Chapter 6 Quiz –
Variant B
Introduction to Business Finance
1. Suppose the real risk-free rate is 3.50% and the future rate of
inflation is expected to be constant at 2.20%. What rate of
return would you expect on a 1-year Treasury security,
assuming the pure expectations theory is valid? Disregard
cross-product terms, i.e., if averaging is required, use the
arithmetic average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%
e. 6.28%
2. Which of the following statements is CORRECT?
a. The yield on a 2-year corporate bond should always exceed the
yield on a 2-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 3-year Treasury 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 real risk-free rate should increase if people expect inflation
to increase.
3. Assume that inflation is expected to decline steadily in the
future, but that the real risk-free rate, r*, will remain constant.
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.
b. If the pure expectations theory holds, the corporate yield curve
must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield
curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk
premium.
4. Which of the following statements is CORRECT?
a. The higher the maturity risk premium, the higher the probability
that the yield curve will be inverted.
b. The most likely explanation for an inverted yield curve is that
investors expect inflation to increase.
c. The most likely explanation for an inverted yield curve is that
investors expect inflation to decrease.
d. If the yield curve is inverted, short-term bonds have lower yields
than long-term bonds.
e. Inverted yield curves can exist for Treasury bonds, but because
of default premiums, the corporate yield curve can never be
inverted.
5. Suppose the U.S. Treasury issued $50 billion of short-term
securities and sold them to the public. Other things held
constant, what would be the most likely effect on short-term
securities' prices and interest rates?
a. Prices and interest rates would both rise.
b. Prices would rise and interest rates would decline.
c. Prices and interest rates would both decline.
d. Prices would decline and interest rates would rise.
e. There is no reason to expect a change in either prices or interest
rates.
6. The four most fundamental factors that affect the cost of
money are (1) production opportunities, (2) time preferences
for consumption, (3) risk, and (4) the skill level of the
economy's labor force.
a. True
b. False
7. Which of the following statements is CORRECT?
a. If the maturity risk premium (MRP) is greater than zero, the
Treasury bond yield curve must be upward sloping.
b. If the maturity risk premium (MRP) equals zero, the Treasury
bond yield curve must be flat.
c. If inflation is expected to increase in the future and the maturity
risk premium (MRP) is greater than zero, the Treasury bond yield
curve must be upward sloping.
d. If the expectations theory holds, the Treasury bond yield curve
will never be downward sloping.
e. Because long-term bonds are riskier than short-term bonds,
yields on long-term Treasury bonds will always be higher than
yields on short-term T-bonds.
8. Assume that the current corporate bond yield curve is upward
sloping. Under this condition, then we could be sure that
a. Inflation is expected to decline in the future.
b. The economy is not in a recession.
c. Long-term bonds are a better buy than short-term bonds.
d. Maturity risk premiums could help to explain the yield curve's
upward slope.
e. Long-term interest rates are more volatile than short-term rates.
9. Suppose 1-year T-bills currently yield 7.00% and the future
inflation rate is expected to be constant at 3.20% 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.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%
10. 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:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
11. 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?
a. The yield on a 10-year bond would be less than that on a 1-year
bill.
b. 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.
c. It is impossible to tell without knowing the coupon rates of the
bonds.
d. The yields on the two securities would be equal.
e. It is impossible to tell without knowing the relative risks of the
two securities.
12. During periods when inflation is increasing, interest rates
tend to increase, while interest rates tend to fall when inflation
is declining.
a. True
b. False
13. Suppose the real risk-free rate is 4.20%, the average expected
future inflation rate is 3.10%, 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, hence the pure
expectations theory is NOT valid. What rate of return would
you expect on a 4-year Treasury security? Disregard cross-
product terms, i.e., if averaging is required, use the arithmetic
average.
a. 6.60%
b. 6.95%
c. 7.32%
d. 7.70%
e. 8.09%
14. Which of the following statements is CORRECT, other things
held constant?
a. If companies have fewer good investment opportunities, interest
rates are likely to increase.
b. If individuals increase their savings rate, interest rates are likely
to increase.
c. If expected inflation increases, interest rates are likely to
increase.
d. Interest rates on all debt securities tend to rise during recessions
because recessions increase the possibility of bankruptcy, hence the
riskiness of all debt securities.
e. Interest rates on long-term bonds are more volatile than rates on
short-term debt securities like T-bills.
15. 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?
a. The yield on a 2-year T-bond must exceed that on a 5-year T-
bond.
b. The yield on a 5-year Treasury bond must exceed that on a 2-
year Treasury bond.
c. The yield on a 7-year Treasury bond must exceed that of a 5-
year corporate bond.
d. The conditions in the problem cannot all be true—they are
internally inconsistent.
e. The Treasury yield curve under the stated conditions would be
humped rather than have a consistent positive or negative slope.
16. If investors expect the rate of inflation to increase sharply in
the future, then we should not be surprised to see an upward-
sloping yield curve.
a. True
b. False
17. Which of the following factors would be most likely to lead to
an increase in nominal interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the Internet has just been introduced, and
it increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
e. The Federal Reserve decides to try to stimulate the economy.
18. 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?
a. The yield curve for U.S. Treasury securities will be upward
sloping.
b. A 5-year corporate bond must have a lower yield than a 5-year
Treasury security.
c. A 5-year corporate bond must have a lower yield than a 7-year
Treasury security.
d. The real risk-free rate cannot be constant if inflation is not
expected to remain constant.
e. This problem assumed a zero maturity risk premium, but that is
probably not valid in the real world.
19. Suppose 10-year T-bonds have a yield of 5.30% and 10-year
corporate bonds yield 6.75%. 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?
a. 1.08%
b. 1.20%
c. 1.32%
d. 1.45%
e. 1.60%
20. Because the maturity risk premium is normally positive, the
yield curve is normally upward sloping.
a. True
b. False
21. If the Treasury yield curve were downward sloping, the yield
to maturity on a 10-year Treasury coupon bond would be
higher than that on a 1-year T-bill.
a. True
b. False
22. Which of the following statements is CORRECT?
a. Downward-sloping yield curves are inconsistent with the
expectations theory.
b. The actual shape of the yield curve depends only on expectations
about future inflation.
c. If the pure expectations theory is correct, a downward-sloping
yield curve indicates that interest rates are expected to decline in
the future.
d. If the yield curve is upward sloping, the maturity risk premium
must be positive and the inflation rate must be zero.
e. Yield curves must be either upward or downward sloping—they
cannot first rise and then decline.
23. Assume that inflation is expected to decline steadily in the
future, but that the real risk-free rate, r*, will remain constant.
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.
b. If the pure expectations theory holds, the corporate yield curve
must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield
curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk
premium.
e. The expectations theory cannot hold if inflation is decreasing.
24. Which of the following statements is CORRECT?
a. The yield on a 3-year Treasury bond cannot exceed the yield on
a 10-year Treasury bond.
b. The yield on a 2-year corporate bond should always exceed the
yield on a 2-year Treasury bond.
c. The yield on a 3-year corporate bond should always exceed the
yield on a 2-year corporate bond.
d. The yield on a 10-year AAA-rated corporate bond should always
exceed the yield on a 5-year AAA-rated corporate bond.
e. 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.