70 32301805
70 32301805
70 32301805
Chapter 15
The Term Structure of Interest Rates
15-1
Chapter 15 - The Term Structure of Interest Rates
4. If the value of a Treasury bond was higher than the value of the sum of its parts
(STRIPPED cash flows) you could
A. profit by buying the stripped cash flows and reconstituting the bond.
B. not profit by buying the stripped cash flows and reconstituting the bond.
C. profit by buying the bond and creating STRIPS.
D. not profit by buying the stripped cash flows and reconstituting the bond but profit by
buying the bond and creating STRIPS.
E. None of these is correct.
5. If the value of a Treasury bond was lower than the value of the sum of its parts (STRIPPED
cash flows) you could
A. profit by buying the stripped cash flows and reconstituting the bond.
B. not profit by buying the stripped cash flows and reconstituting the bond.
C. profit by buying the bond and creating STRIPS.
D. not profit by buying the stripped cash flows and reconstituting the bond and profit by
buying the bond and creating STRIPS.
E. None of these is correct.
6. If the value of a Treasury bond was lower than the value of the sum of its parts (STRIPPED
cash flows)
A. arbitrage would probably occur.
B. arbitrage would probably not occur.
C. the FED would adjust interest rates.
D. arbitrage would probably not occur and the FED would adjust interest rates.
E. None of these is correct.
15-2
Chapter 15 - The Term Structure of Interest Rates
7. If the value of a Treasury bond was higher than the value of the sum of its parts
(STRIPPED cash flows)
A. arbitrage would probably occur.
B. arbitrage would probably not occur.
C. the FED would adjust interest rates.
D. arbitrage would probably not occur and the FED would adjust interest rates.
E. None of these is correct.
8. Bond stripping and bond reconstitution offer opportunities for ______, which can occur if
the _________ is violated.
A. arbitrage; Law of One Price
B. arbitrage; restrictive covenants
C. huge losses; Law of One Price
D. huge losses; restrictive covenants
E. both arbitrage and huge losses; restrictive covenants
15-3
Chapter 15 - The Term Structure of Interest Rates
13. According to the expectations hypothesis, an upward sloping 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.
14. 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 safety of principal theory.
D. Modern portfolio theory.
E. Both the expectations theory and the liquidity preference theory.
15-4
Chapter 15 - The Term Structure of Interest Rates
15. 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 these are correct.
E. None of these is correct.
Suppose that all investors expect that interest rates for the 4 years will be as follows:
16. 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 these is correct.
17. 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 these is correct.
15-5
Chapter 15 - The Term Structure of Interest Rates
18. 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 these is correct.
The following is a list of prices for zero coupon bonds with different maturities and par value
of $1,000.
20. 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 these is correct.
15-6
Chapter 15 - The Term Structure of Interest Rates
22. 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 these is correct.
24. The "break-even" interest 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 is defined as
A. the forward rate.
B. the short rate.
C. the yield to maturity.
D. the discount rate.
E. None of these is correct.
15-7
Chapter 15 - The Term Structure of Interest Rates
25. 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.
26. 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 these is correct.
15-8
Chapter 15 - The Term Structure of Interest Rates
15-9
Chapter 15 - The Term Structure of Interest Rates
31. 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
32. 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 these is correct.
33. 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
34. 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 these is correct.
15-10
Chapter 15 - The Term Structure of Interest Rates
36. Investors can use publicly available financial data to determine which of the following?
I) The shape of the yield curve.
II) Expected future short-term rates (if liquidity premiums are ignored).
