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

I. The liquidity premium is always positive and increases with maturity. II. Investors are assumed to be risk-averse.

III. Investing in a two year zero coupon bond will give a higher rate of return than investing in a one year zero coupon bond and at the same time buying an FRA to lock in an investment rate for the one year period beginning in one years time.

IV. Investing in long bonds and selling before maturity may result in a high holding period yield as the ytm at purchase will be relatively high due to the high liquidity premium while the ytm at sale will be relatively low due to a relatively low liquidity premium.

The correct answers are:

A. I only

B. II only

C. II and III

D. I and II and IV

E. All of the above

17. Assume you have a portfolio comprising one zero-coupon bond with maturity of 5 years and one zero-coupon bond with a maturity of 20 years. Assuming semi-annual compounding and that both bonds have a face value of 100 and that the five-year spot rate is 3% and the 20year spot rate is 6%, what is the modified duration of this portfolio?

A. 11.174

B. 12.5

C. 10.692

D. 8.575

E. 8.729

18. Which of the following are correct?

I. If expected inflation increases, investors will sell bonds as the real value of their investment will fall and bond yields should fall.

II. If the risk of default on a bond issued by a company decreases, the yield to maturity for that bond should decrease.

III. Reinvestment risk occurs when interest rates decrease so that coupons from a bond are reinvested at a lower rate than originally expected.

IV. If interest rates are expected to increase, an investor should consider buying long bonds and selling short bonds to decrease portfolio duration. The correct answer is

A. I and II only

B. III and IV only

C. II and III only

D. All except IV

E. All of the above

19. Assuming the preferred habitat theory holds, which of the following statements are correct?

i. If the risk premium is negative, then the corresponding forward rate is too low and borrowers should try to lock in that forward rate before it increases. ii. A forward rate is equal to an expected future spot rate plus a risk premium that may be positive, negative or zero. iii. If the risk premium is positive, then the corresponding forward rate is too high and investors should try to lock in that forward rate before it falls. iv. If the risk premium is negative, then the corresponding forward rate is too low and investors should try to lock in that forward rate before it increases.

A. (i) & (ii)

B. (i) & (ii) & (iii)

C. (ii) & (iv)

D. (iii) & (iv)

E. (ii) & (iii) & (iv)