Assignment: Understanding Financial Markets and Institutions

Part 1: Multiple Choice Questions

1. These provide a forum in which demanders of funds raise funds by issuing new financial instruments, such as stocks and bonds.
A. investment banks
B. money markets
C. primary markets
D. secondary markets

2. In the U.S., these financial institutions arrange most primary market transactions for businesses.
A. investment banks
B. asset transformer
C. direct transfer agents
D. over-the-counter agents

3. Primary market financial instruments include stock issues from firms allowing their equity shares to be publicly traded on stock market for the first time. We usually refer to these first-time issues as which of the following?
A. initial public offerings
B. direct transfers
C. money market transfers
D. over-the-counter stocks

4. Once firms issue financial instruments in primary markets, these same stocks and bonds are then traded in which of these?
A. initial public offerings
B. direct transfers
C. secondary markets
D. over-the-counter stocks

5. These feature debt securities or instruments with maturities of one year or less.
A. money markets
B. primary markets
C. secondary markets
D. over-the-counter stocks

6. Which of the following is NOT a money market instrument?
A. Treasury bills
B. Commercial paper
C. Corporate bonds
D. Banker's acceptances

7. These money market instruments are short-term funds transferred between financial institutions, usually for no more than one day.
A. Treasury bills
B. Federal funds
C. Commercial paper
D. Banker acceptances

8. Which of the following is NOT a capital market instrument?
A. U.S. Treasury notes and bonds
B. U.S. Treasury bills
C. U.S. government agency bonds
D. Corporate stocks and bonds

9. These capital market instruments are long-term loans to individuals or businesses to purchase homes, pieces of land, or other real property.
A. Treasury notes and bonds
B. Mortgages
C. Mortgage-backed securities
D. Corporate bonds

10. These markets trade currencies for immediate or for some future stated delivery.
A. money markets
B. primary markets
C. foreign exchange markets
D. over-the-counter stocks

11. This is a security formalizing an agreement between two parties to exchange a standard quantity of an asset at a predetermined price on a specified date in the future.
A. derivative security
B. initial public offering
C. liquidity asset
D. trading volume

12. Which of these does NOT perform vital functions to securities markets of all sorts by channeling funds from those with surplus funds to those with shortages of funds?
A. commercial banks
B. secondary markets
C. insurance companies
D. mutual funds

13. This is the ease with which an asset can be converted into cash.
A. direct transfer
B. liquidity
C. primary market
D. secondary market

14. This is the risk that an asset's sale price will be lower than its purchase price.
A. default risk
B. liquidity risk
C. price risk
D. trading risk

15. This is the interest rate that is actually observed in financial markets.
A. nominal interest rates
B. real interest rates
C. real risk free rate
D. market premium

16. This is the interest rate that would exist on a default-free security if no inflation were expected.
A. nominal interest rate
B. real interest rate
C. real risk free rate
D. market premium

17. This is the risk that a security issuer will miss an interest or principal payment or continue to miss such payments.
A. default risk
B. liquidity risk
C. maturity risk
D. price risk

18. This is the continual increase in the price level of a basket of goods and services.
A. deflation
B. inflation
C. recession
D. stagflation

19. Which of these statements is true?
A. The higher the default risk, the higher the interest rate that security buyers will demand.
B. The lower the default risk, the higher the interest rate that security buyers will demand.
C. The higher the default risk, the lower the interest rate that security buyers will demand.
D. The default risk does not impact the interest rate that security buyers will demand.

