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(Comp.

) Callable bonds CG Answer: a MEDIUM


i
. Which of the following statements is CORRECT?

a. Two bonds have the same maturity and the same coupon rate.
However, one is callable and the other is not. The difference in prices
between the bonds will be greater if the current market interest rate is
below the coupon rate than if it is above the coupon rate.

b. A callable 10-year, 10% bond should sell at a higher price than an


otherwise similar noncallable bond.

c. Corporate treasurers dislike issuing callable bonds because these bonds


may require the company to raise additional funds earlier than would
be true if noncallable bonds with the same maturity were used.

d. Two bonds have the same maturity and the same coupon rate.
However, one is callable and the other is not. The difference in prices
between the bonds will be greater if the current market interest rate is
above the coupon rate than if it is below the coupon rate.

e. The actual life of a callable bond will always be equal to or less than
the actual life of a noncallable bond with the same maturity. Therefore,
if the yield curve is upward sloping, the required rate of return will be
lower on the callable bond.

(Comp.) Types of debt CG Answer: c MEDIUM


ii
. Which of the following statements is CORRECT?

a. Senior debt is debt that has been more recently issued, and in
bankruptcy it is paid off after junior debt because the junior debt was
issued first.

b. A company's subordinated debt has less default risk than its senior
debt.

c. Convertible bonds generally have lower coupon rates than non-


convertible bonds of similar default risk because they offer the
possibility of capital gains.

d. Junk bonds typically provide a lower yield to maturity than investment-


grade bonds.

e. A debenture is a secured bond that is backed by some or all of the


firms fixed assets.
(Comp.) Miscellaneous concepts CG Answer: d MEDIUM
iii
. Which of the following statements is CORRECT?

a. One disadvantage of zero coupon bonds is that the issuing firm cannot
realize any tax savings from the use of debt until the bonds mature.

b. Other things held constant, a callable bond should have a lower yield to
maturity than a noncallable bond.

c. Once a firm declares bankruptcy, it must be liquidated by the trustee,


who uses the proceeds to pay bondholders, unpaid wages, taxes, and
legal fees.

d. Income bonds must pay interest only if the company earns the interest.
Thus, these securities cannot bankrupt a company prior to their
maturity, and this makes them safer to the issuing corporation than
"regular" bonds.

e. A firm with a sinking fund that gives it the choice of calling the required
bonds at par or buying the bonds in the open market would generally
choose the open market purchase if the coupon rate exceeded the
going interest rate.

(Comp.) Miscellaneous concepts CG Answer: c MEDIUM


iv
. Which of the following statements is CORRECT?

a. The total return on a bond during a given year is based only on the
coupon interest payments received.

b. All else equal, a bond that has a coupon rate of 10% will sell at a
discount if the required return for bonds of similar risk is 8%.

c. The price of a discount bond will increase over time, assuming that the
bonds yield to maturity remains constant.

d. For a given firm, its debentures are likely to have a lower yield to
maturity than its mortgage bonds.

e. When large firms are in financial distress, they are almost always
liquidated, whereas smaller firms are generally reorganized.

(Comp.) Default and bankruptcy CG Answer: e MEDIUM


v
. Which of the following statements is CORRECT?

a. All else equal, secured debt is more risky than unsecured debt.

b. The expected return on a corporate bond must be greater than its


promised return if the probability of default is greater than zero.

c. All else equal, senior debt has more default risk than subordinated
debt.

d. A companys bond rating is affected by its financial ratios but not by


provisions in its indenture.

e. Under Chapter 11 of the Bankruptcy Act, the assets of a firm that


declares bankruptcy must be liquidated, and the sale proceeds must be
used to pay off claims against it according to the priority of the claims
as spelled out in the Act.
(Comp.) Calling a bond CG Answer: c MEDIUM/HARD
vi
. Which of the following statements is CORRECT?

a. A bond is likely to be called if its coupon rate is below its YTM.

b. A bond is likely to be called if its market price is below its par value.

c. Even if a bond's YTC exceeds its YTM, an investor with an investment


horizon longer than the bond's maturity would be worse off if the bond
were called.

d. A bond is likely to be called if its market price is equal to its par value.

e. A bond is likely to be called if it sells at a discount below par.

