32. The yield curve

A) is a graphical depiction of term structure of interest rates.

B) is usually depicted for U. S. Treasuries in order to hold risk constant across maturities and yields.

C) is usually depicted for corporate bonds of different ratings.

D) A and B.

E) A and C.

Answer: D Difficulty: Easy

Rationale: 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.

Use the following to answer questions 33-36:

Year	1-Year Forward Rate
1	5.8%
2	6.4%
3	7.1%
4	7.3%
5	7.4%

33. 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

Answer: A Difficulty: Difficult

Rationale: $1,000 / [(1.064)(1.071)] = $877.54

34. 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 the above.

Answer: C Difficulty: Moderate

Rationale: [(1.058) (1.064) (1.071) (1.073)]^1/4 - 1 = 6.65%

35. 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) $1,105.47

B) $1,131.91

C) $1,177.89

D) $1,150.01

E) $719.75

Answer: B Difficulty: Difficult

Rationale: i = [(1.058) (1.064) (1.071) (1.073) (1.074)]^1/5 - 1 = 6.8%; FV = 1000, PMT = 100, n = 5, i = 6.8, PV = $1,131.91

36. What should be the holding period return of a 9% annual coupon bond with face value $1000 and five years to maturity if it is purchased at the beginning of year 1 and sold at the beginning of year 2, assuming that rates do not change.

A) 6.0%

B) 7.1%

C) 6.8%

D) 7.4%

E) none of the above.

Answer: A Difficulty: Difficult

Rationale: Using the information in 15.36, P0 = $1,131.91; i = [(1.064) (1.071) (1.073) (1.074)]^1/4 - 1 = 7.05%; FV = 1000, PMT = 100, n = 4, i = 7.05, PV = $1,099.81; HPR = (1099.81 - 1131.91 + 100) / 1131.91 = 6%.

37. 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) 7.2%

B) 8.6%

C) 6.1%

D) 6.9%

E) none of the above.

Answer: B Difficulty: Moderate

Rationale: f3 = (1.072)³ / [(1.061) (1.069)] - 1 = 8.6%

38. Consider two annual coupon bonds, each with two years to maturity. Bond A has a 7% coupon and a price of $1000.62. Bond B has a 10% coupon and sells for $1,055.12. Find the two one-period forward rates that must hold for these bonds.

A) 6.97%, 6.95%

B) 6.95%, 6.95%

C) 6.97%, 6.97%

D) 6.08%, 7.92%

E) 7.00%, 10.00%

Answer: D Difficulty: Difficult

Rationale: 1000.62 = d1 X 70 + d2 X 1070;

1055.12 = d1 X 100 + d2 X 1100;

2620.36 = 3000 d2;

d2 = .8735; d1 = .9427; r1 = 6.08%; r2 = 7.92%.

39. An inverted yield curve is one

A) with a hump in the middle.

B) constructed by using convertible bonds.

C) that is relatively flat.

D) that plots the inverse relationship between bond prices and bond yields.

E) that slopes downward.

Answer: E Difficulty: Easy

Rationale: An inverted yield curve occurs when short-term rates are higher than long-term rates.

40. Assuming the forecasts implicit in a yield curve come to pass, an inverted yield curve would be most favorable for

A) short-term borrowers.

B) long-term borrowers.

C) short-term lenders.

D) long-term lenders.

E) nobody - Neither a borrower nor a lender be.

Answer: D Difficulty: Difficult

Rationale: Short-term borrowers would face high interest rates. Long-term borrowers would lock in a higher rate than necessary. Short-term lenders would earn a high rate initially, but later would earn lower rates. Long-term lenders would lock in higher interest rates than they could in the future. Note: If lower rates occur later, some of the long-term borrowers may choose to prepay their loans.

41. Investors can use publicly available financial date to determine which of the following?

1. the shape of the yield curve

2. future short-term rates

3. the direction the Dow indexes are heading

4. 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

Answer: A Difficulty: Moderate

Rationale: 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.

42. Which of the following is a reason that bond prices do not conform exactly to the present value of the bond's cash flows?

1. A call feature affects the bond's price.

2. After-tax cash flows may be different for different investors.

3. The IRS may impute a “built-in” interest payment.

4. Some investors might choose to sell the bond before its maturity date.

A) I and II

B) I, II, and III

C) I and IV

D) I, II, and IV

E) I, II, III and IV

Answer: E Difficulty: Moderate

Rationale: All of the items listed can affect the actual cash flows. It is not possible to know for sure whether a bond will be called, so cash flows after the call date may or may not be relevant. Investors have different tax brackets and situations and will therefore have different after-tax cash flows. Imputed interest income will apply to zero-coupon or OID bonds. And investors may choose different holding periods, for example, they may evaluate tax-timing options and make decisions based on tax consequences.

43. A liquidity premium

A) compensates long-term investors for the uncertainty about future selling prices.

B) compensates short-term investors for the uncertainty about future selling prices.

C) compensates long-term investors for the lack of liquidity in bond markets.

D) compensates short-term investors for the lack of liquidity in bond markets.

E) is almost never observed in the markets.

Answer: B Difficulty: Easy

Rationale: This definition is given in the section 15.2 of the text, on page 496.

44. The Liquidity Preference Theory states that

A) stocks are preferred to bonds because they are generally more liquid.

B) treasury Bonds are preferred to corporate bonds because they are more liquid.

