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Exam2SP08
Multiple Choice
Identify the choice that best completes the statement or answers the question.
____
1.
For the foreseeable future, the real riskfree rate of interest, r*, is expected to remain at 3 percent. Inflation is
expected to steadily increase over time. The maturity risk premium equals 0.1(t  1)%, where t represents the
bond's maturity. On the basis of this information, which of the following statements is most correct?
a.
The yield on 10year Treasury securities must exceed the yield on 2year Treasury
securities.
b.
The yield on 10year Treasury securities must exceed the yield on 5year corporate bonds.
c.
The yield on 10year corporate bonds must be lower than the yield on 8year Treasury
securities.
d.
All of these statements are correct.
____
2.
Which of the following is most correct?
a.
If the expectations theory is correct (that is, the maturity risk premium is zero), then an
upwardsloping yield curve means that the market believes that interest rates will rise in
the future.
b.
A 5year corporate bond may have a yield less than a 10year Treasury bond.
c.
The yield curve for corporate bonds may be upward sloping even if the Treasury yield
curve is flat.
d.
All of these statements are correct.
____
3.
The real riskfree rate of interest, r*, is 3 percent. Inflation is expected to be 4 percent this year, 5 percent next
year, and 3 percent per year thereafter. The maturity risk premium equals 0.1%(t  1), where t equals the
bond's maturity. That is, a 5year bond has a maturity risk premium of 0.4 percent or 0.004. A 5year
corporate bond yields 8 percent. What is the yield on a 10year corporate bond that has the same default risk
and liquidity premiums as the 5year corporate bond?
a.
7.2%
b.
8.2%
c.
8.0%
d.
6.8%
e.
8.4%
____
4.
You observe the following yield curve for Treasury securities:
Maturity
Yield
1 year
5.8%
2 years
6.2
3 years
6.5
4 years
6.2
5 years
6.0
Assume that the expectations theory is correct. What does the market expect the rate on twoyear Treasury
securities will be three years from today?
a.
5.25%
b.
6.20%
c.
6.00%
d.
5.87%
e.
6.50%
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5.
You read in
The Wall Street Journal
that 30day Tbills are currently yielding 8 percent. Your brotherinlaw,
a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:
•
Inflation premium = 5%.
•
Liquidity premium = 1%.
•
Maturity risk premium = 2%.
•
Default risk premium = 2%.
On the basis of these data, the real riskfree rate of return is
a.
0%
b.
1%
c.
2%
d.
3%
e.
4%
____
6.
Assume that a 3year Treasury note has no maturity risk premium, and that the real riskfree rate of interest is
3 percent. If the Tnote carries a yield to maturity of 13 percent, and if the expected average inflation rate over
the next 2 years is 11 percent, what is the implied expected inflation rate during Year 3?
a.
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 Spring '08
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 Finance, Inflation, Interest

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