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
37. Which of the following combinations will result in a sharply increasing yield curve?
A. Increasing future expected short rates and increasing liquidity premiums
B. Decreasing future expected short rates and increasing liquidity premiums
C. Increasing future expected short rates and decreasing liquidity premiums
D. Increasing future expected short rates and constant liquidity premiums
E. Constant future expected short rates and increasing liquidity premiums
15-11
Chapter 15 - The Term Structure of Interest Rates
Suppose that all investors expect that interest rates for the 4 years will be as follows:
40. What is the price of 3-year zero coupon bond with a par value of $1,000?
A. $889.08
B. $816.58
C. $772.18
D. $765.55
E. None of these is correct.
41. 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. 3%
C. 9%
D. 10%
E. None of these is correct.
15-12
Chapter 15 - The Term Structure of Interest Rates
42. What is the price of a 2-year maturity bond with a 5% coupon rate paid annually? (Par
value = $1,000).
A. $1,092.97
B. $1,054.24
C. $1,028.51
D. $1,073.34
E. None of these is correct.
The following is a list of prices for zero coupon bonds with different maturities and par value
of $1,000.
44. What is, according to the expectations theory, the expected forward rate in the third year?
A. 7.23
B. 9.37%
C. 9.00%
D. 10.9%
E. None of these is correct.
15-13
Chapter 15 - The Term Structure of Interest Rates
46. What is the price of a 4-year maturity bond with a 10% coupon rate paid annually? (Par
value = $1,000).
A. $742.09
B. $1,222.09
C. $1,035.66
D. $1,141.84
E. None of these is correct.
47. You have purchased a 4-year maturity bond with a 9% coupon rate paid annually. The
bond has a par value of $1,000. What would the price of the bond be one year from now if the
implied forward rates stay the same?
A. $995.63
B. $1,108.88
C. $1,000.00
D. $1,042.78
E. None of these is correct.
15-14
Chapter 15 - The Term Structure of Interest Rates
48. Given the bond described above, if interest were paid semi-annually (rather than
annually), and the bond continued to be priced at $917.99, the resulting effective annual yield
to maturity would be:
A. Less than 10%.
B. More than 10%.
C. 10%.
D. Cannot be determined.
E. None of these is correct.
49. 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. $894.21
E. $871.80
50. What would the yield to maturity be on a four-year zero coupon bond purchased today?
A. 5.75%
B. 6.30%
C. 5.65%
D. 5.25%
E. None of these is correct.
15-15
Chapter 15 - The Term Structure of Interest Rates
51. Calculate the price at the beginning of year 1 of an 8% annual coupon bond with face
value $1,000 and 5 years to maturity.
A. $1,105.47
B. $1,131.91
C. $1,084.25
D. $1,150.01
E. $719.75
52. Given the yield on a 3 year zero-coupon bond is 7% and forward rates of 6% in year 1 and
6.5% in year 2, what must be the forward rate in year 3?
A. 7.2%
B. 8.6%
C. 8.5%
D. 6.9%
E. None of these is correct.
53. What should the purchase price of a 1-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $966.37
B. $912.87
C. $950.21
D. $956.02
E. $945.51
15-16
Chapter 15 - The Term Structure of Interest Rates
54. What should the purchase price of a 2-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $966.87
B. $911.37
C. $950.21
D. $956.02
E. $945.51
55. What should the purchase price of a 3-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $887.42
B. $871.12
C. $879.54
D. $856.02
E. $866.32
56. What should the purchase price of a 4-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $887.42
B. $821.15
C. $879.54
D. $856.02
E. $866.32
57. What should the purchase price of a 5-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $776.14
B. $721.15
C. $779.54
D. $756.02
E. $766.32
15-17
Chapter 15 - The Term Structure of Interest Rates
15-18
Chapter 15 - The Term Structure of Interest Rates
63. Discuss the theories of the term structure of interest rates. Include in your discussion the
differences in the theories, and the advantages/disadvantages of each.
64. Term structure of interest rates is the relationship between what variables? What is
assumed about other variables? How is term structure of interest rates depicted graphically?
65. Although the expectations of increases in future interest rates can result in an upward
sloping yield curve; an upward sloping yield curve does not in and of itself imply the
expectations of higher future interest rates. Explain.