20. This is a comparison of market yields on securities, assuming all characteristics except maturity are the same.
A. liquidity risk
B. market risk
C. maturity risk
D. term structure of interest rates

21. According to this theory of term structure of interest rates, at any given point in time, the yield curve reflects the market's current expectations of future short-term rates.
A. Expectations Theory
B. Future Short-term Rates Theory
C. Term Structure of Interest Rates Theory
D. Unbiased Expectations Theory

22. This theory argues that individual investors and financial institutions have specific maturity preferences, and to encourage buyers to hold securities with maturities other than their most preferred requires a higher interest rate.
A. Liquidity Premium Hypothesis
B. Market Segmentation Theory
C. Supply and Demand Theory
D. Unbiased Expectations Theory

23. This is the expected or "implied" rate on a short-term security that will originate at some point in the future.
A. Current yield
B. Forward rate
C. Spot rate
D. Yield to maturity

24. Which of these is NOT a theory that explains the shape of the term structure of interest rates?
A. liquidity theory
B. market segmentation theory
C. short-term structure of interest rates theory
D. unbiased expectations theory

25. Interest rates A particular security's default risk premium is 3 percent. For all securities, the inflation risk premium is 2 percent and the real interest rate is 2.25 percent. The security's liquidity risk premium is 0.75 percent and maturity risk premium is 0.90 percent.
The security has no special covenants. What is the security's equilibrium rate of return?
A. 1.78%
B. 3.95%
C. 8.90%
D. 17.8%

26. Interest rates You are considering an investment in 30-year bonds issued by a corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.50 percent. Your broker has determined the following information about economic activity and the corporation bonds:

Real interest rate = 2.50%
Default risk premium = 1.75%
Liquidity risk premium = 0.70%
Maturity risk premium = 1.50%

What is the inflation premium? What is the fair interest rate on the corporation's 30-year bonds?
A. 1% and 1.49%, respectively
B. 1% and 6.45%, respectively
C. 1% and 7.45%, respectively
D. 3.50% and 9.95%, respectively

27. Interest rates A corporation's 10-year bonds have an equilibrium rate of return of 7 percent. For all securities, the inflation risk premium is 1.50 percent and the real interest rate is 3.0 percent. The security's liquidity risk premium is 0.15 percent and maturity risk premium is 0.70 percent. The security has no special covenants. What is the bond's default risk premium?
A. 1.40%
B. 1.65%
C. 5.35%
D. 9.35%

28. Interest rates A 2-year Treasury security currently earns 5.25 percent. Over the next two years, the real interest rate is expected to be 3.00 percent per year and the inflation premium is expected to be 2.00 percent per year. What is the maturity risk premium on the 2-year Treasury security?
A. 0.25%
B. 1.00%
C. 1.05%
D. 5.00%

29. Unbiased Expectations Theory Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:

Using the unbiased expectations theory, what is the current (long-term) rate for four-year-maturity Treasury securities?
A. 6.00%
B. 6.33%
C. 6.75%
D. 7.00%

30. Unbiased Expectations Theory One-year Treasury bills currently earn 5.50 percent. You expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent. If the unbiased expectations theory is correct, what should the current rate be on two-year Treasury securities?
A. 5.50%
B. 5.625%
C. 5.75%
D. 11.25%

31. Liquidity Premium Hypothesis One-year Treasury bills currently earn 5.50 percent. You expect that one year from now, one-year Treasury bill rates will increase to 5.75 percent. The liquidity premium on two-year securities is 0.075 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities?
A. 3.775%
B. 5.625%
C. 5.662%
D. 11.325%

32. Liquidity Premium Hypothesis Based on economists' forecasts and analysis, one-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows:

Using the liquidity premium hypothesis, what is the current rate on a four-year Treasury security?
A. 7.736%
B. 7.600%
C. 7.738%
D. 8.400%

33. Interest rates The Wall Street Journal reports that the rate on 3-year Treasury securities is 7.00 percent, and the 6-year Treasury rate is 7.25 percent. From discussions with your broker, you have determined that expected inflation premium is 1.75 percent next year, 2.25 percent in Year 2, and 2.40 percent in Year 3 and beyond. Further, you expect that real interest rates will be 3.75 percent annually for the foreseeable future. What is the maturity risk premium on the 6-year Treasury security?
A. 0.83%
B. 0.983%
C. 1.10%
D. 1.233%

