answer: B
form their expectations of
that variable. 168
B) often change their expectations quickly when faced with new Chapter 7 The Stock Market, Theory of Rational Expectations, &
information. Efficient Market Hypothesis 169
C) use only the information from past data on a single variable to 13) If market participants notice that a variable behaves differently
form their expectations of now than in the past, then,
that variable. according to rational expectations theory, we can expect market
D) never change their expectations once they have been made. participants to
Answer: C A) change the way they form expectations about future values of the
variable.
6) In rational expectations theory, the term ʺoptimal forecastʺ is B) begin to make systematic mistakes.
essentially synonymous with C) no longer pay close attention to movements in this variable.
A) correct forecast. D) give up trying to forecast this variable.
B) the correct guess. Answer: A
C) the actual outcome.
D) the best guess. 14) According to rational expectations,
Answer: D A) expectations of inflation are viewed as being an average of past
inflation rates.
7) If a forecast made using all available information is not perfectly B) expectations of inflation are viewed as being an average of
accurate, then it is expected future inflation
A) still a rational expectation. rates.
B) not a rational expectation. C) expectations formation indicates that changes in expectations
C) an adaptive expectation. occur slowly over time as
D) a second-best expectation. past data change.
Answer: A D) expectations will not differ from optimal forecasts using all
available information.
8) If additional information is not used when forming an optimal Answer: D
forecast because it is not
available at that time, then expectations are 15) During the past decade, the average rate of monetary growth
A) obviously formed irrationally. has been 5%, and the average
B) still considered to be formed rationally. inflation rate has been 5%. Everything else held constant, if the
C) formed adaptively. Federal Reserve announces that
D) formed equivalently. the new rate of monetary growth will be 10%, the rational
Answer: B expectation forecast of the inflation
rate will be
· A) 5%.
9) An expectation may fail to be rational if B) between 5 and 10%.
A) relevant information was not available at the time the forecast is C) less than 5%.
made. D) 10%.
B) relevant information is available but ignored at the time the E) more than 10%.
forecast is made. Answer: D
C) information changes after the forecast is made.
D) information was available to insiders only. 7.4 The Efficient Market Hypothesis: Rational Expectations in
Answer: B Financial Markets
1) The theory of rational expectations, when applied to financial
10) According to rational expectations theory, forecast errors of markets, is known as
expectations A) monetarism.
A) are more likely to be negative than positive. B) the efficient markets hypothesis.
B) are more likely to be positive than negative. C) the theory of strict liability.
C) tend to be persistently high or low. D) the theory of impossibility.
D) are unpredictable. Answer: B
Answer: D
2) Another way to state the efficient markets condition is: in an
11) Rational expectations forecast errors will on average be ________ efficient market,
and therefore ________ be A) unexploited profit opportunities will be quickly eliminated.
predicted ahead of time. B) unexploited profit opportunities will never exist.
A) positive; can C) arbitrageurs guarantee that unexploited profit opportunities
B) positive; cannot never exist.
C) negative; can D) every financial market participant must be well informed about
D) zero; cannot securities.
Answer: D Answer: A
3) According to the efficient markets hypothesis, the current price A) beat the market in the next time period.
of a financial security: B) beat the market in the next two subsequent time periods.
A) is the discounted net present value of future interest payments. C) beat the market in the next three subsequent time periods.
B) is determined by the highest successful bidder. D) do not beat the market in the next time period.
C) fully reflects all available relevant information. Answer: D
D) is a result of none of the above.
Answer: C 3) The number and availability of discount brokers has grown
rapidly since the mid-1970s. The
4) According to the efficient markets hypothesis, the best strategy efficient markets hypothesis predicts that people who use discount
for betting on an athletic brokers
tournament, such as the NCAA basketball tournaments, is to A) will likely earn lower returns than those who use full-service
A) randomly pick the winners in each round. brokers.
B) watch as many games as possible on television so you are as well B) will likely earn about the same as those who use full-service
informed as the brokers, but will net more
ʺexperts.ʺ after brokerage commissions.
C) always select the underdog to win. C) are going against evidence suggesting that full-service brokers
D) select the highest seeded team to win each round. can help outperform the
Answer: D market.
D) are likely to outperform the market by a wide margin.
5) If the optimal forecast of the return on a security exceeds the Answer: B
equilibrium return, then:
A) the market is inefficient. 4) Sometimes one observes that the price of a companyʹs stock falls
B) no unexploited profit opportunities exist. after the announcement of favorable earnings. This phenomenon is
C) the market is in equilibrium. A) clearly inconsistent with the efficient markets hypothesis.
D) the market is myopic. B) consistent with the efficient markets hypothesis if the earnings
Answer: A were not as high as
anticipated.