15-19
Chapter 15 - The Term Structure of Interest Rates
66. Explain what the following terms mean: spot rate, short rate, and forward rate. Which of
these is (are) observable today?
15-20
Chapter 15 - The Term Structure of Interest Rates
The term structure of interest rates is the relationship between two variables, years and yield
to maturity (holding all else constant).
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
Treasury STRIPS are created by selling each coupon or principal payment from a whole
Treasury bond as a separate cash flow.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
15-21
Chapter 15 - The Term Structure of Interest Rates
The value of a Treasury bond should be equal to the sum of the value of STRIPS created from
it.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
4. If the value of a Treasury bond was higher than the value of the sum of its parts
(STRIPPED cash flows) you could
A. profit by buying the stripped cash flows and reconstituting the bond.
B. not profit by buying the stripped cash flows and reconstituting the bond.
C. profit by buying the bond and creating STRIPS.
D. not profit by buying the stripped cash flows and reconstituting the bond but profit by
buying the bond and creating STRIPS
E. None of these is correct.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
15-22
Chapter 15 - The Term Structure of Interest Rates
5. If the value of a Treasury bond was lower than the value of the sum of its parts (STRIPPED
cash flows) you could
A. profit by buying the stripped cash flows and reconstituting the bond.
B. not profit by buying the stripped cash flows and reconstituting the bond.
C. profit by buying the bond and creating STRIPS.
D. not profit by buying the stripped cash flows and reconstituting the bond and profit by
buying the bond and creating STRIPS
E. None of these is correct.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
6. If the value of a Treasury bond was lower than the value of the sum of its parts (STRIPPED
cash flows)
A. arbitrage would probably occur.
B. arbitrage would probably not occur.
C. the FED would adjust interest rates.
D. arbitrage would probably not occur and the FED would adjust interest rates
E. None of these is correct.
If the value of a Treasury bond was lower than the value of the sum of its parts (STRIPPED
cash flows) arbitrage would probably occur.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
15-23
Chapter 15 - The Term Structure of Interest Rates
7. If the value of a Treasury bond was higher than the value of the sum of its parts
(STRIPPED cash flows)
A. arbitrage would probably occur.
B. arbitrage would probably not occur.
C. the FED would adjust interest rates.
D. arbitrage would probably not occur and the FED would adjust interest rates
E. None of these is correct.
If the value of a Treasury bond was higher than the value of the sum of its parts (STRIPPED
cash flows) arbitrage would probably occur.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
8. Bond stripping and bond reconstitution offer opportunities for ______, which can occur if
the _________ is violated.
A. arbitrage; Law of One Price
B. arbitrage; restrictive covenants
C. huge losses; Law of One Price
D. huge losses; restrictive covenants
E. both arbitrage and huge losses; restrictive covenants
Bond stripping and bond reconstitution offer opportunities for arbitrage, which can occur if
the Law of One Price is violated.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
15-24
Chapter 15 - The Term Structure of Interest Rates
Arbitrage (also known as riskless economic profit) can occur if the Law of One Price is
violated.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
The yield curve shows the relationship between yield on a bond and the time to maturity on
the bond.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
15-25
Chapter 15 - The Term Structure of Interest Rates
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 sloping, or normal, yield curve.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
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.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
15-26
Chapter 15 - The Term Structure of Interest Rates
13. According to the expectations hypothesis, an upward sloping 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.
An upward sloping yield curve is based on the expectation that short-term interest rates will
increase.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
14. 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 safety of principal theory.
D. Modern portfolio theory.
E. Both the expectations theory and the liquidity preference theory.
A and B are theories that have been proposed to explain the term structure.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
15-27
Chapter 15 - The Term Structure of Interest Rates
15. 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 these are correct.
E. None of these is correct.
The forward rate equals the market consensus expectation of future short interest rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
Suppose that all investors expect that interest rates for the 4 years will be as follows:
16. 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 these is correct.