34. Interest rates A corporation's 10-year bonds are currently yielding a return of 7.75 percent. The expected inflation premium is 3.0 percent annually and the real interest rate is expected to be 3.00 percent annually over the next 10 years. The liquidity risk premium on the corporation's bonds is 0.50 percent. The maturity risk premium is 0.25 percent on 2-year securities and increases by 0.10 percent for each additional year to maturity. What is the default risk premium on the corporation's 10-year bonds?
A. 0.18%
B. 0.20%
C. 0.22%
D. 0.27%

35. Unbiased Expectations Theory Suppose we observe the following rates: 1R1 = 6%, 1R2 = 7.5%. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year interest rate expected one year from now, E(2r1)?
A. 6.75%
B. 7.50%
C. 9.02%
D. 13.5%

36. Unbiased Expectations Theory The Wall Street Journal reports that the rate on 4-year Treasury securities is 4.75 percent and the rate on 5-year Treasury securities is 5.95 percent. According to the unbiased expectations hypotheses, what does the market expect the 1-year Treasury rate to be four years from today, E(5r1)?
A. 1.11%
B. 5.95%
C. 10.70%
D. 10.89%

37. Liquidity Premium Hypothesis The Wall Street Journal reports that the rate on 3-year Treasury securities is 4.75 percent and the rate on 4-year Treasury securities is 5.00 percent. The one-year interest rate expected in three years is E(4r1), 5.25 percent. According to the liquidity premium hypotheses, what is the liquidity premium on the 4-year Treasury security, L4?
A. 0.0375%
B. 0.504%
C. 5.01%
D. 5.04%

38. Liquidity Premium Hypothesis Suppose we observe the following rates: 1R1 = 8%, 1R2 = 10%, and E(2r1) = 8%. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L2?
A. 1.02%
B. 4.04%
C. 6.15%
D. 12.03%

39. Forecasting Interest Rates You note the following yield curve in The Wall Street Journal. According to the unbiased expectations hypothesis, what is the one-year forward rate for the period beginning one year from today, 2f1?
A. 1.01%
B. 1.19%
C. 5.625%
D. 7.51%

40. Forecasting Interest Rates On May 23, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:

Using the unbiased expectations theory, what is the one-year forward rate on zero-coupon Treasury bonds for year four as of May 23, 20XX?
A. 5.925%
B. 6.45%
C. 7.05%
D. 10.32%

41. Interest rates The Wall Street Journal reports that the current rate on 10-year Treasury bonds is 6.75 percent, on 20-year Treasury bonds is 7.25 percent, and on a 20-year corporate bond is 8.50 percent. Assume that the maturity risk premium is zero. If the default risk premium and liquidity risk premium on a 10-year corporate bond is the same as that on the 20-year corporate bond, what is the current rate on a 10-year corporate bond.
A. 7.50%
B. 8.00%
C. 8.50%
D. 8.75%

42. Interest rates The Wall Street Journal reports that the current rate on 5-year Treasury bonds is 6.50 percent and on 10-year Treasury bonds is 6.75 percent. Assume that the maturity risk premium is zero. Calculate the expected rate on a 5-year Treasury bond purchased five years from today, E(5r1).
A. 6.625%
B. 6.75%
C. 7.00%
D. 7.58%

43. Unbiased Expectations Theory Suppose we observe the three-year Treasury security rate (1R3) to be 6 percent, the expected one-year rate next year E(2r1) to be 3 percent, and the expected one-year rate the following year E(3r1) to be 5 percent. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year Treasury security rate, 1R1?
A. 3.00%
B. 10.13%
C. 14.00%
D. 19.88%

44. Unbiased Expectations Theory The Wall Street Journal reports that the rate on 3-year Treasury securities is 6.25 percent and the rate on 5-year Treasury securities is 6.45 percent. According to the unbiased expectations hypotheses, what does the market expect the 2-year Treasury rate to be three years from today, E(4r2)?
A. 6.35%
B. 6.75%
C. 7.25%
D. 7.45%

