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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
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sloping, or normal, yield curve.
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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.
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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
interest rates, 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
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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.
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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).
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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)
$$1,073
E) none of the
above
Answer: D
Difficulty: Moderate
1/2
Rationale:
[(1.05)(1.07)]
- 1 = 6%; FV = 1000, n =
2, PMT = 100, i = 6,
PV = $$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 $$1,000.
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14.
What is, according
to
the expectations theory,
the expected forward
rate
in the
third
year?
A) 7.00%
B) 7.33%
C) 9.00%
D)
11.19%
E) none of the
above
Answer: C
Difficulty: Moderate
Rationale: 881.68 / 808.88 - 1 = 9%
15.
What is the yield to maturity on a
3-year zero coupon bond?
A) 6.37%
B)
9.00%
C) 7.33%
D) 10.00%
E) none of the above
Answer: C Difficulty: Moderate
Rationale:
(1000 / 808.81)
1/3
-1 =
7.33%
16.
What is the price of a 4-year maturity
bond with a 12% coupon rate paid
annually? (Par value = $$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
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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
maturity
habitats
if yields on
alternative maturities are 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
rate for year 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.
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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
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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.
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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);
2
(1.059964)
- 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.
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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
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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:
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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
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33.
Given the yield on a 3
year zero-coupon bond is 7.2% and forward rates
of 6.1% in year 1 and 6.9% in year 2,
what must be the forward rate in
year
3?
A) 8.4%
B) 8.6%
C) 8.1%
D) 8.9%
E) none of the above.
Answer: B Difficulty: Moderate
Rationale: f3 =
(1.072)
3
/ [(1.061) (1.069)]
- 1 = 8.6%
34.
An inverted yield curve is one
A) with a hump in the
middle.
B) constructed by
using convertible bonds.
C) that is relatively flat.
D) that plots the inverse
relationship between bond prices and bond
yields.
E) that
slopes downward.
Answer: E
Difficulty: Easy
Rationale:
An
inverted
yield
curve
occurs
when
short-term
rates
are
higher
than
long-term rates.
35.
Investors can use
publicly available financial date to determine
which
of the following?
I)
the shape of the yield curve
II)
future short-
term rates
III)
the direction the Dow indexes are
heading
IV)
the
actions to be taken by the Federal Reserve
A) I and II
B) I and III
C) I, II, and III
D) I, III, and IV
E) I, II, III, and IV
Answer: A Difficulty: Moderate
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Rationale: Only the shape of the yield
curve and future inferred rates
can be
determined. The movement of the Dow Indexes and
Federal Reserve
policy are influenced
by term structure but are determined by many other
variables also.
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36.
Which of the following combinations
will result in a sharply increasing
yield curve?
A)
increasing expected short rates and increasing
liquidity premiums
B)
decreasing expected short rates and increasing
liquidity premiums
C)
increasing expected short rates and decreasing
liquidity premiums
D)
increasing expected short rates and constant
liquidity premiums
E)
constant expected short rates and increasing
liquidity premiums
Answer:
A Difficulty: Moderate
Rationale:
Both
of
the
forces
will
act
to
increase
the
slope
of
the
yield
curve.
37.
The yield
curve is a component of
A)
the Dow Jones Industrial Average.
B) the consumer price index.
C) the index of leading
economic indicators.
D)
the producer price index.
E) the inflation index.
Answer: C Difficulty: Easy
Rationale:
Since the yield curve is often used to forecast
the business
cycle, it is used as one
of the leading economic indicators.
38.
The most
recently issued Treasury securities are called
A) on the run.
B) off the run.
C) on the market.
D) off the market.
E) none of the above.
Answer: A Difficulty: Easy
Use the following to answer
questions 39-42:
Suppose
that all investors expect that interest rates for
the 4 years will be
as follows:
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