$1,000/(1.05)(1.07)(1.09) = $816.58
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-28
Chapter 15 - The Term Structure of Interest Rates
17. 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 these is correct.
The forward interest rate given for the first year of the investment is given as 5% (see table
above).
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
18. 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 these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-29
Chapter 15 - The Term Structure of Interest Rates
[(1.05)(1.07)(1.09)]1/3 − 1 = 6.99.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
The following is a list of prices for zero coupon bonds with different maturities and par value
of $1,000.
20. 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 these is correct.
881.68/808.88 − 1 = 9%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-30
Chapter 15 - The Term Structure of Interest Rates
(1000/808.81)1/3 − 1 = 7.33%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
22. 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 these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
15-31
Chapter 15 - The Term Structure of Interest Rates
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.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
24. The "break-even" interest 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 is defined as
A. the forward rate.
B. the short rate.
C. the yield to maturity.
D. the discount rate.
E. None of these is correct.
The forward rate for year n, fn, is the "break-even" interest 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.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
15-32
Chapter 15 - The Term Structure of Interest Rates
25. 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.
In order to earn the yield to maturity quoted at the time of the investment, coupons must be
reinvested at that rate.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Term structure of interest rates
26. 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 these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-33
Chapter 15 - The Term Structure of Interest Rates
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.
AACSB: Analytic
Bloom's: Understand
Difficulty: Basic
Topic: Term structure of interest rates
The pure yield curve is calculated using stripped or zero coupon Treasuries.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Term structure of interest rates
15-34
Chapter 15 - The Term Structure of Interest Rates
The on the run yield curve is a plot of yield as a function of maturity for recently issued
coupon bonds trading at or near par.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Term structure of interest rates
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.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
15-35
Chapter 15 - The Term Structure of Interest Rates
31. 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
$1,000/[(1.064)(1.071)] = $877.54
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
32. 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 these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-36
Chapter 15 - The Term Structure of Interest Rates
33. 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
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
34. 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 these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-37
Chapter 15 - The Term Structure of Interest Rates
An inverted yield curve occurs when short-term rates are higher than long-term rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
36. Investors can use publicly available financial data to determine which of the following?
I) The shape of the yield curve
II) Expected future short-term rates (if liquidity premiums are ignored)
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
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.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Term structure of interest rates
15-38
Chapter 15 - The Term Structure of Interest Rates
37. Which of the following combinations will result in a sharply increasing yield curve?
A. Increasing future expected short rates and increasing liquidity premiums
B. Decreasing future expected short rates and increasing liquidity premiums
C. Increasing future expected short rates and decreasing liquidity premiums
D. Increasing future expected short rates and constant liquidity premiums
E. Constant future expected short rates and increasing liquidity premiums
Both of the forces will act to increase the slope of the yield curve.
AACSB: Analytic
Bloom's: Remember
Difficulty: Intermediate
Topic: Yield curve
Since the yield curve is often used to forecast the business cycle, it is used as one of the
leading economic indicators.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Yield curve
15-39
Chapter 15 - The Term Structure of Interest Rates
The most recently issued Treasury securities are called on the run.
AACSB: Analytic
Bloom's: Remember
Difficulty: Basic
Topic: Term structure of interest rates
Suppose that all investors expect that interest rates for the 4 years will be as follows:
40. What is the price of 3-year zero coupon bond with a par value of $1,000?
A. $889.08
B. $816.58
C. $772.18
D. $765.55
E. None of these is correct.
$1,000/(1.03)(1.04)(1.05) = $889.08
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-40
Chapter 15 - The Term Structure of Interest Rates
41. 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. 3%
C. 9%
D. 10%
E. None of these is correct.
The forward interest rate given for the first year of the investment is given as 3% (see table
above).