45. Forecasting Interest Rates Assume the current interest rate on a one-year Treasury bond (1R1) is 5.00 percent, the current rate on a two-year Treasury bond (1R2) is 5.75 percent, and the current rate on a three-year Treasury bond (1R3) is 6.25 percent. If the unbiased expectations theory of the term structure of interest rates is correct, what is the one-year interest rate expected on Treasury bills during year 3, 3f1?
A. 5.00%
B. 5.67%
C. 7.26%
D. 8.00%

46. Forecasting Interest Rates A recent edition of The Wall Street Journal reported interest rates of 3.10 percent, 3.50 percent, 3.75 percent, and 3.95 percent for three-year, four-year, five-year, and six-year Treasury security yields, respectively, According to the unbiased expectation theory of the term structure of interest rates, what are the expected one-year rates for year 6?
A. 3.575%
B. 3.95%
C. 4.96%
D. 5.33%

47. A particular security's default risk premium is 3%. For all securities, the inflation risk premium is 1.75% and the real interest rate is 4.2%. The security's liquidity risk premium is 0.35% and maturity risk premium is 0.95%. The security has no special covenants. Calculate the security's equilibrium rate of return.
A. 8.50%
B. 6.05%
C. 10.25%
D. 9.90%

48. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.55%. Your broker has determined the following information about economic activity and Moore Corporation bonds:

Real interest rate = 2.75%
Default risk premium = 1.05%
Liquidity risk premium = 0.50%
Maturity risk premium = 1.85%

What is the inflation premium?
A. 0.80%
B. 1.25%
C. 6.25%
D. 8.00%

49. You are considering an investment in 30-year bonds issued by Moore Corporation. The bonds have no special covenants. The Wall Street Journal reports that 1-year T-bills are currently earning 3.55%. Your broker has determined the following information about economic activity and Moore Corporation bonds:

Real interest rate = 2.75%
Default risk premium = 1.05%
Liquidity risk premium = 0.50%
Maturity risk premium = 1.85%

What is the fair interest rate on Moore Corporation 30-year bonds?
A. 3.80%
B. 6.45%
C. 6.95%
D. 9.70%

50. Dakota Corporation 15-year bonds have an equilibrium rate of return of 9%. For all securities, the inflation risk premium is 1.95% and the real interest rate is 3.65%. The security's liquidity risk premium is 0.35% and maturity risk premium is 0.95%. The security has no special covenants. Calculate the bond's default risk premium.
A. 2.10%
B. 3.05%
C. 3.40%
D. 2.45%

51. A 2-year Treasury security currently earns 5.13%. Over the next 2 years, the real interest rate is expected to be 2.15% per year and the inflation premium is expected to be 1.75% per year. Calculate the maturity risk premium on the 2-year Treasury security.
A. 5.13%
B. 3.38%
C. 2.98%
D. 1.23%

52. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following 3 years (i.e., years 2, 3 and 4, respectively) are as follows:
1R1 = 5%, E(2r1) = 7%, E(3r1) = 7.5% E(4r1) = 7.85%
Using the unbiased expectations theory, calculate the current (long-term) rates for one-year and two-year -maturity Treasury securities.
A. One-year: 5.00%; Two-year: 5.50%
B. One-year: 5.00%; Two-year: 6.00%
C. One-year: 5.50%; Two-year: 6.15%
D. One-year: 5.50%; Two-year: 5.75%

53. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following 3 years (i.e., years 2, 3 and 4 respectively) are as follows:
1R1 = 5%, E(2r1) = 6%, E(3r1) = 7.5% E(4r1) = 7.85%
Using the unbiased expectations theory, calculate the current (long-term) rates for three-year- and four-year-maturity Treasury securities.
A. One-year: 6.16%; Two-year: 6.58%
B. One-year: 6.16%; Two-year: 6.78%
C. One-year: 6.25%; Two-year: 6.45%
D. One-year: 5.95%; Two-year: 6.45%

