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
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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.
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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.
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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.
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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
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