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
42. What is the price of a 2-year maturity bond with a 5% coupon rate paid annually? (Par
value = $1,000)
A. $1,092.97
B. $1,054.24
C. $1,028.51
D. $1,073.34
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-41
Chapter 15 - The Term Structure of Interest Rates
[(1.03)(1.04)(1.05)]1/3 − 1 = 4%.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
The following is a list of prices for zero coupon bonds with different maturities and par value
of $1,000.
44. What is, according to the expectations theory, the expected forward rate in the third year?
A. 7.23
B. 9.37%
C. 9.00%
D. 10.9%
E. None of these is correct.
862.57/788.66 − 1 = 9.37%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-42
Chapter 15 - The Term Structure of Interest Rates
(1000/788.66)1/3 − 1 = 8.24%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
46. What is the price of a 4-year maturity bond with a 10% coupon rate paid annually? (Par
value = $1,000)
A. $742.09
B. $1,222.09
C. $1,035.66
D. $1,141.84
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
15-43
Chapter 15 - The Term Structure of Interest Rates
47. You have purchased a 4-year maturity bond with a 9% coupon rate paid annually. The
bond has a par value of $1,000. What would the price of the bond be one year from now if the
implied forward rates stay the same?
A. $995.63
B. $1,108.88
C. $1,000.00
D. $1,042.78
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
48. Given the bond described above, if interest were paid semi-annually (rather than
annually), and the bond continued to be priced at $917.99, the resulting effective annual yield
to maturity would be:
A. Less than 10%
B. More than 10%
C. 10%
D. Cannot be determined
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-44
Chapter 15 - The Term Structure of Interest Rates
49. 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. $894.21
E. $871.80
$1,000/[(1.055)(1.06)] = $894.21
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
50. What would the yield to maturity be on a four-year zero coupon bond purchased today?
A. 5.75%
B. 6.30%
C. 5.65%
D. 5.25%
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-45
Chapter 15 - The Term Structure of Interest Rates
51. Calculate the price at the beginning of year 1 of an 8% annual coupon bond with face
value $1,000 and 5 years to maturity.
A. $1,105.47
B. $1,131.91
C. $1,084.25
D. $1,150.01
E. $719.75
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
52. Given the yield on a 3 year zero-coupon bond is 7% and forward rates of 6% in year 1 and
6.5% in year 2, what must be the forward rate in year 3?
A. 7.2%
B. 8.6%
C. 8.5%
D. 6.9%
E. None of these is correct.
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-46
Chapter 15 - The Term Structure of Interest Rates
53. What should the purchase price of a 1-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $966.37
B. $912.87
C. $950.21
D. $956.02
E. $945.51
$1,000/(1.046) = $956.02
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
54. What should the purchase price of a 2-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $966.87
B. $911.37
C. $950.21
D. $956.02
E. $945.51
$1,000/[(1.046)(1.049)] = $911.37
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
15-47
Chapter 15 - The Term Structure of Interest Rates
55. What should the purchase price of a 3-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $887.42
B. $871.12
C. $879.54
D. $856.02
E. $866.32
$1,000/[(1.046)(1.049)(1.052)] = $866.32
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
56. What should the purchase price of a 4-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $887.42
B. $821.15
C. $879.54
D. $856.02
E. $866.32
$1,000/[(1.046)(1.049)(1.052)(1.055)] = $821.15
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
15-48
Chapter 15 - The Term Structure of Interest Rates
57. What should the purchase price of a 5-year zero coupon bond be if it is purchased today
and has face value of $1,000?
A. $776.14
B. $721.15
C. $779.54
D. $756.02
E. $766.32
$1,000/[(1.046)(1.049)(1.052)(1.055)(1.058)] = $776.14
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-49
Chapter 15 - The Term Structure of Interest Rates
[(1.046)(1.049)(1.052)(1.055)(1.058)]1/5 − 1 = 5.2%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
[(1.046)(1.049)(1.052)(1.055)]1/4 − 1 = 5.05%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
[(1.046)(1.049)(1.052)]1/3 − 1 = 4.9%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
15-50
Chapter 15 - The Term Structure of Interest Rates
[(1.046)(1.049)]1/2 − 1 = 4.7%
AACSB: Analytic
Bloom's: Apply
Difficulty: Intermediate
Topic: Term structure of interest rates
63. Discuss the theories of the term structure of interest rates. Include in your discussion the
differences in the theories, and the advantages/disadvantages of each.