54. Suppose that the current one-year rate (one-year spot rate) and expected one-year T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
1R1 = 5%, E(2r1) = 6%, E(3r1) = 7.5% E(4r1) = 6.85%

Using the unbiased expectations theory, calculate the current (long-term) rates for one-, two-, three-, and four-year-maturity Treasury securities.
A. 5.00%; 5.50%; 6.16%; 6.33%
B. 5.00%; 5.25%; 6.10%; 6.27%
C. 5.00%; 5.50%; 6.10%; 6.23%
D. 5.00%; 5.25%; 6.16%; 6.49%

55. One-year Treasury bills currently earn 3.75 percent. You expect that one year from now, one-year Treasury bill rates will increase to 4.15 percent. If the unbiased expectations theory is correct, what should the current rate be on two-year Treasury securities?
A. 4.25%
B. 3.85%
C. 3.95%
D. 4.35%

56. One-year Treasury bills currently earn 4.5 percent. You expect that one year from now, one-year Treasury bill rates will increase to 6.65 percent. The liquidity premium on two-year securities is 0.05 percent. If the liquidity theory is correct, what should the current rate be on two-year Treasury securities?
A. 5.24%
B. 5.59%
C. 5.65%
D. 5.95%

57. Based on economists' forecasts and analysis, one-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows:

R1 = 5.95%
E(r2) = 6.25% L2 = 0.05%
E(r3) = 6.75% L3 = 0.10%
E(r4) = 7.15% L4 = 0.12%

Using the liquidity premium hypothesis, what should be the current rate on four-year Treasury securities?
A. 6.59%
B. 6.75%
C. 6.82%
D. 7.13%

58. The Wall Street Journal reports that the rate on 3-year Treasury securities is 7.00%, and the 6-year Treasury rate is 6.20%. From discussions with your broker, you have determined that expected inflation premium is 2.25% next year, 2.50% in Year 2, and 2.50% in Year 3 and beyond. Further, you expect that real interest rates will be 4.4% annually for the foreseeable future. Calculate the maturity risk premium on the 3-year Treasury security.
A. 0.00%
B. 0.10%
C. 4.50%
D. 2.60%

59. The Wall Street Journal reports that the rate on 3-year Treasury securities is 6.50%, and the 6-year Treasury rate is 6.80%. From discussions with your broker, you have determined that expected inflation premium is 2.25% next year, 2.50% in Year 2, and 2.60% in Year 3 and beyond. Further, you expect that real interest rates will be 3.4% annually for the foreseeable future. Calculate the maturity risk premium on the 3-year and the 6-year Treasury security.
A. 3-year: 0.6%; 6-year: 0.80%
B. 3-year: 0.5%; 6-year: 0.90%
C. 3-year: 0.6%; 6-year: 1.20%
D. 3-year: 0.5%; 6-year: 0.80%

60. Nikki G's Corporation's 10-year bonds are currently yielding a return of 9.25%. The expected inflation premium is 2.0% annually and the real interest rate is expected to be 3.10% annually over the next 10 years. The liquidity risk premium on Nikki G's bonds is 0.1%. The maturity risk premium is 0.10% on 2-year securities and increases by 0.05% for each additional year to maturity. Calculate the default risk premium on Nikki G's 10-year bonds.
A. 2.55%
B. 5.65%
C. 3.55%
D. 1.85%

61. Suppose we observe the following rates: 1R1 = 12%, 1R2 = 15%. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year interest rate expected one year from now, E(2r1)?
A. 13.5%
B. 14.2%
C. 15.6%
D. 18.0%

62. The Wall Street Journal reports that the rate on 4-year Treasury securities is 7.50% and the rate on 5-year Treasury securities is 9.15%. According to the unbiased expectations hypotheses, what does the market expect the 1-year Treasury rate to be four years from today, E(5r1)?
A. 16.0%
B. 18.4%
C. 15.9%
D. 13.7%

