Question 1

Which one of the following rates represents the change, if any, in your purchasing power as a result of owning a bond?

Accepted Answer

The real rate represents the change in purchasing power as it takes into account the inflation rate. Owning a bond may provide a nominal rate of return, but if inflation is higher, the real rate of return may be negative, resulting in a decrease in purchasing power. The risk-free rate and realized rate may not necessarily reflect changes in purchasing power, and the current rate may refer to different rates depending on the context.

Question 2

Which bond would you generally expect to have the highest yield?

Accepted Answer

Generally, the higher the risk associated with a bond, the higher the yield that bond will offer. Junk bonds are considered higher risk and therefore offer higher yields compared to other types of bonds. Long-term and taxable nature of the bond also contribute to higher yield.

Question 3

You are trying to compare the present values of two separate streams of cash flows that have equivalent risks. One stream is expressed in nominal values and the other stream is expressed in real values. You decide to discount the nominal cash flows using a nominal annual rate of 8 percent. What rate should you use to discount the real cash flows?

Accepted Answer

To compare the present values of two cash flows with equivalent risks, they both should be discounted at a comparable rate. The comparable rate for the real cash flows is the real rate, and thus the answer is D. Option A is incorrect as it would assume that inflation is zero, which is not realistic. Option B is incorrect as it would be used to calculate the effective annual rate for periodic compounding, but it is not relevant when comparing real and nominal cash flows. Option C is incorrect as it does not account for inflation, and the risk-free rate is typically a nominal rate. Option E is incorrect as it would only adjust for the risk premium and not the inflation component.

Question 4

The taxability risk premium compensates bondholders for which one of the following?

Accepted Answer

The taxability risk premium compensates bondholders for a bond's unfavorable tax status, as it accounts for the additional taxes investors might have to pay on the bond's earnings compared to a tax-exempt municipal bond.

Question 5

The 7 percent bonds issued by Modern Kitchens pay interest semiannually, mature in eight years, and have a $1,000 face value. Currently, the bonds sell for $987. What is the yield to maturity?

Accepted Answer

The answer of The 7 percent bonds issued by Modern...

Question 6

Which one of the following premiums is compensation for the possibility that a bond issuer may not pay a bond's interest or principal payments as expected?

Accepted Answer

Default risk premium compensates investors for the possibility that the issuer may default on interest or principal payments, thereby not fulfilling their obligations towards the bondholders.

Question 7

A Treasury yield curve plots Treasury interest rates relative to:

Accepted Answer

The Treasury yield curve plots Treasury interest rates relative to time to maturity. It shows the yields on U.S. government debt securities with different maturities ranging from 1 month to 30 years. The yield curve is an important tool for understanding the overall state of the economy and has implications for various financial decisions.

Question 8

The Fisher effect is defined as the relationship between which of the following variables?

Accepted Answer

The Fisher effect describes the relationship between real rates (adjusted for inflation), inflation rates, and nominal rates. Therefore, the correct choice is (D), which includes these three variables. The other options include some combination of other premiums or risks but do not include both real rates and inflation rates.

Question 9

Interest rates that include an inflation premium are referred to as:

Accepted Answer

Nominal rates include an inflation premium, reflecting the total amount of interest paid including the effect of inflation, unlike real rates which are adjusted to remove the effects of inflation.

Question 10

Real rates are defined as nominal rates that have been adjusted for which of the following?

Accepted Answer

Real rates are nominal rates adjusted for inflation. This adjustment reflects the actual purchasing power of the money borrowed or invested.

Question 11

The interest rate risk premium is the:

Accepted Answer

The interest rate risk premium is the compensation that investors demand for accepting interest rate risk. This is because changes in interest rates can affect the value of existing bonds, and investors need to be compensated for the risk of these fluctuations.

Question 12

A six-year, $1,000 face value bond issued by Taylor Tools pays interest semiannually on February 1 and August 1. Assume today is October 1. What will be the difference, if any, between this bond's clean and dirty prices today?

Accepted Answer

Since the last interest payment was made on August 1, the bond has accrued interest for two months (August and September), which the buyer would have to pay the seller if they purchased the bond on October 1 (i.e. the buyer would pay the seller the dirty price, which includes accrued interest). Therefore, the difference between the clean price (without accrued interest) and the dirty price (with accrued interest) would be two months' interest.

Question 13

Which one of the following risk premiums compensates for the inability to easily resell a bond prior to maturity?

Accepted Answer

Liquidity premium compensates investors for the risk that they may not be able to quickly sell the bond if they need to raise funds prior to maturity. This may result in a lower price when selling the bond, or in extreme cases, a complete inability to sell the bond. Default risk compensates investors for the risk that the borrower will not pay back the bond, taxability compensates for tax liability, inflation risk compensates for the risk that inflation will lower the bond's purchasing power, and interest rate risk compensates for the risk of changes in interest rates affecting the value of the bond.

Question 14

Which one of the following statements is false concerning the term structure of interest rates?

Accepted Answer

The statement that the term structure of interest rates and the time to maturity are always directly related is false. In reality, the relationship between the two can vary based on various economic factors and market conditions.

Question 15

The pure time value of money is known as the:

Accepted Answer

The term structure of interest rates reflects the pure time value of money, showing the relationship between interest rates and different maturities, independent of other factors like inflation or risk.

Question 16

The yields on a corporate bond differ from those on a comparable Treasury security primarily because of:

Accepted Answer

Corporate bonds typically offer higher yields than comparable Treasury securities primarily due to the additional risks they carry, including the risk of default (the issuer failing to make interest or principal payments) and the impact of taxes. Treasury securities are considered virtually risk-free in terms of default, as they are backed by the full faith and credit of the U.S. government, and their interest income is exempt from state and local taxes.

Question 17

The Fisher effect primarily emphasizes the effects of ________ on an investor's rate of return.

Accepted Answer

The Fisher effect primarily emphasizes the effects of inflation on an investor's rate of return, illustrating how inflation affects real and nominal interest rates.

Question 18

Today, June 15, you want to buy a bond with a quoted price of 98.64. The bond pays interest on January 1 and July 1. Which one of the following prices represents your total cost of purchasing this bond today?

Accepted Answer

The total cost of the bond includes the quoted price plus accrued interest, which is the interest that has accumulated since the last interest payment date. The dirty price includes this accrued interest, whereas the clean price does not. The asked price and bid price refer to the prices at which someone is willing to sell or buy the bond, respectively, and may not be relevant to the total cost of purchasing the bond.

Question 19

Which one of the following statements is correct?

Accepted Answer

The real rate of interest is adjusted for inflation, meaning it subtracts the inflation rate from the nominal (or stated) interest rate. If there is positive inflation, the real interest rate will indeed be less than the nominal rate, as inflation erodes the purchasing power of the money.

Question 20

U. S. Treasury bonds:

Accepted Answer

U.S. Treasury bonds are quoted as a percentage of their par (or face) value. This is a standard practice in the bond market, where the price of a bond is typically expressed as a percentage of its 100 par value.

Quiz 7: Interest Rates and Bond Valuation