Business Finance exam practice questions

a. Households start saving a larger percentage of their income.
b. Corporations step up their expansion plans and thus increase their demand for capital.
c. The level of inflation begins to decline.
d. The economy moves from a boom to a recession.
e. The Federal Reserve decides to try to stimulate the economy.

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b. Corporations step up their expansion plans and thus increase their demand for capital.

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e. This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

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

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.

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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.

The Treasury yield curve is downward sloping.
Empirical data indicate that a positive maturity risk premium applies to both Treasury and corporate bonds.
Empirical data also indicate that there is no liquidity premium for Treasury securities but that a positive liquidity premium is built into corporate bond yields.
On the basis of this information, which of the following statements is most CORRECT?

a. A 10-year corporate bond must have a higher yield than a 5-year Treasury bond.
b. A 10-year Treasury bond must have a higher yield than a 10-year corporate bond.
c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.
d. The corporate yield curve must be flat.
e. Since the Treasury yield curve is downward sloping, the corporate yield curve must also be downward sloping.

Correct Answer
c. A 5-year corporate bond must have a higher yield than a 10-year Treasury bond.

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.

Correct Answer
b. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.

a. The yield on a 3-year Treasury bond cannot exceed the yield on a 2-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.

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

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.

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

a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.
b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.
c. 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.
d. If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
e. The yield curve can never be downward sloping.

Correct Answer
a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope.

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.

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d. Maturity risk premiums could help to explain the yield curve’s upward slope.

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.

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c. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease.

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.

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

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.

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

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%.

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

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.

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

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.

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

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.

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

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.

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

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.

Correct 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.

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.

Correct 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.

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.

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

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.

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