(7-4) Current yield and YTM CG Answer: b HARD


vii
. Which of the following statements is CORRECT?

a. Assume that two bonds have equal maturities and are of equal risk, but
one bond sells at par while the other sells at a premium above par. The
premium bond must have a lower current yield and a higher capital
gains yield than the par bond.

b. A bonds current yield must always be either equal to its yield to


maturity or between its yield to maturity and its coupon rate.

c. If a bond sells at par, then its current yield will be less than its yield to
maturity.

d. If a bond sells for less than par, then its yield to maturity is less than its
coupon rate.

e. A discount bonds price declines each year until it matures, when its
value equals its par value.

(7-5) Int. rates and bond prices CG Answer: a HARD


viii
. Assume that a noncallable 10-year T-bond has a 12% annual coupon, while
a 15-year noncallable T-bond has an 8% annual coupon. Assume also that
the yield curve is flat, and all Treasury securities have a 10% yield to
maturity. Which of the following statements is CORRECT?

a. If interest rates decline, the prices of both bonds would increase, but
the 15-year bond would have a larger percentage increase in price.

b. If interest rates decline, the prices of both bonds would increase, but
the 10-year bond would have a larger percentage increase in price.

c. The 10-year bond would sell at a discount, while the 15-year bond
would sell at a premium.

d. The 10-year bond would sell at a premium, while the 15-year bond
would sell at par.

e. If the yield to maturity on both bonds remains at 10% over the next
year, the price of the 10-year bond would increase, but the price of the
15-year bond would fall.

Which of the following statements is CORRECT?

a. A time line is not meaningful unless all cash flows occur annually.

b. Time lines are useful for visualizing complex problems prior to doing
actual calculations.

c. Time lines cannot be constructed in situations where some of the cash


flows occur annually but others occur quarterly.

d. Time lines cannot be constructed for annuities where the payments


occur at the beginning of the periods.

e. Some of the cash flows shown on a time line can be in the form of
annuity payments, but none can be uneven amounts.

(5-1) Time lines FJ Answer: d MEDIUM


ix
. Which of the following statements is CORRECT?

a. A time line is not meaningful unless all cash flows occur annually.

b. Time lines are not useful for visualizing complex problems prior to
doing actual calculations.

c. Time lines cannot be constructed in situations where some of the cash


flows occur annually but others occur quarterly.

d. Time lines can be constructed for annuities where the payments occur
at either the beginning or the end of the periods.

e. Some of the cash flows shown on a time line can be in the form of
annuity payments, but none can be uneven amounts.
(5-1) Time lines FJ Answer: c MEDIUM
x
. Which of the following statements is CORRECT?

a. A time line is not meaningful unless all cash flows occur annually.

b. Time lines are not useful for visualizing complex problems prior to
doing actual calculations.

c. Time lines can be constructed to deal with situations where some of


the cash flows occur annually but others occur quarterly.

d. Time lines can only be constructed for annuities where the payments
occur at the end of the periods, i.e., for ordinary annuities.

e. Time lines cannot be constructed where some of the payments


constitute an annuity but others are unequal and thus are not part of
the annuity.

(5-1) Time lines FJ Answer: e MEDIUM


xi
. Which of the following statements is CORRECT?

a. A time line is not meaningful unless all cash flows occur annually.

b. Time lines are not useful for visualizing complex problems prior to
doing actual calculations.

c. Time lines cannot be constructed to deal with situations where some of


the cash flows occur annually but others occur quarterly.

d. Time lines can only be constructed for annuities where the payments
occur at the end of the periods, i.e., for ordinary annuities.

e. Time lines can be constructed where some of the payments constitute


an annuity but others are unequal and thus are not part of the annuity.

(5-3) Effects of factors on PVs CJ Answer: b MEDIUM


xii
. You plan to analyze the value of a potential investment by calculating the
sum of the present values of its expected cash flows. Which of the
following would lower the calculated value of the investment?

a. The cash flows are in the form of a deferred annuity, and they total to
$100,000. You learn that the annuity lasts for only 5 rather than 10
years, hence that each payment is for $20,000 rather than for $10,000.

b. The discount rate increases.

c. The riskiness of the investments cash flows decreases.

d. The total amount of cash flows remains the same, but more of the cash
flows are received in the earlier years and less are received in the later
years.

e. The discount rate decreases.

