Question: Assume that the current corporate bond yield curve is upward sloping, or normal. Under this condition, we could be sure that

Answer Options:
a. Long-term interest rates are more volatile than short-term rates.
b. Inflation is expected to decline in the future.
c. The economy is not in a recession.
d. Long-term bonds are a better buy than short-term bonds.
e. Maturity risk premiums could help to explain the yield curve’s upward slope.

Answer: e. Maturity risk premiums could help to explain the yield curve’s upward slope.

Question: Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT?

Answer Options:
a. In equilibrium, long-term rates must be equal to short-term rates.
b. An upward-sloping yield curve implies that future short-term rates are expected to decline.
c. The maturity risk premium is assumed to be zero.

Answer: b. An upward-sloping yield curve implies that future short-term rates are expected to decline.

Question: Which of the following statements is CORRECT?

Answer Options:
a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%.
b. The interest rate today on a 2-year bond should be approximately 6%.
c. The interest rate today on a 2-year bond should be approximately 7%.
d. The interest rate today on a 3-year bond should be approximately 7%.
e. The interest rate today on a 3-year bond should be approximately 8%.

Answer: a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%.

Question: The real risk-free rate of interest is expected to remain constant at 3% for the foreseeable future. However, inflation is expected to increase steadily over the next 30 years, so the Treasury yield curve has an upward slope. Assume that the pure expectations theory holds. You are also considering two corporate bonds, one with a 5-year maturity and one with a 10-year maturity. Both have the same default and liquidity risks. Given these assumptions, which of these statements is CORRECT?

Answer Options:
a. Since the pure expectations theory holds, the 10-year corporate bond must have the same yield as the 5-year corporate bond.
b. Since the pure expectations theory holds, all 5-year Treasury bonds must have higher yields than all 10-year Treasury bonds.
c. Since the pure expectations theory holds, all 10-year corporate bonds must have the same yield as 10-year Treasury bonds.
d. The 10-year Treasury bond must have a higher yield than the 5-year corporate bond.
e. The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Answer: e. The 10-year corporate bond must have a higher yield than the 5-year corporate bond.

Question: If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT?

Answer Options:
a. An upward-sloping yield curve would imply that interest rates are expected to be lower in the future.
b. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now.
c. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond.
d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.
e. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

Answer: d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds.

Question: Assuming the pure expectations theory is correct, which of the following statements is CORRECT?

Answer Options:
a. If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise.
b. If both 2-year and 3-year Treasury rates are 7%, then 5-year rates must also be 7%.
c. If 1-year rates are 6% and 2-year rates are 7%, then the market expects 1-year rates to be 6.5% in one year.
d. Reinvestment rate risk is higher on long-term bonds, and interest rate (price) risk is higher on short-term bonds.
e. Interest rate (price) risk and reinvestment rate risk are relevant to investors in corporate bonds, but these concepts do not apply to Treasury bonds.

Answer: a. If 2-year Treasury bond rates exceed 1-year rates, then the market must expect interest rates to rise.

Question: If the pure expectations theory holds, which of the following statements is CORRECT?

Answer Options:
a. The yield on a 3-year Treasury bond should always exceed the yield on a 2-year Treasury bond.
b. The yield on a 2-year corporate bond must 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. If inflation is expected to increase, then the yield on a 2-year bond should exceed that on a 3-year bond.

Answer: b. The yield on a 2-year corporate bond must always exceed the yield on a 2-year Treasury bond.

Question: Which of the following statements is CORRECT?

Answer Options:
a. The yield curve for both Treasury and corporate bonds should be flat.
b. The yield curve for Treasury securities would be flat, but the yield curve for corporate securities might be downward sloping.
c. The yield curve for Treasury securities cannot be downward sloping.
d. The maturity risk premium would be zero.
e. If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end up with more money if he or she bought 2-year bonds.

Answer: e. If 2-year bonds yield more than 1-year bonds, an investor with a 2-year time horizon would almost certainly end up with more money if he or she bought 2-year bonds.

Question: Which of the following statements is CORRECT?

Answer Options:
a. The maturity premiums embedded in the interest rates on U.S. Treasury securities are due primarily to the fact that the probability of default is higher on long-term bonds than on short-term bonds.
b. Reinvestment rate risk is lower, other things held constant, on long-term than on short-term bonds.
c. The pure expectations theory of the term structure states that borrowers generally prefer to borrow on a long-term basis while savers generally prefer to lend on a short-term basis, and as a result, the yield curve is normally upward sloping.
d. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.
e. Liquidity premiums are generally higher on Treasury than on corporate bonds.

Answer: d. If the maturity risk premium were zero and interest rates were expected to decrease in the future, then the yield curve for U.S. Treasury securities would, other things held constant, have an upward slope.

Question: If the pure expectations theory is correct (that is, the maturity risk premium is zero), which of the following is CORRECT?

Answer Options:
a. An upward-sloping Treasury yield curve means that the market expects interest rates to decline in the future.
b. A 5-year T-bond would always yield less than a 10-year T-bond.
c. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.
d. The yield curve for stocks must be above that for bonds, but both yield curves must have the same slope.
e. If the maturity risk premium is zero for Treasury bonds, then it must be negative for corporate bonds.

Answer: c. The yield curve for corporate bonds may be upward sloping even if the Treasury yield curve is flat.

Question: Which of the following statements is CORRECT?

Answer Options:
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.

Answer: a. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve.

Question: Inflation is expected to increase steadily over the next 10 years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?

Answer Options:
a. The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.
b. The yield on any corporate bond must exceed the yields on all Treasury bonds.
c. The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
d. The stated conditions 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.

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

Question: Which of the following statements is CORRECT?

Answer Options:
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.

Answer: c. If the pure expectations theory is correct, a downward-sloping yield curve indicates that interest rates are expected to decline in the future.

Question: Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT?

Answer Options:
a. If the yield curve for Treasury securities is flat, Short’s bond must under all conditions have the same yield as Long’s bonds.
b. If the yield curve for Treasury securities is upward sloping, Long’s bonds must under all conditions have a higher yield than Short’s bonds.
c. If Long’s and Short’s bonds have the same default risk, their yields must under all conditions be equal.
d. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short’s bonds must under all conditions have a lower yield than Long’s bonds.
e. If the Treasury yield curve is downward sloping, Long’s bonds must under all conditions have the lower yield.

Answer: d. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short’s bonds must under all conditions have a lower yield than Long’s bonds.

Question: 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.

Answer Options:
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%

Answer: b. 3.99%

Question: If a firm raises capital by selling new bonds, it could be called the “issuing firm,” and the coupon rate is generally set equal to the required rate on bonds of equal risk.

Answer Options:
a. True
b. False

Answer: b. False