C) the liquidity premium is expected to be positive because short-term investors dominate the market.

D) bonds of large corporations are preferred because they have the highest liquidity.

E) liquidity premiums can be measured precisely.

Answer: C Difficulty: Moderate

Rationale: Short-term investors are not willing to hold long-term bonds unless they are compensated with a positive liquidity premium. The normal upward-sloping yield curve implies that f₂ - E(r₂), the liquidity premium, is expected to be positive.

45. Which of the following combinations will result in a sharply increasing yield curve?

A) increasing expected short rates and increasing liquidity premiums

B) decreasing expected short rates and increasing liquidity premiums

C) increasing expected short rates and decreasing liquidity premiums

D) increasing expected short rates and constant liquidity premiums

E) constant expected short rates and increasing liquidity premiums

Answer: A Difficulty: Moderate

Rationale: Both of the forces will act to increase the slope of the yield curve. This concept is illustrated graphically in Figure 15.5 on page 500.

46. The yield curve is a component of

A) the Dow Jones Industrial Average.

B) the consumer price index.

C) the index of leading economic indicators.

D) the producer price index.

E) the inflation index.

Answer: C Difficulty: Easy

Rationale: Since the yield curve is often used to forecast the business cycle, it is used as one of the leading economic indicators.

47. The most recently issued Treasury securities are called

A) on the run.

B) off the run.

C) on the market.

D) off the market.

E) none of the above.

Answer: A Difficulty: Easy

Use the following to answer questions 48-51:

Suppose that all investors expect that interest rates for the 4 years will be as follows:

Year	Forward Interest Rate
0	(today)3%
1	4%
2	5%
3	6%

48. 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 the above

Answer: A Difficulty: Moderate

Rationale: $1,000 / (1.03)(1.04)(1.05) = $889.08

49. 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 the above

Answer: B Difficulty: Moderate

Rationale: The forward interest rate given for the first year of the investment is given as 3% (see table above).

50. 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 the above

Answer: C Difficulty: Moderate

Rationale: [(1.03)(1.04)]^1/2 - 1 = 3.5%; FV = 1000, n = 2, PMT = 50, i = 3.5, PV = $1,028.51

51. What is the yield to maturity of a 3-year zero coupon bond?

A) 7.00%

B) 9.00%

C) 6.99%

D) 4%

E) none of the above

Answer: D Difficulty: Moderate

Rationale: [(1.03)(1.04)(1.05)]^1/3 - 1 = 4%.

Use the following to answer questions 52-55:

The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000.

Maturity (Years)	Price
1	$925.16
2	$862.57
3	$788.66
4	$711.00

52. 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 the above

Answer: B Difficulty: Moderate

Rationale: 862.57 / 788.66 - 1 = 9.37%

53. What is the yield to maturity on a 3-year zero coupon bond?

A) 6.37%

B) 9.00%

C) 7.33%

D) 8.24%

E) none of the above

Answer: D Difficulty: Moderate

Rationale: (1000 / 788.66)^1/3 -1 = 8.24%

54. 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 the above

Answer: C Difficulty: Difficult

Rationale: (1000 / 711.00)^1/4 -1 = 8.9%; FV = 1000, PMT = 100, n = 4, i = 8.9, PV = $1,035.66

55. 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

D) $1,042.78

E) none of the above

Answer: A Difficulty: Difficult

Rationale: (925.16 / 711.00)]^1/3 - 1.0 = 9.17%; FV = 1000, PMT = 90, n = 3, i = 9.17, PV = $995.63

56. Given the following pattern of forward rates:

Year	Forward Rate
1	4%
2	5%
3	5.5%

If one year from now the term structure of interest rates changes so that it looks exactly the same as it does today, what would be your holding period return if you purchased a 3-year zero coupon bond today and held it for one year?

A) 6%

B) 4%

C) 3%

D) 6%

E) none of the above

Answer: B Difficulty: Difficult

Rationale: $1,000 / (1.05)(1.055) = $902.73 (selling price); $1,000 / (1.04)(1.05)(1.055) = $868.01 (purchase price); ($902.73 - $868.01) / $868.01 = 4%.

57.

Par Value	$1,000
Time to Maturity	18 years
Coupon	9% (paid annually)
Current Price	$917.99
Yield to Maturity	10%

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 the above

Answer: B Difficulty: Moderate

Rationale: FV = 1000, PV = -917.99, PMT = 45, n = 36, i = 4.995325 (semi-annual); (1.4995325)² - 1 = 10.24%.

Use the following to answer questions 58-60:

Year	1-Year Forward Rate
1	5%
2	5.5%
3	6.0%
4	6.5%
5	7.0%

58. 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

Answer: D Difficulty: Difficult

Rationale: $1,000 / [(1.055)(1.06)] = $894.21

59. 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 the above.

Answer: A Difficulty: Moderate

Rationale: [(1.05) (1.055) (1.06) (1.065)]^1/4 - 1 = 5.75%

60. 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) $1084.25

D) $1,150.01

E) $719.75

Answer: C Difficulty: Difficult

Rationale: i = [(1.05) (1.055) (1.06) (1.065) (1.07)]^1/5 - 1 = 6%; FV = 1000, PMT = 80, n = 5, i = 6, PV = $1084.25

61. 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 the above.

Answer: C Difficulty: Moderate

Rationale: f3 = (1.07)³ / [(1.06) (1.065)] - 1 = 8.5%