The expectations hypothesis is the most commonly accepted theory of term structure. The
theory states that the forward rate equals the market consensus expectation of future short-
term rates. Thus, yield to maturity is determined solely by current and expected future one-
period interest rates. An upward sloping, or normal, yield curve would indicate that investors
anticipate an increase in interest rates. An inverted, or downward sloping, yield curve would
indicate an expectation of decreased interest rates. A horizontal yield curve would indicate an
expectation of no interest rate changes.
The liquidity preference theory of term structure maintains that investors prefer to be liquid to
illiquid, all else equal, and will demand a liquidity premium in order to go long term. Thus,
liquidity preference readily explains the upward sloping, or normal, yield curve. However,
liquidity preference does not readily explain other yield curve shapes.
Feedback: The purpose of this question is to ascertain that students understand the various
explanations (and deficiencies of these explanations) of term structure.
15-51
Chapter 15 - The Term Structure of Interest Rates
64. Term structure of interest rates is the relationship between what variables? What is
assumed about other variables? How is term structure of interest rates depicted graphically?
Term structure of interest rates is the relationship between yield to maturity and term to
maturity, all else equal. The "all else equal" refers to risk class. Term structure of interest rates
is depicted graphically by the yield curve, which is usually a graph of U. S. Treasuries of
different yields and different terms to maturity. The use of U. S. Treasuries allows one to
examine the relationship between yield and maturity, holding risk constant. The yield curve
depicts this relationship at one point in time only.
Feedback: This question is designed to ascertain that students understand the relationships
involved in term structure, the restrictions on the relationships, and how the relationships are
depicted graphically.
65. Although the expectations of increases in future interest rates can result in an upward
sloping yield curve; an upward sloping yield curve does not in and of itself imply the
expectations of higher future interest rates. Explain.
The effects of possible liquidity premiums confound any simple attempt to extract expectation
from the term structure. That is, the upward sloping yield curve may be due to expectations of
interest rate increases, or due to the requirement of a liquidity premium, or both. The liquidity
premium could more than offset expectations of decreased interest rates, and an upward
sloping yield would result.
Feedback: The purpose of this question is to assure that the student understands the
confounding of the liquidity premium with the expectations hypothesis, and that the
interpretations of term structure are not clear-cut.
15-52
Chapter 15 - The Term Structure of Interest Rates
66. Explain what the following terms mean: spot rate, short rate, and forward rate. Which of
these is (are) observable today?
The n-period spot rate is the yield to maturity on a zero-coupon bond with a maturity of n
periods. The short rate for period n is the one-period interest rate that will prevail in period n.
The forward rate for period n is the short rate that would satisfy a "break-even condition"
equating the total returns on two n-period investment strategies. The first strategy is an
investment in an n-period zero-coupon bond. The second is an investment in an n-1 period
zero-coupon bond "rolled over" into an investment in a one-period zero. Spot rates and
forward rates are observable today, but because interest rates evolve with uncertainty, future
short rates are not.
Feedback: This question checks whether the student understands the difference between each
kind of rate.
AACSB: Analytic
Bloom's: Understand
Difficulty: Intermediate
Topic: Term structure of interest rates
15-53
Chapter 15 - The Term Structure of Interest Rates
Feedback: This questions tests the students understanding of the relationship between the
prices of zero-coupon bonds and the yield curve.
AACSB: Analytic
Bloom's: Apply
Difficulty: Challenge
Topic: Term structure of interest rates
15-54