6) The efficient markets hypothesis suggests that if an unexploited C) consistent with the efficient markets hypothesis if the earnings
profit opportunity arises in an were not as low as
efficient market, anticipated.
A) it will tend to go unnoticed for some time. D) consistent with the efficient markets hypothesis if the favorable
B) it will be quickly eliminated. earnings were expected.
C) financial analysts are your best source of this information. Answer: B
D) prices will reflect the unexploited profit opportunity.
Answer: B 5) You read a story in the newspaper announcing the proposed
merger of Dell Computer and
7) Financial markets quickly eliminate unexploited profit Gateway. The merger is expected to greatly increase Gatewayʹs
opportunities through changes in profitability. If you decide to
A) dividend payments. invest in Gateway stock, you can expect to earn
B) tax laws. A) above average returns since you will share in the higher profits.
C) asset prices. B) above average returns since your stock price will definitely
D) monetary policy. appreciate as higher profits
Answer: C are earned.
C) below average returns since computer makers have low profit
8) The elimination of unexploited profit opportunities requires that rates.
________ market participants D) a normal return since stock prices adjust to reflect expected
be well informed. changes in profitability
A) all almost immediately.
B) a few Answer: D
C) zero
D) many 6) To say that stock prices follow a ʺrandom walkʺ is to argue that
Answer: B stock prices
A) rise, then fall, then rise again.
7.5 Evidence on the Efficient Market Hypothesis B) rise, then fall in a predictable fashion.
1) If a mutual fund outperforms the market in one period, evidence C) tend to follow trends.
suggests that this fund is D) cannot be predicted based on past trends.
A) highly likely to consistently outperform the market in Answer: D
subsequent periods due to its
superior investment strategy. 7) The efficient markets hypothesis predicts that stock prices follow
B) likely to under-perform the market in subsequent periods to a ʺrandom walk.ʺ The
average its overall returns. implication of this hypothesis for investing in stocks is
C) not likely to consistently outperform the market in subsequent A) a ʺchurning strategyʺ of buying and selling often to catch market
periods. swings.
D) not likely to outperform the market in any subsequent period. B) turning over your stock portfolio each month, selecting stocks by
Answer: C throwing darts at the
stock page.
2) Studies of mutual fund performance indicate that mutual funds C) a ʺbuy and hold strategyʺ of holding stocks to avoid brokerage
that outperformed the market commissions.
in one time period usually D) following the advice of technical analysts.
Answer: C A) the random walk.
B) the small-firm effect.
8) Rules used to predict movements in stock prices based on past C) the January effect.
patterns are, according to the D) excessive volatility.
efficient markets hypothesis, Answer: D
A) a waste of time.
B) profitably employed by all financial analysts. 15) Excessive volatility refers to the fact that
C) the most efficient rules to employ. A) stock returns display mean reversion.
D) consistent with the random walk hypothesis. B) stock prices can be slow to react to new information.
Answer: A C) stock price tend to rise in the month of January.
D) stock prices fluctuate more than is justified by dividend
9) Tests used to rate the performance of rules developed in fluctuations.
technical analysis conclude that Answer: D
technical analysis
A) outperforms the overall market. 16) Mean reversion refers to the fact that
B) far outperforms the overall market, suggesting that stockbrokers A) small firms have higher than average returns.
provide valuable B) stocks that have had low returns in the past are more likely to do
services. well in the future.
C) does not outperform the overall market. C) stock returns are high during the month of January.
D) does not outperform the overall market, suggesting that D) stock prices fluctuate more than is justified by fundamentals.
stockbrokers do not provide Answer: B
services of any value.
Answer: C 17) Evidence in support of the efficient markets hypothesis includes
A) the failure of technical analysis to outperform the market.
10) Which of the following accurately summarize the empirical B) the small-firm effect.
evidence about technical analysis? C) the January effect.
A) Technical analysts fare no better than other financial analysison D) excessive volatility.
average they do not Answer: A
outperform the market.
B) Technical analysts tend to outperform other financial analysis, 18) Evidence against market efficiency includes
but on average they A) failure of technical analysis to outperform the market.
nevertheless under-perform the market. B) the random walk behavior of stock prices.
C) Technical analysts fare no better than other financial analysis, C) the inability of mutual fund managers to consistently beat the
and like other financial market.
analysts they outperform the market. D) the January effect.
D) Technical analysts fare no better than other financial analysis, Answer: D
and like other financial
analysts they under-perform the market. 19) The efficient markets hypothesis suggests that allocating your
Answer: A funds in the financial markets
on the advice of a financial analyst
11) The small-firm effect refers to the A) will certainly mean higher returns than if you had made
A) negative returns earned by small firms. selections by throwing darts at
B) returns equal to large firms earned by small firms. the financial page.
