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Chapter 15 The Term Structure of Interest
Rates
Multiple Choice Questions
1.
The term structure of interest rates
is:
A)
The relationship between the rates of
interest on all securities.
B)
The
relationship between the interest rate on a
security and its time to maturity.
C)
The
relationship between the yield on a bond and its
default rate.
D)
All of the above.
E)
None of the above.
Answer: B Difficulty:
Easy
Rationale: The term structure of
interest rates is the relationship between two
variables,
years and yield to maturity
(holding all else constant).
2.
The yield curve shows at any point in
time:
A)
The relationship between the yield on a
bond and the duration of the bond.
B)
The
relationship between the coupon rate on a bond and
time to maturity of the
bond.
C)
The relationship between yield on a
bond and the time to maturity on the bond.
D)
All of the above.
E)
None of the
above.
Answer:
C Difficulty: Easy
3.
An inverted
yield curve implies that:
A)
Long-term interest rates
are lower than short-term interest rates.
B)
Long-term interest rates are higher
than short-term interest rates.
C)
Long-term
interest rates are the same as short-term interest
rates.
D)
Intermediate term interest rates are
higher than either short- or long-term interest
rates.
E)
none of the above.
Answer: A
Difficulty: Easy
Rationale: The inverted, or
downward sloping, yield curve is one in which
short-term
rates are higher than long-
term rates. The inverted yield curve has been
observed
frequently, although not as
frequently as the upward sloping, or normal, yield
curve.
335
Chapter 15 The Term Structure of
Interest Rates
4.
An upward sloping yield curve is a(n)
_______ yield curve.
A)
normal.
B)
humped.
C)
inverted.
D)
flat.
E)
none of the above.
Answer: A Difficulty: Easy
Rationale: The
upward sloping yield curve is referred to as the
normal yield curve,
probably because,
historically, the upward sloping yield curve is
the shape that has been
observed most
frequently.
5.
According to the expectations
hypothesis, a normal yield curve implies that
A)
interest
rates are expected to remain stable in the future.
B)
interest
rates are expected to decline in the future.
C)
interest
rates are expected to increase in the future.
D)
interest
rates are expected to decline first, then
increase.
E)
interest rates are expected to increase
first, then decrease.
Answer: C Difficulty: Easy
Rationale: An
upward sloping yield curve is based on the
expectation that short-term
interest
rates will increase.
6.
Which of the following is not proposed
as an explanation for the term structure of
interest rates?
A)
The expectations theory.
B)
The liquidity
preference theory.
C)
The market segmentation theory.
D)
Modern
portfolio theory.
E)
A, B, and C.
Answer: D Difficulty: Easy
Rationale: A,
B, and C are all theories that have been proposed
to explain the term
structure.
336
Chapter 15 The Term Structure of
Interest Rates
7.
The expectations theory of the term
structure of interest rates states that
A)
forward rates
are determined by investors' expectations of
future interest rates.
B)
forward rates exceed the expected
future interest rates.
C)
yields on long- and short-maturity
bonds are determined by the supply and demand
for the securities.
D)
all of the above.
E)
none of the
above.
Answer: A
Difficulty: Easy
Rationale: The forward rate equals the
market consensus expectation of future short
interest rates.
8.
Which of the following
theories state that the shape of the yield curve
is essentially
determined by the supply
and demands for long-and short-maturity bonds?
A)
Liquidity
preference theory.
B)
Expectations theory.
C)
Market segmentation
theory.
D)
All
of the above.
E)
None of the above.
Answer: C Difficulty: Easy
Rationale:
Market segmentation theory states that the markets
for different maturities
are separate
markets, and that interest rates at the different
maturities are determined by
the
intersection of the respective supply and demand
curves.
9.
According to the
yield curve
usually should be:
A)
inverted.
B)
normal.
C)
upward sloping
D)
A and B.
E)
B and C.
Answer: E Difficulty: Easy
Rationale:
According to the liquidity preference theory,
investors would prefer to be
liquid
rather than illiquid. In order to accept a more
illiquid investment, investors
require
a liquidity premium and the normal, or upward
sloping, yield curve results.
337
Chapter 15 The Term
Structure of Interest Rates
Use the following to answer
questions 10-13:
Suppose that all investors expect that
interest rates for the 4 years will be as
follows:
10.
What is the
price of 3-year zero coupon bond with a par value
of $$1,000?
A)
$$863.83
B)
$$816.58
C)
$$772.18
D)
$$765.55
E)
none of the above
Answer: B
Difficulty: Moderate
Rationale: $$1,000 /
(1.05)(1.07)(1.09) = $$816.58
11.
If you have just purchased a 4-year
zero coupon bond, what would be the expected rate
of return on your investment in the
first year if the implied forward rates stay the
same?
(Par value of the bond = $$1,000)
A)
5%
B)
7%
C)
9%
D)
10%
E)
none of the above
Answer: A
Difficulty: Moderate
Rationale: The forward
interest rate given for the first year of the
investment is given as
5% (see table
above).
338
Chapter 15 The Term Structure of
Interest Rates
12.