(5-3) Effects of factors on PVs CJ Answer: b MEDIUM


xiii
. You plan to analyze the value of a potential investment by calculating the
sum of the present values of its expected cash flows. Which of the
following would increase the calculated value of the investment?

a. The cash flows are in the form of a deferred annuity, and they total to
$100,000. You learn that the annuity lasts for 10 years rather than 5
years, hence that each payment is for $10,000 rather than for $20,000.

b. The discount rate decreases.

c. The riskiness of the investments cash flows increases.

d. The total amount of cash flows remains the same, but more of the cash
flows are received in the later years and less are received in the earlier
years.

e. The discount rate increases.


i.(Comp.) Callable bonds C GAnswer: a MEDIUMa is correct because,
with the current market rate below the coupon bond, both bonds will sell at a premium, but the
premium will be larger for the noncallable bond. The same logic explains why d is false.

ii.(Comp.) Types of debt CG Answer: c MEDIUM

iii.(Comp.) Miscellaneous concepts C G Answer: d MEDIUM

iv.(Comp.) Miscellaneous concepts C G Answer: c MEDIUM

v.(Comp.) Default and bankruptcy C G Answer: e MEDIUM

vi.(Comp.) Calling a bond C G Answer: c MEDIUM/HARDA bond


would not be called unless the current rate was below the YTM, in which case it would sell at a
premium, because only then would it be profitable to refund the bond. The investor would get
the funds, then reinvest at the new low market rate. Thus, the investor would end up earning
less than the YTM, even after receiving the call premium.

vii.(7-4) Current yield and YTM C GAnswer: b HARDAnswer a is incorrect


because a premium bond must have a negative capital gains yield. Answer c is incorrect because
a bond selling at par must have a current yield equal to its YTM. Answer d is incorrect because
a bond selling at below par must have a YTM > the coupon rate. Answer e is incorrect because a
discount bond's price must rise over time. That leaves answer b as the only possibly correct
answer. Note that YTM = Current yield +/- Capital gains yield, so Current yield = YTM +/-
Capital gains yield. The capital gains yield will be positive or negative depending on whether
the coupon rate is above or below the YTM. That means that the current yield must either equal
the YTM or be between the YTM and the coupon rate. b's correctness is also demonstrated
below:

Par bond Premium Discount

Par $1,000 $1,000 $1,000

Maturity 10 10 10

Coup rate 10% 11% 9%

YTM 10.00% 10.00% 10.00%

Ann coup $100.00 $110.00 $90.00

Price $1,000.00 $1,061.45 $938.55


Cur Yield 10.00% 10.36% 9.59% Equal to or between YTM and coupon rate.

Cap gain 0.00% -0.36% 0.41%

viii.(7-5) Int. rates and bond pricesC G Answer: a HARDWe can tell by
inspection that c, d, and e are all incorrect. That leaves Answers a and b as the only possibly correct
statements. Also, recognize that longer-term bonds, and also bonds whose payments come late (like
low coupon bonds) are most sensitive to changes in interest rates. Thus, the 15-year, 8% coupon
bond would be more sensitive to a decline in rates. Finally, we can do some calculations to confirm
that a is the correct answer:

Current situation Rates decline

10-year 15-year 10-year 15-year

Par $1,000 $1,000 $1,000 $1,000

Maturity 10 15 10 15

Coup rate 12% 8% 12% 8%

YTM 10.00% 10.00% 9.00% 9.00%

Ann coup $120 $80 $120 $80

Price $1,122.89 $847.88 $1,192.53 $919.39

% Gain 6.2% 8.4%

ix.(5-1) Time lines FJ Answer: d MEDIUM

x.(5-1) Time linesF J Answer: c MEDIUM

xi.(5-1) Time lines FJ Answer: e MEDIUM


xii.(5-3) Effects of factors on PVs CJ Answer: b MEDIUM

xiii.(5-3) Effects of factors on PVs C J Answer: b MEDIUM


1. Which of the following actions would be most likely to reduce potential conflicts of
interest between stockholders and bondholders?

a. Compensating managers with stock options.

b. Financing risky projects with additional debt.

c. The threat of hostile takeovers.

d. The use of covenants in bond agreements that limit the firms use of
additional debt and constrain managers actions.

e. Abolishing the Security and Exchange Commission.