63. The Wall Street Journal reports that the rate on 3-year Treasury securities is 7.25% and the rate on 4-year Treasury securities is 8.50%. The one-year interest rate expected in three years is E(4r1), 4.10%. According to the liquidity premium hypotheses, what is the liquidity premium on the 4-year Treasury security, L4?
A. 6.7%
B. 7.1%
C. 8.2%
D. 9.6%

64. Suppose we observe the following rates: 1R1 = 13%, 1R2 = 16%, and E(2r1) = 10%. If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity premium for year 2, L2?
A. 8.7%
B. 9.1%
C. 9.7%
D. 10.0%

65. You note the following yield curve in The Wall Street Journal. According to the unbiased expectations hypothesis, what is the one-year forward rate for the period beginning one year from today, 2f1?
A. 7.6%
B. 8.6%
C. 9.0%
D. 10.2%

66. On May 23, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year zero-coupon Treasury security rates were as follows:
1R1 = 4.55%, 1R2 = 4.75%, 1R3 = 5.25%, 1R4 = 5.95%
Using the unbiased expectations theory, calculate the one-year forward rates on zero-coupon Treasury bonds for years two, three, and four as of May 23, 20XX.
A. Year 1: 4.95%; Year 2: 6.26%; Year 3: 8.08%
B. Year 1: 3.75%; Year 2: 6.02%; Year 3: 9.00%
C. Year 1: 4.95%; Year 2: 7.26%; Year 3: 8.08%
D. Year 1: 3.65%; Year 2: 6.32%; Year 3: 11.08%

67. The Wall Street Journal reports that the current rate on 10-year Treasury bonds is 6.25%, on 20-year Treasury bonds is 7.95%, and on a 20-year corporate bond is 10.75%. Assume that the maturity risk premium is zero. If the default risk premium and liquidity risk premium on a 10-year corporate bond is the same as that on the 20-year corporate bond, calculate the current rate on a 10-year corporate bond.
A. 9.05%
B. 6.15%
C. 7.60%
D. 8.70%

68. The Wall Street Journal reports that the current rate on 5-year Treasury bonds is 6.45% and on 10-year Treasury bonds is 7.75%. Assume that the maturity risk premium is zero. Calculate the expected rate on a 5-year Treasury bond purchased five years from today, E(5r5).
A. 7.25%
B. 8.12%
C. 9.07%
D. 10.16%

69. Suppose we observe the three-year Treasury security rate (1R3) to be 11%, the expected one-year rate next year E(2r1) to be 4%, and the expected one-year rate the following year E(3r1) to be 5%. If the unbiased expectations theory of the term structure of interest rates holds, what is the one-year Treasury security rate, 1R1?
A. 18.57%
B. 10.19%
C. 23.19%
D. 25.24%

70. Assume the current interest rate on a one-year Treasury bond (1R1) is 5.50%, the current rate on a two-year Treasury bond (1R2) is 5.95%, and the current rate on a three-year Treasury bond (1R3) is 8.50%. If the unbiased expectations theory of the term structure of interest rates is correct, what is the one-year interest rate expected on Treasury bills during year 3, 3f1?
A. 13.79%
B. 12.29%
C. 11.69%
D. 10.29%

71. If the yield curve is downward sloping, what is the yield to maturity on a 30-year Treasury bond relative to a 10-year Treasury bond?
A. The yield on the 10-year bond must be greater than the yield on the 30-year bond.
B. The yield on the 10-year bond must be less than the yield on the 30-year bond.
C. The yields on the two bonds are equal.
D. We need to know the other risk premiums to answer this question.