What is the
price of a 2-year maturity bond with a 10% coupon
rate paid annually? (Par
value =
$$1,000)
A)
$$1,092
B)
$$1,054
C)
$$1,000
D)
$$1,073
E)
none of the above
Answer: D
Difficulty: Moderate
Rationale:
[(1.05)(1.07)]
1/2
- 1 = 6%;
FV = 1000, n = 2, PMT = 100, i = 6, PV =
$$1,073.34
13.
What is the
yield to maturity of a 3-year zero coupon bond?
A)
7.00%
B)
9.00%
C)
6.99%
D)
7.49%
E)
none of the above
Answer: C
Difficulty: Moderate
Rationale:
[(1.05)(1.07)(1.09)]
1/3
- 1
= 6.99.
Use the
following to answer questions 14-16:
The following is a list of
prices for zero coupon bonds with different
maturities and par value of
$$1,000.
339
Chapter 15
The Term Structure of Interest Rates
14.
What is, according to the expectations
theory, the expected forward rate in the
third
year?
A)
7.00%
B)
7.33%
C)
9.00%
D)
11.19%
E)
none of the above
Answer: C
Difficulty: Moderate
Rationale: 881.68 / 808.88
- 1 = 9%
15.
What is the yield to
maturity on a 3-year zero coupon bond?
A)
6.37%
B)
9.00%
C)
7.33%
D)
10.00%
E)
none of the above
Answer: C Difficulty:
Moderate
Rationale: (1000 /
808.81)
1/3
-1 =
7.33%
16.
What is the price of a
4-year maturity bond with a 12% coupon rate paid
annually? (Par
value = $$1,000)
A)
$$742.09
B)
$$1,222.09
C)
$$1,000.00
D)
$$1,141.92
E)
none of the above
Answer: D
Difficulty: Difficult
Rationale: (1000 /
742.09)
1/4
-1 = 7.74%; FV =
1000, PMT = 120, n = 4, i = 7.74, PV =
$$1,141.92
340
Chapter 15 The Term Structure of
Interest Rates
17.
The market
segmentation theory of the term structure of
interest rates
A)
theoretically can explain
all shapes of yield curves.
B)
definitely
holds in the
C)
assumes that markets for different
maturities are separate markets.
D)
A and B.
E)
A
and C.
Answer:
E Difficulty: Easy
Rationale: Although this
theory is quite tidy theoretically, both investors
and borrows
will depart from their
attractive enough.
18.
An upward sloping yield curve
A)
may be an indication that interest
rates are expected to increase.
B)
may
incorporate a liquidity premium.
C)
may reflect
the confounding of the liquidity premium with
interest rate
expectations.
D)
all of the
above.
E)
none of the above.
Answer: D Difficulty:
Easy
Rationale: One of the problems of the
most commonly used explanation of term
structure, the expectations hypothesis,
is that it is difficult to separate out the
liquidity
premium from interest rate
expectations.
19.
The
n
that equates the return on
an
n
-period
zero-
coupon bond to that of an
n-1
-period zero-coupon bond
rolled over into a one-year
bond in
year
n
is defined as
A)
the forward rate.
B)
the short
rate.
C)
the yield to maturity.
D)
the discount
rate.
E)
None of the above.
Answer: A Difficulty:
Easy
Rationale: The forward rate for year n,
fn, is the
equates the return on an
n-period zero- coupon bond to that of an
n-1-period
zero-coupon bond rolled over
into a one-year bond in year n.
341
Chapter 15 The Term
Structure of Interest Rates
20.
When computing yield to maturity, the
implicit reinvestment assumption is that the
interest payments are reinvested at
the:
A)
Coupon rate.
B)
Current yield.
C)
Yield to maturity at the time of the
investment.
D)
Prevailing yield to maturity at the
time interest payments are received.
E)
The average
yield to maturity throughout the investment
period.
Answer:
C Difficulty: Moderate
Rationale: In order to earn
the yield to maturity quoted at the time of the
investment,
coupons must be reinvested
at that rate.
21.
Which one of the
following statements is
true
?
A)
The
expectations hypothesis indicates a flat yield
curve if anticipated future
short-term
rates exceed the current short-term rate.
B)
The basic conclusion of the
expectations hypothesis is that the long-term rate
is
equal to the anticipated long-term
rate.
C)
The liquidity preference hypothesis
indicates that, all other things being equal,
longer maturities will have lower
yields.
D)
The segmentation hypothesis contends
that borrows and lenders are constrained to
particular segments of the yield curve.
E)
None of the above.
Answer: D Difficulty:
Moderate
Rationale: A flat yield curve indicates
expectations of existing rates. Expectations
hypothesis states that the forward rate
equals the market consensus of expectations of
future short interest rates. The
reverse of C is true.
22.
The concepts
of spot and forward rates are most closely
associated with which one of
the
following explanations of the term structure of
interest rates.
A)
Segmented Market theory
B)
Expectations Hypothesis
C)
Preferred
Habitat Hypothesis
D)
Liquidity Premium theory
E)
None of the above
Answer: B Difficulty:
Moderate
Rationale: Only the expectations
hypothesis is based on spot and forward rates. A
and
C assume separate markets for
different maturities; liquidity premium assumes
higher
yields for longer
maturities.