2. Which of the following statements is CORRECT?

a. Corporations are taxed more favorably than sole proprietorships.

b. Corporations have unlimited liability.

c. Because of their size, large corporations face fewer regulations than smaller
corporations and sole proprietorships.

d. Reducing the threat of corporate takeover increases the likelihood that


managers will act in shareholders interests.

e. Bond covenants are designed to protect bondholders and to reduce potential


conflicts between stockholders and bondholders..

3. Which of the following statements is CORRECT?

a. Hostile takeovers are most likely to occur when a firms stock is selling below
its intrinsic value as a result of poor management.

b. The efficiency of the U.S. economy would probably be increased if hostile


takeovers were absolutely forbidden.

cc. Hostile takeovers are most likely to occur when a firms stock sells at a price
above its intrinsic value because its management has been issuing overly
optimistic statements about its likely future performance.

d. In general, it is more in bondholders interests than stockholders interests for


a firm to shift its investment focus away from safe, stable investments and
into risky investments, especially those that primarily involve research and
development.
e. Stockholders in general would be better off if managers never disclosed
favorable events and therefore caused the price of the firms stock to sell at a
price below its intrinsic value.

4. You recently sold 100 shares of Microsoft stock to your brother at a family
reunion. At the reunion your brother gave you a check for the stock and you
gave your brother the stock certificates. Which of the following best describes
this transaction?

a. This is an example of a direct transfer of capital.

b. This is an example of a primary market transaction.

c. This is an example of an exchange of physical assets.

d. This is an example of a money market transaction.

e. This is an example of a derivative market transaction.

5. Which of the following is an example of a capital market instrument?

a. Commercial paper.

b. Preferred stock.

c. U.S. Treasury bills.

d. Banker's acceptances.

e. Money market mutual funds.

6. Money markets are markets for

a. Foreign currencies.

b. Consumer automobile loans.

c. Common stocks.

d. Long-term bonds.

ee.Short-term debt securities such as Treasury bills and commercial paper.

7. You recently sold 200 shares of Disney stock, and the transfer was made
through a broker. This is an example of:

a. A money market transaction.

b. A primary market transaction.


c. A secondary market transaction.

d. A futures market transaction.

e. An over-the-counter market transaction.

8. Which of the following items is NOT normally considered to be a current asset?

a. Accounts receivable.

b. Inventory.

c. Bonds.

d. Cash.

e. Short-term, highly-liquid, marketable securities.

9. Which of the following items cannot be found on a firms balance sheet under
current liabilities?

a. Accounts payable.

b. Short-term notes payable to the bank.

c. Accrued wages.

d. Cost of goods sold.

e. Accrued payroll taxes.

10.A loss incurred by a corporation

a. Must be carried forward unless the company has had 2 loss years in a row.

b. Can be carried back 2 years, then carried forward up to 20 years following


the loss.

c. Can be carried back 5 years and forward 3 years.

d. Cannot be used to reduce taxes in other years except with special


permission from the IRS.

e. Can be carried back 3 years or forward 10 years, whichever is more


advantageous to the firm.

11.On its 12/31/11 balance sheet, Barnes Inc showed $510 million of retained
earnings, and exactly that same amount was shown the following year.
Assuming that no earnings restatements were issued, which of the following
statements is CORRECT?
a. If the company lost money in 2011, it must have paid dividends.

b. The company must have had zero net income in 2011.

c. The company must have paid out half of its 2011 earnings as dividends.

d. The company must have paid no dividends in 2011.

e. Dividends could have been paid in 2011, but they would have had to equal
the earnings for the year.

