Solved MCQs
Term Structure Of Interest Rate
1. The term structure of interest rates is:
A) The relationship between the rates of interest on all securities.
B) The relationship between the interest rate on a security and its time to maturity.
C) The relationship between the yield on a bond and its default rate.
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D) All of the above.
E) None of the above.
Rationale: The term structure of interest rates is the relationship between two variables, years and yield to maturity (holding all else constant).
2. The yield curve shows at any point in time:
A) The relationship between the yield on a bond and the duration of the bond.
B) The relationship between the coupon rate on a bond and time to maturity of the bond.
C) The relationship between yield on a bond and the time to maturity on the bond.
D) All of the above.
E) None of the above.
3. An inverted yield curve implies that:
A) Long-term interest rates are lower than short-term interest rates.
B) Long-term interest rates are higher than short-term interest rates.
C) Long-term interest rates are the same as short-term interest rates.
D) Intermediate term interest rates are higher than either short- or long-term interest rates.
E) none of the above.
Rationale: The inverted, or downward sloping, yield curve is one in which short-term rates are higher than long-term rates. The inverted yield curve has been observed frequently, although not as frequently as the upward sloping, or normal, yield curve.
4. An upward sloping yield curve is a(n) _______ yield curve.
A) normal.
B) humped.
C) inverted.
D) flat.
E) none of the above.
Rationale: The upward sloping yield curve is referred to as the normal yield curve, probably because, historically, the upward sloping yield curve is the shape that has been observed most frequently.
5. According to the expectations hypothesis, a normal yield curve implies that
A) interest rates are expected to remain stable in the future.
B) interest rates are expected to decline in the future.
C) interest rates are expected to increase in the future.
D) interest rates are expected to decline first, then increase.
E) interest rates are expected to increase first, then decrease.
Rationale: An upward sloping yield curve is based on the expectation that short-term interest rates will increase.
6. Which of the following is not proposed as an explanation for the term structure of interest rates:
A) The expectations theory.
B) The liquidity preference theory.
C) The market segmentation theory.
D) Modern portfolio theory.
E) A, B, and C.
Rationale: A, B, and C are all theories that have been proposed to explain the term structure.
7. The expectations theory of the term structure of interest rates states that
A) forward rates are determined by investors' expectations of future interest rates.
B) forward rates exceed the expected future interest rates.
C) yields on long- and short-maturity bonds are determined by the supply and demand for the securities.
D) all of the above.
E) none of the above.
Rationale: The forward rate equals the market consensus expectation of future short interest rates.
8. Which of the following theories state that the shape of the yield curve is essentially determined by the supply and demands for long-and short-maturity bonds?
A) Liquidity preference theory.
B) Expectations theory.
C) Market segmentation theory.
D) All of the above.
E) None of the above.
Rationale: Market segmentation theory states that the markets for different maturities are separate markets, and that interest rates at the different maturities are determined by the intersection of the respective supply and demand curves.
9. If forward rates are known with certainty and all bonds are fairly priced
A) all bonds would have the same yield to maturity.
B) all short-maturity bonds would have lower prices than all long-maturity bonds.
C) all bonds would have the same price.
D) all bonds would provide equal 1-year rates of return.
E) none of the above.
Rationale: In a world of perfect certainty, all bond must offer equal rates of return over any holding period; otherwise, at least one bond would be dominated by the others in that this bond would offer a lower rate of return than would combinations of other bonds. No one would be willing to hold this bond, and the price of the bond would decline .
10. According to the "liquidity preference" theory of the term structure of interest rates, the yield curve usually should be:
A) inverted.
B) normal.
C) upward sloping.
D) A and B.
E) B and C.
Rationale: According to the liquidity preference theory, investors would prefer to be liquid rather than illiquid. In order to accept a more illiquid investment, investors require a liquidity premium and the normal, or upward sloping, yield curve results.
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Use the following to answer questions 11-14:
Suppose that all investors expect that interest rates for the 4 years will be as follows:
| Year | Forward Interest Rate |
| 0 | (today)5% |
| 1 | 7% |
| 2 | 9% |
| 3 | 10% |
11. What is the price of 3-year zero coupon bond with a par value of $1,000?
A) $863.83
B) $816.58
C) $772.18
D) $765.55
E) none of the above
Rationale: $1,000 / (1.05)(1.07)(1.09) = $816.58
12. 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) 7%
C) 9%
D) 10%
E) none of the above
Rationale: The forward interest rate given for the first year of the investment is given as 5% (see table above).
13. What is the price of a 2-year maturity bond with a 10% coupon rate paid annually? (Par value = $1,000)
A) $1,092.97
B) $1,054.24
C) $1,000.00
D) $1,073.34
E) none of the above
Rationale: [(1.05)(1.07)]1/2 - 1 = 6%; FV = 1000, n = 2, PMT = 100, i = 6, PV = $1,073.34
14. What is the yield to maturity of a 3-year zero coupon bond?
A) 7.00%
B) 9.00%
C) 6.99%
D) 7.49%
E) none of the above
Rationale: [(1.05)(1.07)(1.09)]1/3 - 1 = 6.99.
Use the following to answer questions 15-18:
The following is a list of prices for zero coupon bonds with different maturities and par value of $1,000.
| Maturity (Years) | Price |
| 1 | $943.40 |
| 2 | $881.68 |
| 3 | $808.88 |
| 4 | $742.09 |
15. What is, according to the expectations theory, the expected forward rate in the third year?
A) 7.00%
B) 7.33%
C) 9.00%
D) 11.19%
E) none of the above
Rationale: 881.68 / 808.88 - 1 = 9%
16. What is the yield to maturity on a 3-year zero coupon bond?
A) 6.37%
B) 9.00%
C) 7.33%
D) 10.00%
E) none of the above
Rationale: (1000 / 808.81)1/3 -1 = 7.33%
17. What is the price of a 4-year maturity bond with a 12% coupon rate paid annually? (Par value = $1,000)
A) $742.09
B) $1,222.09
C) $1,000.00
D) $1,141.92
E) none of the above
Rationale: (1000 / 742.09)1/4 -1 = 7.74%; FV = 1000, PMT = 120, n = 4, i = 7.74, PV = $1,141.92
18. You have purchased a 4-year maturity bond with a 10% 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) $808.88
B) $1,108.88
C) $1,000
D) $1,042.78
E) none of the above
Rationale: (943.40 / 742.09)]1/3 - 1.0 = 8.33%; FV = 1000, PMT = 100, n = 3, i = 8.33, PV = $1,042.78
19. The market segmentation theory of the term structure of interest rates
A) theoretically can explain all shapes of yield curves.
B) definitely holds in the "real world".
C) assumes that markets for different maturities are separate markets.
D) A and B.
E) A and C.
Rationale: Although this theory is quite tidy theoretically, both investors and borrows will depart from their "preferred maturity habitats" if yields on alternative maturities are attractive enough.
20. Given the following pattern of forward rates:
| Year | Forward Rate |
| 1 | 5% |
| 2 | 6% |
| 3 | 6.5% |
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) 8%
C) 9%
D) 5%
E) none of the above
Rationale: $1,000 / (1.06)(1.065) = $885.82 (selling price); $1,000 / (1.05)(1.06)(1.065) = $843.64 (purchase price); ($885.82 - $843.64) / $843.64 = 5%.
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Umeed
MBA 3rd Sem