72. One-year Treasury bill rates in 20XX averaged 5.15% and inflation for the year was 7.3%. If investors had expected the same inflation rate as that realized, calculate the real interest rate for 20XX according to the Fisher effect.
A. 0.00%
B. -2.15%
C. 2.15%
D. 3.95%

73. Assume that you observe the following rates on long-term bonds:
U.S. Treasury bonds = 4.15%
AAA Corporate bonds = 6.2%
BBB Corporate bonds = 7.15%

The main reason for the differences in the interest rates is:
A. Maturity risk premium
B. Inflation premium
C. Default risk premium
D. Convertibility premium

74. Which of the following statements is correct?
A. According to the unbiased expectations theory, the return for holding a 2-year bond to maturity is equal to the nominal rate divided by the real interest rate.
B. The rate on a 10-year Corporate can never be less than the rate on a 10-year Treasury.
C. We usually observe the inverted yield curve.
D. The rate on a 3-year Treasury can never be less than the rate on a 15-year Treasury.

75. One-year interest rates are 3%. The market expects one-year rates to be 5% one year from now. The market also expects one-year rates to be 7% two years from now. Assume that the unbiased expectations theory holds. Which of the following is correct?
A. The yield curve is downward sloping.
B. The yield curve is flat.
C. The yield curve is upward sloping.
D. We need the maturity risk premiums to be able to answer this question.

76. Which of the following statements is correct?
A. If the unbiased expectations theory is correct, we could see an inverted yield curve.
B. If a yield curve is inverted, long-term bonds have higher yields than short-term bonds.
C. If the maturity risk premium is zero, the yield curve would be flat.
D. If the unbiased expectations theory is correct, the maturity risk premium is zero.

77. The Wall Street Journal states that the yield curve for Treasuries is downward sloping and there is no liquidity premium or maturity risk premium. Given this information, which of the following statements is correct?
A. A 30-year corporate bond must have a higher yield than a 5-year corporate bond.
B. A 5-year corporate bond must have a higher yield than a 30-year Treasury bond.
C. A 5-year Treasury bond must have a higher yield than a 5-year corporate bond.
D. All of these statements are correct.

78. Which of the following statements is correct?
A. An IPO is an example of a primary market transaction.
B. Money markets are subject to wider price fluctuations and are therefore more risky than capital market instruments.
C. A direct transfer of funds is more efficient than utilizing financial institutions.
D. The market segmentation theory argues that the different investors have different risk preferences which determine the shape of the yield curve.

79. In 20XX, the 10-year Treasury rate was 4.5% while the average 10-year Aaa corporate bond debt carried an interest rate of 6.0%. What is the average default risk premium on Aaa corporate bonds?
A. 0.75%
B. 1.5%
C. 1.95%
D. 2.25%

80. Which of the following statements is correct?
A. The default risk premium of Baa 20-year corporate bonds over Aaa 20-year corporate bonds does not vary.
B. The market segmentation theory assumes that borrowers and investors do not want to shift from one maturity sector to another without an interest rate premium.
C. Real interest rates are the rates that are quoted in the news.
D. All of these statements are correct.

81. All of the following are types of financial institutions except _______.
A. Insurance companies
B. Pension funds
C. Thrifts
D. Federal Reserve Bank

82. All of the following are benefits that financial institutions provide to our economy except _________.
A. Increased liquidity
B. Increased monitoring
C. Increased dollar amount of funds flowing from suppliers to fund users
D. Increased price risk

83. All of the following are factors that affect nominal interest rates except ___________.
A. Time to maturity
B. Real interest rate
C. Convertibility features
D. Foreign exchange

84. Which of the following statements is correct?
A. A flat yield curve occurs when the yield-to-maturity is virtually unaffected by the term-to-maturity.
B. Real interest rates are generally lower than nominal interest rates.
C. Liquidity risk is the risk that a security may be difficult to sell on short notice for its true value.
D. All of these statements are correct.

85. Which of the following statements is incorrect?
A. Governments affect foreign exchange rates indirectly by altering prevailing interest rates within their own countries.
B. Foreign currency exchange rates vary with the day-to-day demand and supply of the two foreign currencies.
C. Central governments can intervene in foreign exchange markets directly and value their currency at high rates relative to another currency.
D. All of these statements are correct.