12.Which of the following statements is CORRECT?

a. Typically, a firms DPS should exceed its EPS.

b. Typically, a firms net income should exceed its EBIT.

c. If a firm is more profitable than average, we would normally expect to see its
stock price exceed its book value per share.

d. If a firm is more profitable than most other firms, we would normally expect
to see its book value per share exceed its stock price, especially after
several years of high inflation.

e. The more depreciation a firm has in a given year, the higher its EPS, other
things held constant

13.Which of the following factors could explain why Michigan Energy's cash
balance increased even though it had a negative cash flow last year?

a. The company sold a new issue of bonds.

b. The company made a large investment in new plant and equipment.

c. The company paid a large dividend.

d. The company had high depreciation expenses.

e. The company repurchased 20% of its common stock.

14.You plan to analyze the value of a potential investment by calculating the sum
of the present values of its expected cash flows. Which of the following would
lower the calculated value of the investment?
a. The cash flows are in the form of a deferred annuity, and they total to
$100,000. You learn that the annuity lasts for only 5 rather than 10 years,
hence that each payment is for $20,000 rather than for $10,000.

b. The discount rate increases.

c. The riskiness of the investments cash flows decreases.

d. The total amount of cash flows remains the same, but more of the cash flows
are received in the earlier years and less are received in the later years.

e. The discount rate decreases.

15.Which of the following statements is CORRECT?

a. The cash flows for an ordinary (or deferred) annuity all occur at the
beginning of the periods.

b. If a series of unequal cash flows occurs at regular intervals, such as once a


year, then the series is by definition an annuity.

c. The cash flows for an annuity due must all occur at the ends of the periods.

d. The cash flows for an annuity must all be equal, and they must occur at
regular intervals, such as once a year or once a month.

e. If some cash flows occur at the beginning of the periods while others occur
at the ends, then we have what the textbook defines as a variable annuity.

16.Your bank account pays a 6% nominal rate of interest. The interest is


compounded quarterly. Which of the following statements is CORRECT?

a. The periodic rate of interest is 1.5% and the effective rate of interest is 3%.

b. The periodic rate of interest is 6% and the effective rate of interest is greater
than 6%.

c. The periodic rate of interest is 1.5% and the effective rate of interest is
greater than 6%.

d. The periodic rate of interest is 3% and the effective rate of interest is 6%.

e. The periodic rate of interest is 6% and the effective rate of interest is also
6%.

17.A $50,000 loan is to be amortized over 7 years, with annual end-of-year


payments. Which of these statements is CORRECT?

a. The annual payments would be larger if the interest rate were lower.
b. If the loan were amortized over 10 years rather than 7 years, and if the
interest rate were the same in either case, the first payment would include
more dollars of interest under the 7-year amortization plan.

c. The proportion of each payment that represents interest as opposed to


repayment of principal would be lower if the interest rate were lower.

d. The last payment would have a higher proportion of interest than the first
payment.

e. The proportion of interest versus principal repayment would be the same for
each of the 7 payments.

18.Which of the following bank accounts has the highest effective annual return?

a. An account that pays 8% nominal interest with monthly compounding.

b. An account that pays 8% nominal interest with annual compounding.

c. An account that pays 7% nominal interest with daily (365-day) compounding.

d. An account that pays 7% nominal interest with monthly compounding.

e. An account that pays 8% nominal interest with daily (365-day) compounding.

19.Relaxant Inc. operates as a partnership. Now the partners have decided to


convert the business into a corporation. Which of the following statements is
CORRECT?

a. Relaxants shareholders (the ex-partners) will now be exposed to less liability.

b. The company will probably be subject to fewer regulations and required


disclosures.

c. Assuming the firm is profitable, none of its income will be subject to federal
income taxes.

d. The firm's investors will be exposed to less liability, but they will find it more
difficult to transfer their ownership.

e. The firm will find it more difficult to raise additional capital to support its
growth.

20.Which of the following could explain why a business might choose to operate as a
corporation rather than as a sole proprietorship or a partnership?
a. Corporations generally face fewer regulations.

b. Less of a corporations income is generally subject to federal taxes.

c. Corporate shareholders are exposed to unlimited liability, but this factor is


offset by the tax advantages of incorporation.

d. Corporate investors are exposed to unlimited liability.

e. Corporations generally find it easier to raise large amounts of capital.