C) abnormally high returns earned by small firms. B) will always mean lower returns than if you had made selections
D) low returns after adjusting for risk earned by small firms. by throwing darts at the
Answer: C financial page.
C) is not likely to prove superior to a strategy of making selections
12) The January effect refers to the fact that by throwing darts at the
A) most stock market crashes have occurred in January. financial page.
B) stock prices tend to fall in January. D) is good for the economy.
C) stock prices have historically experienced abnormal price Answer: C
increases in January.
D) the football team winning the Super Bowl accurately predicts the 176
behavior of the stock Chapter 7 The Stock Market, Theory of Rational Expectations, &
market for the next year. Efficient Market Hypothesis 177
Answer: C 20) According to the efficient markets hypothesis, purchasing the
reports of financial analysts
13) When a corporation announces a major decline in earnings, the A) is likely to increase oneʹs returns by an average of 10%.
stock price may initially B) is likely to increase oneʹs returns by about 3 to 5%.
decline significantly and then rise back to normal levels over the C) is not likely to be an effective strategy for increasing financial
next few weeks. This impact returns.
is called ________. D) is likely to increase oneʹs returns by an average of about 2 to 3%.
A) the January effect Answer: C
B) mean reversion
C) market overreaction 21) Which of the following types of information most likely allows
D) the small-firm effect the exploitation of a profit
Answer: C opportunity?
A) Financial analystsʹ published recommendations
14) A phenomenon closely related to market overreaction is B) Technical analysis
C) Hot tips from a stockbroker B) the responses are not always reliable.
D) Insider information C) it leads to market churning.
Answer: D D) it requires the use of a technical analyst.
Answer: B
22) The advantage of a ʺbuy-and-hold strategyʺ is that
A) net profits will tend to be higher because there will be fewer 2) Survey evidence may be a poor guide to market behavior because
brokerage commissions. A) a marketʹs behavior may not be equally influenced by the
B) losses will eventually be eliminated. expectations of all the survey
C) the longer a stock is held, the higher will be its price. participants.
D) profits are guaranteed. B) survey questions are ambiguous.
Answer: A C) the survey takers record Answers however they want to.
D) the survey has too many participants.
23) For small investors, the best way to pursue a ʺbuy and holdʺ Answer: A
strategy is to
A) buy and sell individual stocks frequently. 3) Survey evidence does conclusively show that
B) buy no-load mutual funds with high management fees. A) people are always truthful when filling out a survey.
C) buy no-load mutual funds with low management fees. B) every participant in a market must react for the market price to
D) buy load mutual funds. change.
Answer: C C) if the way a variable moves changes, the way expectations of this
variable are formed
24) The efficient markets hypothesis indicates that investors will change also.
A) can use the advice of technical analysts to outperform the D) surveys are always reliable.
market. Answer: C
B) do better on average if they adopt a ʺbuy and holdʺ strategy.
C) let too many unexploited profit opportunities go by if they adopt 7.7 Behavioral Finance
a ʺbuy and holdʺ 1) ________ occurs when people are more unhappy when they suffer
strategy. losses than they are happy
D) do better if they purchase loaded mutual funds. when they achieve gains.
Answer: B A) Loss fundamentals
B) Loss aversion
25) The efficient markets hypothesis suggests that investors C) Loss leader
A) should purchase no-load mutual funds which have low D) Loss cycle
management fees. Answer: B
B) can use the advice of technical analysts to outperform the
market. 2) Psychologists have found that people tend to be ________ in their
C) let too many unexploited profit opportunities go by if they adopt own judgments.
a ʺbuy and holdʺ A) underconfident
strategy. B) overconfident
D) act on all ʺhot tipsʺ they hear. C) indecisive
Answer: A D) insecure
Answer: B
26) The tech stock crash of 2000 is evidence in support of
A) the efficient markets hypothesis. 3) ________ and ________ may provide an explanation for stock market
B) a rational bubble. bubbles.
C) rational expectations. A) Overconfidence; social contagion
D) the small-firm effect. B) Underconfidence; social contagion
Answer: B C) Overconfidence; social isolationism
D) Underconfidence; social isolationism
27) A situation when an asset price differs from its fundamental Answer: A
value is
A) a random walk.
B) an inflation.
C) a deflation.
D) a bubble.
Answer: D

28) In a rational bubble, investors can have ________ expectations.

A) irrational
B) adaptive
C) rational
D) myopic
Answer: C

7.6 Evidence on Rational Expectations in Other Markets

1) Tests of rational expectations in markets other than financial
markets required the use of
survey data from market participants. One problem with using
survey data is
A) it is not readily available.