Chapter 2: Interest Rates

1. When the T-bond market becomes more liquid, other things equal, the demand curve for corporate
bonds shifts to the … and the demand curve for T-bond shifts to the ...?
a. Right, left
b. Right, right
c. Left, left
d. Left, right

2. The risk premium on corporate bonds become smaller if:

a. The riskiness of corporate bonds increases
b. The riskiness of corporate bonds decreases
c. The liquidity of corporate bonds increases
d. The liquidity of corporate bonds decreases
e. (a) and (d)
f. (b) and (c)
3. The interest rate on municipal bonds falls relative to the interest rate on Treasury securities when
a. income tax rates are raised
b. there is a major default in the municipal bond market
c. corporate bonds become riskier
d. municipal bonds become less widely traded
e. none of the above

4. The liquidity premium theory of the term structure

a. suggests that markets for bonds of different maturities are completely separate because people have preferred
habitats
b. indicates that today's long-term interest rate equals the average of short-term interest rates that people expect
to occur over the life of the long-term bond
c. assumes that bonds of different maturities are perfect substitutes
d. does none of the above
5. Which of the following theories of the term structure is (are) able to explain the fact that interest rates on
bonds of different maturities tend to move together over time?
a. The expectations theory
b. The segmented markets theory
c. The liquidity premium theory
d. Both (a) and (b) of the above
e. Both (a) and (c) of the above

6. Yield curves can be classified as

a. downward sloping
b. upward sloping
c. Flat
d. all of the above
e. only (a) and (b) of the above
7. Factors that influence interest rates on bonds include
a. Term to maturity
b. Risk
c. Liquidity
d. Tax considerations
e. All of the above

8. An inverted yield curve implies that:

a. Long-term interest rates are lower than short-term interest rates.
b. Long-term interest rates are higher than short-term interest rates.
c. Long-term interest rates are the same as short-term interest rates.
d. Intermediate term interest rates are higher than either short- or long-
term interest rates.
e. none of the above.
9. According to the expectations hypothesis, a normal 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

10. Which of the following theories state that the shape of the yield curve is essentially determ ined by the
supply and demands for long-and short-maturity bonds?
a. Liquidity preference theory
b. Expectations theory

c. Market segmentation theory.

d. All of the above.

e. None of the above.

1. The 1-year spot rate is 9%. The 2-year spot rate (on US T-Bonds) is 9.5% p.a. and the 3-year spot rate is
10% p.a.

(a) Calculate the implied one year ahead, 1-year forward rate, f12. Explain why a 1-year forward rate of 9.6%
would not be expected to prevail in the market.

(b) Calculate the forward rates f23 and f13. Is there any link between f12, f23 and f13?

2. If the expectations hypothesis (EH) holds, why might the yield curve be:

(a) flat

(b) upward sloping

(c) downward sloping

What might cause a parallel shift in the yield curve? The government implements a credible
‘tight’ monetary policy by raising short-term (e.g. 3-month) interest rates. Why might this result in a downward
sloping yield curve?
3. Quoted spot rate are as follows:
Year Spot rate (%)
1 r1 = 5.00
2 r2 = 5.40
3 r3 = 5.70
4 r4 = 5.90
5 r5 = 6.00
(a) What are the discount factors for each date - that is, the value today of $1 paid in year t?
(b) Calculate the PV and hence the fair price of the following ‘Treasury Notes’ (i.e. coupon bonds) all of
which have a $1,000 par value.
(i) 5% coupon, 2-year Note
(ii) 5% coupon, 5-year Note
(iii) 10% coupon, 5-year Note
(c) What are the one year forward rates applicable between
(i) year 1 and year 2
(ii) year 2 and year 3
4. Suppose that you expect the one-period interest rate between 5 and 6 years into the future to be
10%, and that you observe that the price of zero-coupon bonds with 5 and 6 years to maturity to
be $73.50 and $70, respectively. (The face value of the bonds is $100.) Design a strategy for
trading in these bonds which would yield a positive expected return at the end of 6 years. What
considerations would determine whether you undertake the strategy and, if you do, on what
scale?
5. Consider a consol that pays $50 every year with the first payment occurring twelve months
from now and suppose that its yield is 3.5%.
a. Compute the price of this consol bond today
b. If instead of annual payments of $50, the consol bond pays $25 semiannually with the
first payment occurring six months from now, what is its price today?
Now, imagine that, instead of a consol bond, the contract has the form of an annuity that pays
$50 every year for 30 years with a 3.5% yield. The annuity’s first payment will be twelve
months from now.
c. Compute the price of this annuity today
d. If instead of annual payments of $50, the annuity pays $25 semiannually with the first
payment occurring six months from now, what is its price today?