1. 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 increase so that coupons from a bond are reinvested at a higher rate than originally expected.  

IV. If interest rates are expected to increase, an investor should consider selling long bonds and buying 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. II and IV only

2. Assume you have a portfolio comprising one zero-coupon bond with maturity of 3 years and one zero-coupon bond with a maturity of 10 years. Assuming semi-annual compounding and that both bonds have a face value of 100 and that the three-year spot rate is 3% and the 10-year spot rate is 5%, what is the modified duration of this portfolio?

A. 5.68

B. 8.729

C. 6.79

D. 7.46

E.   12.56

3. Assume that the preferred habitat theory holds and that the one-year spot rate is 4.6% per annum nominal and that the 18-month spot rate is 4.8% per annum nominal. Assuming that investors have a preferred investment horizon of 18 months and semi-annual compounding and that the expected six-month rate in one year’s time is 4.60% per annum nominal, what is the risk premium for 18 month bonds?

A. 0, as equilibrium has been achieved since the demand for 18 month bonds is correct relative to the demand for 12 month bonds

B. +0.40% as there is too little demand for 18 month bonds relative to 12 month bonds

C. -0.40%, as there is too much demand for 18 month bonds relative to 12 month bonds

D. +0.60%, as there is too little demand for 18 month bonds relative to 12 month bonds E. -0.60%, as there is too much demand for 18 month bonds relative to 12 month bonds.