1. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 6.00% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

a.0.85% b.0.97% c.1.15% d.1.00% e.0.82%

Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.50% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? Here we assume that the pure expectations theory is NOT valid. Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

a.2.50 b.1.90 c.2.15 d.3.05 e.2.60

Assume 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.The real risk-free rate cannot be constant if inflation is not expected to remain constant.

b.The yield curve for U.S. Treasury securities will be upward sloping.

c.A 5-year corporate bond must have a lower yield than a 7-year Treasury security.

d.A 5-year corporate bond must have a lower yield than a 5-year Treasury security.

e.This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.

Crockett Corporation's 5-year bonds yield 6.35%, and 5-year T-bonds yield 4.45%. The real risk-free rate is r* = 2.80%, the default risk premium for Crockett's bonds is DRP = 1.00% versus zero for T-bonds, the liquidity premium on Crockett's bonds is LP = 0.90% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1)0.1%, where t = number of years to maturity. What inflation premium (IP) is built into 5-year bond yields?

a.1.40% b.1.10% c.1.11% d.1.25% e.1.33%

Kay Corporation's 5-year bonds yield 5.90% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1)0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds?

a.0.25% b.0.17% c.0.20% d.0.23% e.0.19%

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.65%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is thedefault risk premiumon corporate bonds?

a.0.86% b.1.34% c.1.20% d.1.22% e.1.10%

Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.20% per year to maturity applies, i.e., MRP = 0.20%(t), where t is the number of years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 2.70% applies to A-rated corporate bonds. What is the difference in the yields on a 5-year A-rated corporate bond and on a 10-year Treasury bond? Here we assume that the pure expectations theory is NOT valid, and disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

a.1.91 b.2.20 c.2.27 d.2.13 e.1.78

The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT?

a.The conditions in the problem cannot all be true--they are internally inconsistent.

b.The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.

c.The yield on a 2-year T-bond must exceed that on a 5-year T-bond

d.The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.

e.The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope.

Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years. Both bonds promise to pay a semiannual coupon, they are not callable or corvertible, and they are equally liquid. Further assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the following statements is CORRECT?

a.If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as Long's bonds.

b.If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a higher yield than Short's bonds.

c.If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal.

d.If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds must under all conditions have a lower yield than Long's bonds.

e.If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.