Question 1. During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining.

a. True
b. False

Question 2. Consider 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. 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 the default risk premium on corporate bonds?

a. 1.08%
b. 1.45%
c. 1.32%
d. 1.20%
e. 1.60%

Question 3. Keys Corporation's 5-year bonds yield 6.20% 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 liquidity premium for Keys' bonds is LP = 0.5% 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.Determine  the default risk premium (DRP) on Keys' bonds?

a. 1.17%
b. 1.73%
c. 1.43%
d. 1.57%
e. 1.30%

Question 4. If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill?

a. The yield on a 10-year bond would have to be higher than that on a 1 year bill because of the maturity risk premium.
b. It is impossible to tell without knowing the coupon rates of the bonds.
c. The yields on the two securities would be equal.
d. The yield on a 10-year bond would be less than that on a 1-year bill.
e. It is impossible to tell without knowing the relative risks of the two securities.

Question 5. Consider the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.02% per year to maturity applies, i.e., MRP = 0.20%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 1.35% 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. 0.77%
b. 0.81%
c. 0.94%
d. 0.89%
e. 0.85%

Question 6. One of the four most fundamental factors that affect the cost of money as discussed in the text is the time preference for consumption. The higher the time preference, the lower the cost of money, other things held constant.

a. True
b. False

Question 7. In the foreseeable future, the real risk-free rate of interest, r*, is expected to remain at 3%, inflation is expected to steadily increase, and the maturity risk premium is expected to be 0.1(t - 1)%, where t is the number of years until the bond matures. Given this information, which of the following statements is CORRECT?

a. The yield on 2-year Treasury securities must exceed the yield on 5-year Treasury securities.
b. The yield curve must be upward sloping.
c. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate bonds.
d. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds.
e. The yield curve must be "humped."

Question 8. Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. Evaluate the maturity risk premium (MRP) on all 5-year bonds?

a. 0.90%
b. 0.81%
c. 0.93%
d. 0.99%
e. 1.09%

Question 9. Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The default risk premium for Kop's bonds is DRP = 0.40%, the liquidity premium on Kop's bonds is LP = 1.70% versus zero on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. Determine real risk-free rate, r*?

a. 2.04%
b. 2.50%
c. 2.26%
d. 2.38%
e. 2.14%

Question 10. Kay Corporation's 5-year bonds yield 6.20% 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. 0.36%
b. 0.41%
c. 0.50%
d. 0.40%
e. 0.55%