Question1: Suppose the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3% next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information, which of the following statements is CORRECT?
[A] A 5-year corporate bond will have a lower yield than a seven year Treasury security.
[B] The real risk-free rate cannot be constant if inflation is not expected to remain constant.
[C] This problem's assumption of a zero maturity risk premium is probably not valid in the real world.
[D] The yield curve for U.S. Treasury securities will be upward sloping.
[E] A 5-year corporate bond will have a lower yield than a 5-year Treasury security.
Question2: Suppose that the rate on a 1-year bond is now 6%, but all investors in the market expect 1-year rates to be 7 percent one year from now and then to rise to 8 percent two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT?
[A] The interest rate today on a 2-year bond would be 7 percent.
[B] The interest rate today on a 3-year bond would be 7 percent.
[C] The interest rate today on a 3-year bond would be 8 percent.
[D] The yield curve would be downward sloping, with the rate on a 1-year bond at 6 percent.
[E] The interest rate today on a 2-year bond would be 6 percent.
Question3: Inflation is expected to increase steadily over the next ten years, there is a positive maturity risk premium on both Treasury and corporate bonds, and the real risk-free rate of interest is expected to remain constant. Which of the following statements is CORRECT?
[A] The yield on 7-year corporate bonds must exceed the yield on 10-year Treasury bonds.
[B] The stated conditions cannot all be true they are internally inconsistent.
[C] The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.
[D] The yield on 10-year Treasury securities must exceed the yield on 7-year Treasury securities.
[E] The yield on all corporate bonds must exceed the yields on all Treasury bonds.
Question4: You read in The Wall Street Journal that thirty day T-bills are currently yielding 8 percent. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:
[A] Maturity risk premium 2%
[B] Default risk premium 2%
[C] Inflation premium 5%
[D] Liquidity premium 1%
Question5: Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. On the basis of these data, determine the real risk-free rate of return
[A] 4%
[B] 0%
[C] 1%
[D] 2%
[E] 3%