Chapter 6 Sample Problems

i
. Which of the following statements is CORRECT?
a. Downward sloping yield curves are inconsistent with the expectations theory.
b. The 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 inflation rate must be expected to
increase.
e. Yield curves must be either upward or downward slopingthey cannot first rise
and then decline.
ii
. Which of the following statements is CORRECT?

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.

iii
. Which of the following is CORRECT?

a. Even if the pure expectations theory is correct, there might at times be an

inverted Treasury yield curve.
b. If the yield curve is inverted, short-term bonds have lower yields than long-term
bonds.
c. The higher the maturity risk premium, the higher the probability that the yield
curve will be inverted.
d. Inverted yield curves can exist for Treasury bonds, but because of default
premiums, the corporate yield curve cannot become inverted.
e. The most likely explanation for an inverted yield curve is that investors expect
inflation to increase in the future.
iv
. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%,
and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%
(t), where t is the years to maturity. What rate of return would you expect on a 5-
year Treasury security, assuming the pure expectations theory is NOT valid?
a. 5.95%
b. 6.05%
c. 6.15%
d. 6.25%
e. 6.35%
v
. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%,
a maturity premium of 0.08% per year to maturity applies, i.e., MRP = 0.08%(t),
where t is the years to maturity. Suppose also that a liquidity premium of 0.5% and
a default risk premium of 0.85% applies to A-rated corporate bonds. How much
higher would the rate of return be on a 10-year A-rated corporate bond than on a
5-year Treasury bond. Here we assume that the pure expectations theory is NOT
valid.
a. 1.75%
b. 1.80%
c. 1.85%
d. 1.90%
e. 1.95%
vi
. Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bill is
6.0%. Assuming the pure expectations theory is correct, what is the market's
forecast for 1-year rates 1 year from now?
a. 6.65%
b. 6.74%
c. 6.83%
d. 6.92%
e. 7.01%
vii
. Keys Corporation's 5-year bonds yield 6.50%, and 5-year T-bonds yield 4.40%.
The real risk-free rate is r* = 2.5%, the inflation premium for 5 years bonds is IP =
1.50%, the default risk premium for Keys' bonds is DRP = 0.50% 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 Keys' bonds?
a. 1.30%
b. 1.40%
c. 1.50%
d. 1.60%
e. 1.70%
viii
. One-year Treasury securities yield 5%, 2-year Treasury securities yield 5.5%, and
3-year Treasury securities yield 6%. Assume that the expectations theory holds.
What does the market expect will be the yield on 1-year Treasury securities two
years from now?
a. 6.01%
b. 6.51%
c. 7.01%
d. 7.51%
e. 8.01%
ix
. Three-year Treasury securities currently yield 6%, while 4-year Treasury securities
currently yield 6.5%. Assume that the expectations theory holds. What does the
market believe the rate will be on 1-year Treasury securities three years from now?
a. 8.01%
b. 8.51%
c. 9.01%
d. 9.51%
e. 10.01%
x
. Currently, 3-year Treasury securities yield 5.4%, 7-year Treasury securities yield
5.8%, and 10-year Treasury securities yield 6.2%. If the expectations theory is
correct, what does the market expect will be the yield on 3-year Treasury securities
seven years from today?
a. 6.54%
b. 7.14%
c. 5.80%
d. 4.58%
e. 5.68%
i. Yield curve Answer: c EASY

ii. Interest rates Answer: c EASY

iii. Yield curve Answer: a MEDIUM

iv. Inflation and interest rates; MRP exists Answer: d EASY

Real rate, r* 3.50%

Inflation 2.25%
MRP Years: 5 Per year: 0.10% 0.50%
Difference = Yield on t-year T-bond 6.25%

v. Corporate vs. Treasury bond yields Answer: a EASY/MEDIUM

r* 3.50%
IP 2.25%
MRP, 5-year T-bond Per year: 0.08% Years: 5 0.40%
MRP, 10-year corporate Per year: 0.08% Years: 10 0.80%
LP 0.50%
DRP 0.85%
T-bond yield 6.15%
A bond yield 7.90%
Difference 1.75%

vi. Estimating the 1-year forward rate Answer: e MEDIUM

1-year rate today 5.0%

2-year rate today 6.0%
Ending return if buy the 2-year bond = needed return on series of 1-year bonds 1.1236
Rate of return, or yield, on a 1-year bond 1 year from now: X in (1.05)(1+X) = 1.1236
X = 1.1236/1.05 - 1 = 7.01%

vii. Liquidity Premium (LP) Answer: d MEDIUM

Maturity 5
rKeys' Yield 6.50%
rT-bond Yield 4.40%
r* Included in both bonds 2.50%
IP Included in both bonds 1.50%
DRP Included in Keys only 0.50%
MRP Included in both bonds (t-1)*0.1% 0.40%
LP 1.60%

viii . Expectations theory

Answer: c

r2 = 2 year rate today

r3 = 3 year rate today
2r1 = 1 year rate, two years from now

(1 + r3)3 = (1 + r2)2(1 + 2r1)

(1.06)3 = (1.055)2(1 + 2r1)
 2r1 = 7.01%
ix. Expected interest rates Answer: a

r3 = 3 year rate today

3r1 = 1 year rate, three years from now
r4 = 4 year rate today

(1 + r4)4 = (1 + r3)3(1 + 3r1)

(1.065)4 = (1.06)3(1 + 3r1)
3r1 = 8.01%

x. Expectations theory Answer: b

r7 = 7 year rate today

7r3 = 3 year rate, seven years from now
r10 = 10 year rate today

(1 + r10)10 = (1 + r7)7(1 + 7r3)3

(1.062)10 = (1.058)7(1 + 7r3)3
7r3 = 7.14%