86. The theory that argues that individual investors and financial institutions have specific maturity preferences is called the ______________.
A. Market segmentation theory
B. Unbiased expectations theory
C. Liquidity preference theory
D. Inverted forward theory

87. The theory that states that the yield curve reflects the market's current expectations of future short-term rates is called the _____________.
A. Market segmentation theory
B. Liquidity premium theory
C. Unbiased expectations theory
D. Inverted forward theory

88. Which of the following statements is incorrect?
A. The over-the-counter market operates in a fixed location to conduct trades for local stocks.
B. Liquidity is the ease with which an asset can be converted into cash.
C. An initial public offering is an example of a primary market transaction.
D. Money market instruments have maturities of less than one year.

89. All of the following are secondary market transactions except ___________.
A. GE sells $30 million of new preferred stock
B. Microsoft sells $2 million of IBM preferred stock out of its marketable securities portfolio
C. The Magellan Fund buys $100 million of Apple previously issued bonds
D. All-State Insurance Co. sells $5 million in IBM bonds

90. Which of the following is not correct with respect to derivative securities?
A. They are among the riskiest of securities in the financial securities markets.
B. They can be used for hedging purposes.
C. Examples of derivatives include futures, options and swaps.
D. All of these are correct statements about derivatives.

91. Which of the following is not correct with respect to financial institutions?
A. Financial institutions channel funds from those with shortages to those with surplus funds.
B. Commercial banks, insurance companies and mutual funds are examples of financial institutions.
C. Financial institutions reduce monitoring costs and liquidity costs.
D. Financial institutions reduce price risk.

92. All of the following are factors that influence interest rates for individual securities except ________.
A. The security's term to maturity
B. Inflation
C. Special provisions regarding the use of funds raised by a particular security issuer
D. The home mortgage rate

93. The real interest rate is _______________________.
A. The rate charged to the corporations with the best credit rating or least amount of default risk
B. The rate that a security would pay if no inflation were expected over its holding period
C. The rate that a security would pay if the security had no maturity risk
D. None of these statements is a correct definition.

94. All of the following special provisions benefit security holders except ____________.
A. Tax-free status
B. Convertibility
C. Callability
D. All of these provisions are beneficial to security holders.

95. An example of an illiquid asset is _____________________.
A. U.S. Treasury bill
B. Bonds issued by GM
C. Common stock issued by Apple Inc.
D. Common stock issued by a small but financially strong firm

96. All of the following are common shapes for the yield curve except ____________.
A. Elliptical
B. Upward-sloping
C. Flat
D. Inverted

Part 2: Short Answer Questions

97. Classify the following transactions as taking place in the primary or secondary markets:

a. A company issues new common stock.
b. A company issues common stock in an IPO.
c. A shareholder sells preferred stock out of its marketable securities portfolio.
d. A mutual fund buys previously issued bonds.
e. An insurance company sells another company's common stock.
f. A company buys another company's stock from a mutual fund.

98. Classify the following financial instruments as money market securities or capital market securities:
a. Common Stock
b. Corporate Bonds
c. Mortgages
d. U.S. Treasury Bills
e. U.S. Treasury Notes
f. U.S. Treasury Bonds
g. State and Government Bonds

99. What is a derivative security and what determines its value?

Part 3: Essay Questions

100. What shape does the term structure usually take? Why?

101. What does the "term structure of interest rates" mean?

102. Why is it useful to calculate forward rates?

103. George Washington wants to invest in one of two corporate bonds issued by separate firms. One bond yields 7% with a 10-year maturity; the other offers a 10% yield with a 9-year maturity. George thinks the 9-year bond is the better deal since the rate is higher. Is this necessarily so? Explain what factors George should consider before making a choice.

104. How do Financial Intermediaries (FIs) act as asset transformers?