342
Chapter 15 The Term Structure of
Interest Rates
Use the following to answer question
23:
23.
Given the bond described
above, if interest were paid semi-annually (rather
than
annually), and the bond continued
to be priced at $$850, the resulting effective
annual
yield to maturity would be:
A)
Less than 12%
B)
More than 12%
C)
12%
D)
Cannot be determined
E)
None of the
above
Answer: B
Difficulty: Moderate
Rationale: FV = 1000, PV =
-850, PMT = 50, n = 40, i = 5.9964 (semi-annual);
(1.059964)
2
- 1 =
12.35%.
24.
Interest rates might
decline
A)
because real interest rates are
expected to decline.
B)
because the inflation
rate is expected to decline.
C)
because
nominal interest rates are expected to increase.
D)
A
and B.
E)
B and C.
Answer: D Difficulty: Easy
Rationale: The nominal rate is
comprised of the real interest rate plus the
expected
inflation rate.
343
Chapter 15
The Term Structure of Interest Rates
25.
Forward rates ____________ future short
rates because ____________.
A)
are equal to;
they are both extracted from yields to maturity.
B)
are equal to; they are perfect
forecasts.
C)
differ from; they are imperfect
forecasts.
D)
differ from; forward rates are
estimated from dealer quotes while future short
rates
are extracted from yields to
maturity.
E)
are equal to; although they are
estimated from different sources they both are
used
by traders to make purchase
decisions.
Answer: C Difficulty: Easy
Rationale: Forward rates are the
estimates of future short rates extracted from
yields to
maturity but they are not
perfect forecasts because the future cannot be
predicted with
certainty; therefore
they will usually differ.
26.
The
pure yield curve
can be
estimated
A)
by using zero-coupon bonds.
B)
by using
coupon bonds if each coupon is treated as a
separate
C)
by using corporate bonds with different
risk ratings.
D)
by estimating liquidity
premiums for different maturities.
E)
A and B.
Answer: E
Difficulty: Moderate
Rationale: The pure yield
curve is calculated using zero coupon bonds, but
coupon
bonds may be used if each coupon
is treated as a separate
27.
The
on the run yield curve
is
A)
a
plot of yield as a function of maturity for zero-
coupon bonds.
B)
a plot of yield as a
function of maturity for recently issued coupon
bonds trading at
or near par.
C)
a
plot of yield as a function of maturity for
corporate bonds with different risk
ratings.
D)
a plot of liquidity
premiums for different maturities.
E)
A and B.
Answer: B
Difficulty: Moderate
344
Chapter 15 The Term Structure of
Interest Rates
28.
The market
segmentation and preferred habitat theories of
term structure
A)
are identical.
B)
vary in that market segmentation is
rarely accepted today.
C)
vary in that market
segmentation maintains that borrowers and lenders
will not
depart from their preferred
maturities and preferred habitat maintains that
market
participants will depart from
preferred maturities if yields on other maturities
are
attractive enough.
D)
A and B.
E)
B
and C.
Answer:
E Difficulty: Moderate
Rationale: Borrowers and
lenders will depart from their preferred maturity
habitats if
yields are attractive
enough; thus, the market segmentation hypothesis
is no longer
readily
accepted.
29.
The yield curve
A)
is a graphical depiction of term
structure of interest rates.
B)
is usually
depicted for U. S. Treasuries in order to hold
risk constant across
maturities and
yields.
C)
is usually depicted for corporate bonds
of different ratings.
D)
A and B.
E)
A and C.
Answer: D
Difficulty: Easy
Rationale: The yield curve
(yields vs. maturities, all else equal) is
depicted for U. S.
Treasuries more
frequently than for corporate bonds, as the risk
is constant across
maturities for
Treasuries.
Use
the following to answer questions
30-32:
345
Chapter 15 The Term
Structure of Interest Rates
30.
What should the purchase price of a
2-year zero coupon bond be if it is purchased at
the
beginning of year 2 and has face
value of $$1,000?
A)
$$877.54
B)
$$888.33
C)
$$883.32
D)
$$893.36
E)
$$871.80
Answer: A
Difficulty: Difficult
Rationale: $$1,000 /
[(1.064)(1.071)] = $$877.54
31.
What would
the yield to maturity be on a four-year zero
coupon bond purchased today?
A)
5.80%
B)
7.30%
C)
6.65%
D)
7.25%
E)
none of the above.
Answer: C Difficulty:
Moderate
Rationale: [(1.058) (1.064) (1.071)
(1.073)]
1/4
- 1 =
6.65%
32.
Calculate the price at
the beginning of year 1 of a 10% annual coupon
bond with face
value $$1,000 and 5 years
to maturity.
A)
$$1,105
B)
$$1,132
C)
$$1,179
D)
$$1,150
E)
$$1,119
Answer: B Difficulty:
Difficult
Rationale: i = [(1.058) (1.064) (1.071)
(1.073) (1.074)]
1/5
- 1 =
6.8%; FV = 1000, PMT =
100, n = 5, i =
6.8, PV = $$1,131.91
346
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