FINANCE 101 Self-Test No. 3 for Midterm #1

Market yields incorporate a premium for past inflation experience  True True  False False

Wrong!  Try again!

Correct!  Nominal yields incorporate a premium for expected inflation to preserve the purchasing power of lender’s principal

If the market consensus is for expected inflation to increase…..  Nominal rates should fall Nominal rates should fall  Nominal rates should rise Nominal rates should rise  Real rates should fall Real rates should fall  Real rates should rise Real rates should rise

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Correct!  Nominal rates should increase. If they did not, the real cost of borrowing would fall, causing borrowing demand to increase. Lenders would be less willing to lend if they cannot maintain their purchasing power, thus decreasing the supply of funds.

If you expect inflation to be 2% next year and a one-year note has a yield of 6%, then the expected real rate of interest is  -4% -4%  -2% -2%  4% 4%  8% 8%

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Correct!  4%, the difference between the nominal yield and expected inflation

An upward sloping yield curve suggests that investors expect future short-term rates to ___ and security prices to ____  Fall; fall Fall; fall  Fall; rise Fall; rise  Rise; fall Rise; fall  Rise; rise Rise; rise

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Correct!  Under the expectations hypothesis, future short-term rates are expected to rise if the yield curve is upward sloping. If future yields are expected to rise, then future security prices should fall.

Which of the following statements is correct about the yield curve?  Interest rates of different maturities tend to move together over time Interest rates of different maturities tend to move together over time  When short-term rates are low, the yield curve is usually upward sloping When short-term rates are low, the yield curve is usually upward sloping  Short-term interest rates move more than long-term rates Short-term interest rates move more than long-term rates  All of the above are true All of the above are true

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Correct!  Because long-term rates can be considered an average of current and future expected one-period rates, yields on securities of different maturities should move together over time, but not by the same magnitude. When short-term rates are low, the yield curve tends to be upward sloping. Short term rates have much more volatility than long-term rates.

Forward rates represent breakeven future short-term rates when comparing risk-free investments of different maturities  True True  False False

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Correct!  True. The forward rate is the rate that would make you indifferent between a “rollover” strategy of two short-term investments versus holding a longer term investment.

The yield on a municipal bond will be ____ than the yield of an equivalent risk and maturity corporate security. – Lower. Lower. – Higher. Higher. – The same as. The same as. – Need more information. Need more information.

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Correct!  It will be lower because the interest income is tax-free. Investors will make choices based on after-tax yields.

Investors expect to earn the promised yield to maturity on junk bonds. – True True – False False

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Correct!  False. In the presence of significant risk of default, the expected yield to maturity will be less than the promised yield because there is some probability that there will be no return.

A corporate bond rated AAA should have a _____ yield to maturity compared to a A rated bond of comparable maturity in the same industry. – higher higher – lower lower – identical identical – cannot tell from information given cannot tell from information given

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Correct!  AAA bonds should have a lower yield because this category represents the highest rating and thus the lowest chance of default.

The ________ of a security gives a measure of its marketability – maturity. maturity. – bid-asked spread. bid-asked spread. – yield to maturity. yield to maturity. – All of the above. All of the above.

Wrong!  Try again

Correct!  The bid-offer spread measures the marketability of a security. Lower bid-offer spreads means there is more active trading and therefore less of a cost for the dealer to make a market. Higher bid-offer spreads mean there is less liquidity and are required for the dealer to assume the risk of holding the securities to make a market.

Congratulations!  You have successfully completed Self-Test #3