21.Which of the following bonds would have the greatest percentage increase in
value if all interest rates in the economy fall by 1%?

a. 10-year, zero coupon bond.

b. 20-year, 10% coupon bond.

c. 20-year, 5% coupon bond.

d. 1-year, 10% coupon bond.

e. 20-year, zero coupon bond.

22.Which of the following statements is CORRECT?

a. If a coupon bond is selling at par, its current yield equals its yield to maturity.

b. If a coupon bond is selling at a discount, its price will continue to decline


until it reaches its par value at maturity.

c. If interest rates increase, the price of a 10-year coupon bond will decline by a
greater percentage than the price of a 10-year zero coupon bond.

d. If a bonds yield to maturity exceeds its annual coupon, then the bond will
trade at a premium.

e. If a coupon bond is selling at a premium, its current yield equals its yield to
maturity.

23.Which of the following statements is CORRECT?


a. Senior debt is debt that has been more recently issued, and in bankruptcy it
is paid off after junior debt because the junior debt was issued first.

b. A company's subordinated debt has less default risk than its senior debt.

c. Convertible bonds generally have lower coupon rates than non-convertible


bonds of similar default risk because they offer the possibility of capital
gains.

d. Junk bonds typically provide a lower yield to maturity than investment-grade


bonds.

e. A debenture is a secured bond that is backed by some or all of the firms


fixed assets.

24.Basic objective of diversification is


a. Increasing return
b. Maximizing return
c. Decreasing risk
d. Maximizing risk

ANSWERS

1..d 2.e 3.a 4.a 5.b 6.e 7.c 8.c 9.d 10.b 11.d 12.c 13.a

14.b 15.d 16.c 17.c 18.e 21.e 22.a 23.c 24.c

(5-6) Annuities FJ Answer: c MEDIUM

. Which of the following statements is CORRECT?

a. The cash flows for an ordinary (or deferred) annuity all occur at the
beginning of the periods.

b. If a series of unequal cash flows occurs at regular intervals, such as once a


year, then the series is by definition an annuity.

c. The cash flows for an annuity due must all occur at the beginning of the
periods.

d. The cash flows for an annuity may vary from period to period, but they must
occur at regular intervals, such as once a year or once a month.
e. If some cash flows occur at the beginning of the periods while others occur
at the ends, then we have what the textbook defines as a variable annuity.

(5-16) Quarterly compounding CJ Answer: c MEDIUM

25. Your bank account pays a 6% nominal rate of interest. The interest is
compounded quarterly. Which of the following statements is CORRECT?

a. The periodic rate of interest is 1.5% and the effective rate of interest is 3%.

b. The periodic rate of interest is 6% and the effective rate of interest is greater
than 6%.

c. The periodic rate of interest is 1.5% and the effective rate of interest is
greater than 6%.

d. The periodic rate of interest is 3% and the effective rate of interest is 6%.

e. The periodic rate of interest is 6% and the effective rate of interest is also
6%.

(5-16) Quarterly compounding CJ Answer: d MEDIUM

. Your bank account pays an 8% nominal rate of interest. The interest is


compounded quarterly. Which of the following statements is CORRECT?

a. The periodic rate of interest is 2% and the effective rate of interest is 4%.

b. The periodic rate of interest is 8% and the effective rate of interest is greater
than 8%.

c. The periodic rate of interest is 4% and the effective rate of interest is less
than 8%.

d. The periodic rate of interest is 2% and the effective rate of interest is greater
than 8%.

e. The periodic rate of interest is 8% and the effective rate of interest is also
8%.

(5-18) Amortization CJ Answer: c MEDIUM

. A $50,000 loan is to be amortized over 7 years, with annual end-of-year


payments. Which of these statements is CORRECT?
a. The annual payments would be larger if the interest rate were lower.

b. If the loan were amortized over 10 years rather than 7 years, and if the
interest rate were the same in either case, the first payment would include
more dollars of interest under the 7-year amortization plan.

c. The proportion of each payment that represents interest as opposed to


repayment of principal would be lower if the interest rate were lower.

d. The last payment would have a higher proportion of interest than the first
payment.

e. The proportion of interest versus principal repayment would be the same for
each of the 7 payments.

