12. Assume that the yield curve is initially flat at 5% per annum. In particular, the one-year and two-year spot rates are both 5% per annum (i.e. ??₁ = 5% and ??₂ = 5%). Now assume that an announcement has just been made by the Reserve Bank of Australia such that interest rates are expected to increase by 1% in one years time. Assuming annual compounding and that the Pure Expectations Hypothesis holds, which statement below is incorrect?

A. After the announcement, investors will sell long bonds and buy short bonds and the yield curve will become upward sloping.

B. Before the announcement by the RBA,(1 + ??₁)(1.05) = (1 + ??₂)²

C. After the announcement by the RBA, (1 + ??₁)(1.06) = (1 + ??₂)²

D. After the announcement, investors will sell long bonds and buy short bonds because investors have relatively long investment horizons.

E. In one years time, investors will sell long bonds and buy short bonds.

13. What is the price of an Australian 180-day bill with a face value of $100 when the interest rate is 7% p.a. nominal and it is assumed that there are 365 days in a year?

A. 96.66

B. 96.62

C. 96.72

D. 98.32

E. None of the above

14. A 6% coupon bond paying interest semi-annually has a modified duration of 9, sells for $1000, and is priced at a yield to maturity (YTM) of 6%. If the YTM decreases to 4%, the price, using the concept of duration, is predicted to

A. decrease by $80

B. increase by $80

C. decrease by $180

D. increase by $180

E. increase by $90

15. Consider a 5-year zero-coupon bond with a face value of 100. The 5-year spot rate is 6% p.a. nominal. Assume that dollar duration, Macaulay Duration and Modified Duration are expressed as positive numbers. Assuming semi-annual compounding and based on the concept of duration, which statement below is incorrect?

A. The bond has dollar duration of 361.21.

B. The bond has a modified duration of 10 years.

C. The bond will increase in value by 4.85% if the yield curve shifts downwards by 100 basis points at all maturities.

D. The bond will increase in value by 722.42 cents if the yield curve shifts downwards by 200 basis points at all maturities.

E. The bond has Macaulay duration of 5 years.

16. Suppose that the liquidity premium hypothesis holds. Which of the following statements are correct?

i. Investors are assumed to be risk-averse.

ii. The liquidity premium for a 10-year government bond is higher than the liquidity premium for a 10-year BB rated corporate bond.

iii. Investing in a two-year zero coupon bond may give a lower rate of return than investing in a one year zero coupon bond and then investing in a one year zero coupon bond in one years time if interest rates in one years time increase.

iv. Forward rates calculated assuming that the liquidity premium hypothesis is true, are the same as the forward rates calculated assuming that the pure expectations hypothesis is true.

The correct answers are:

A. (i) only

B. (i) & (iii)

C. (i) & (iii) & (iv)

D. (i) & (ii)

E. (iv) only