(5-18) Amortization CJ Answer: d MEDIUM

. A $150,000 loan is to be amortized over 7 years, with annual end-of-year


payments. Which of these statements is CORRECT?

a. The annual payments would be larger if the interest rate were lower.

b. If the loan were amortized over 10 years rather than 7 years, and if the
interest rate were the same in either case, the first payment would include
more dollars of interest under the 7-year amortization plan.

c. The proportion of each payment that represents interest as opposed to


repayment of principal would be higher if the interest rate were lower.

d. The proportion of each payment that represents interest versus repayment


of principal would be higher if the interest rate were higher.

e. The proportion of interest versus principal repayment would be the same for
each of the 7 payments.

(5-18) Amortization CJ Answer: b MEDIUM

. Which of the following statements regarding a 15-year (180-month) $125,000,


fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.)

a. The remaining balance after three years will be $125,000 less one third of
the interest paid during the first three years.
b. Because it is a fixed-rate mortgage, the monthly loan payments (which
include both interest and principal payments) are constant.

c. Interest payments on the mortgage will increase steadily over time, but the
total amount of each payment will remain constant.

d. The proportion of the monthly payment that goes towards repayment of


principal will be lower 10 years from now than it will be the first year.

e. The outstanding balance declines at a slower rate in the later years of the
loans life.

Assume that inflation is expected to decline steadily in the future, but that the real
risk-free rate, r*, will remain constant. Which of the following statements is
CORRECT, other things held constant?

a. If the pure expectations theory holds, the Treasury yield curve must be
downward sloping.

b. If the pure expectations theory holds, the corporate yield curve must be
downward sloping.

c. If there is a positive maturity risk premium, the Treasury yield curve must be
upward sloping.

d. If inflation is expected to decline, there can be no maturity risk premium.

e. The expectations theory cannot hold if inflation is decreasing.

(6-2) Interest rate levels CH Answer: b MEDIUM

. Which of the following factors would be most likely to lead to an increase in


nominal interest rates?

a. Households reduce their consumption and increase their savings.

b. A new technology like the Internet has just been introduced, and it increases
investment opportunities.

c. There is a decrease in expected inflation.

d. The economy falls into a recession.

e. The Federal Reserve decides to try to stimulate the economy.

(6-2) Interest rate levels CH Answer: c MEDIUM


. Which of the following statements is CORRECT, other things held constant?

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.

(6-2) Interest rate levels CH Answer: b MEDIUM

. Which of the following would be most likely to lead to a higher level of interest
rates in the economy?

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.

(6-4) Yield curve CH Answer: e MEDIUM

. In the foreseeable future, the real risk-free rate of interest, r*, is expected to
remain at 3%, inflation is expected to steadily increase, and the maturity risk
premium is expected to be 0.1(t 1)%, where t is the number of years until the
bond matures. Given this information, which of the following statements is
CORRECT?

a. The yield on 2-year Treasury securities must exceed the yield on 5-year
Treasury securities.

b. The yield on 5-year Treasury securities must exceed the yield on 10-year
corporate bonds.
c. The yield on 5-year corporate bonds must exceed the yield on 8-year
Treasury bonds.

d. The yield curve must be "humped."

e. The yield curve must be upward sloping.

(6-4) Yield curve CH Answer: a MEDIUM

. If the Treasury yield curve is downward sloping, how should the yield to maturity
on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

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

b. The yield on a 10-year bond would have to be higher than that on a 1-year
bill because of the maturity risk premium.

c. It is impossible to tell without knowing the coupon rates of the bonds.

d. The yields on the two securities would be equal.

e. It is impossible to tell without knowing the relative risks of the two securities.

(6-4) Yield curve CH Answer: e MEDIUM

. Assume the following: The real risk-free rate, r*, is expected to remain constant
at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a
year thereafter. The maturity risk premium is zero. Given this information,
which of the following statements is CORRECT?

a. The yield curve for U.S. Treasury securities will be upward sloping.

b. A 5-year corporate bond must have a lower yield than a 5-year Treasury
security.

c. A 5-year corporate bond must have a lower yield than a 7-year Treasury
security.

d. The real risk-free rate cannot be constant if inflation is not expected to


remain constant.

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

(6-4) Yield curve CH Answer: c MEDIUM


. Which of the following statements is CORRECT?

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.