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    Intermediate Accounting CH 6 Solutions

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    Natazia Ibañez
    i. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. ii. If expected inflation increases, interest rates are likely to increase. iii. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. This summarizes the key points made in the sample problems document regarding which answer choices are correct for questions i, ii, and iii.

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    Intermediate Accounting CH 6 Solutions

    Uploaded by

    Natazia Ibañez
    412 views6 pages
    i. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. ii. If expected inflation increases, interest rates are likely to increase. iii. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. This summarizes the key points made in the sample problems document regarding which answer choices are correct for questions i, ii, and iii.

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    Intermediate Accounting Ch 6 Solutions

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    Intermediate Accounting Ch 6 Solutions

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    i. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. ii. If expected inflation increases, interest rates are likely to increase. iii. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. This summarizes the key points made in the sample problems document regarding which answer choices are correct for questions i, ii, and iii.

    Copyright:

    © All Rights Reserved
    Download as DOC, PDF, TXT or read online from Scribd
    Download as doc, pdf, or txt
    412 views6 pages

    Intermediate Accounting CH 6 Solutions

    Uploaded by

    Natazia Ibañez
    i. If the pure expectations theory is correct, a downward sloping yield curve indicates that interest rates are expected to decline in the future. ii. If expected inflation increases, interest rates are likely to increase. iii. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. This summarizes the key points made in the sample problems document regarding which answer choices are correct for questions i, ii, and iii.

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    © All Rights Reserved
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    of 6

    Chapter 6 Sample Problems

    i
    . Which of the following statements is CORRECT?
    a. Downward sloping yield curves are inconsistent with the expectations theory.
    b. The shape of the yield curve depends only on expectations about future
    inflation.
    c. If the pure expectations theory is correct, a downward sloping yield curve
    indicates that interest rates are expected to decline in the future.
    d. If the yield curve is upward sloping, the inflation rate must be expected to
    increase.
    e. Yield curves must be either upward or downward slopingthey cannot first rise
    and then decline.
    ii
    . Which of the following statements is CORRECT?

    a. If companies have fewer good investment opportunities, interest rates are likely
    to increase.
    b. If individuals increase their savings rate, interest rates are likely to increase.
    c. If expected inflation increases, interest rates are likely to increase.
    d. Interest rates on all debt securities tend to rise during recessions because
    recessions increase the possibility of bankruptcy, hence the riskiness of all debt
    securities.
    e. Interest rates on long-term bonds are more volatile than rates on short-term
    debt securities like T-bills.

    iii
    . Which of the following is CORRECT?

    a. Even if the pure expectations theory is correct, there might at times be an


    inverted Treasury yield curve.
    b. If the yield curve is inverted, short-term bonds have lower yields than long-term
    bonds.
    c. The higher the maturity risk premium, the higher the probability that the yield
    curve will be inverted.
    d. Inverted yield curves can exist for Treasury bonds, but because of default
    premiums, the corporate yield curve cannot become inverted.
    e. The most likely explanation for an inverted yield curve is that investors expect
    inflation to increase in the future.
    iv
    . Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%,
    and a maturity premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%
    (t), where t is the years to maturity. What rate of return would you expect on a 5-
    year Treasury security, assuming the pure expectations theory is NOT valid?
    a. 5.95%
    b. 6.05%
    c. 6.15%
    d. 6.25%
    e. 6.35%
    v
    . Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.25%,
    a maturity premium of 0.08% per year to maturity applies, i.e., MRP = 0.08%(t),
    where t is the years to maturity. Suppose also that a liquidity premium of 0.5% and
    a default risk premium of 0.85% applies to A-rated corporate 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.
    a. 1.75%
    b. 1.80%
    c. 1.85%
    d. 1.90%
    e. 1.95%
    vi
    . Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bill is
    6.0%. Assuming the pure expectations theory is correct, what is the market's
    forecast for 1-year rates 1 year from now?
    a. 6.65%
    b. 6.74%
    c. 6.83%
    d. 6.92%
    e. 7.01%
    vii
    . Keys Corporation's 5-year bonds yield 6.50%, and 5-year T-bonds yield 4.40%.
    The real risk-free rate is r* = 2.5%, the inflation premium for 5 years bonds is IP =
    1.50%, the default risk premium for Keys' bonds is DRP = 0.50% 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 Keys' bonds?
    a. 1.30%
    b. 1.40%
    c. 1.50%
    d. 1.60%
    e. 1.70%
    viii
    . One-year Treasury securities yield 5%, 2-year Treasury securities yield 5.5%, and
    3-year Treasury securities yield 6%. Assume that the expectations theory holds.
    What does the market expect will be the yield on 1-year Treasury securities two
    years from now?
    a. 6.01%
    b. 6.51%
    c. 7.01%
    d. 7.51%
    e. 8.01%
    ix
    . Three-year Treasury securities currently yield 6%, while 4-year Treasury securities
    currently yield 6.5%. Assume that the expectations theory holds. What does the
    market believe the rate will be on 1-year Treasury securities three years from now?
    a. 8.01%
    b. 8.51%
    c. 9.01%
    d. 9.51%
    e. 10.01%
    x
    . Currently, 3-year Treasury securities yield 5.4%, 7-year Treasury securities yield
    5.8%, and 10-year Treasury securities yield 6.2%. If the expectations theory is
    correct, what does the market expect will be the yield on 3-year Treasury securities
    seven years from today?
    a. 6.54%
    b. 7.14%
    c. 5.80%
    d. 4.58%
    e. 5.68%
    i. Yield curve Answer: c EASY

    ii. Interest rates Answer: c EASY

    iii. Yield curve Answer: a MEDIUM

    iv. Inflation and interest rates; MRP exists Answer: d EASY

    Real rate, r* 3.50%


    Inflation 2.25%
    MRP Years: 5 Per year: 0.10% 0.50%
    Difference = Yield on t-year T-bond 6.25%

    v. Corporate vs. Treasury bond yields Answer: a EASY/MEDIUM

    r* 3.50%
    IP 2.25%
    MRP, 5-year T-bond Per year: 0.08% Years: 5 0.40%
    MRP, 10-year corporate Per year: 0.08% Years: 10 0.80%
    LP 0.50%
    DRP 0.85%
    T-bond yield 6.15%
    A bond yield 7.90%
    Difference 1.75%

    vi. Estimating the 1-year forward rate Answer: e MEDIUM

    1-year rate today 5.0%


    2-year rate today 6.0%
    Ending return if buy the 2-year bond = needed return on series of 1-year bonds 1.1236
    Rate of return, or yield, on a 1-year bond 1 year from now: X in (1.05)(1+X) = 1.1236
    X = 1.1236/1.05 - 1 = 7.01%

    vii. Liquidity Premium (LP) Answer: d MEDIUM

    Maturity 5
    rKeys' Yield 6.50%
    rT-bond Yield 4.40%
    r* Included in both bonds 2.50%
    IP Included in both bonds 1.50%
    DRP Included in Keys only 0.50%
    MRP Included in both bonds (t-1)*0.1% 0.40%
    LP 1.60%

    viii . Expectations theory

    Answer: c

    r2 = 2 year rate today


    r3 = 3 year rate today
    2r1 = 1 year rate, two years from now

    (1 + r3)3 = (1 + r2)2(1 + 2r1)


    (1.06)3 = (1.055)2(1 + 2r1)
    2r1 = 7.01%
    ix. Expected interest rates Answer: a

    r3 = 3 year rate today


    3r1 = 1 year rate, three years from now
    r4 = 4 year rate today

    (1 + r4)4 = (1 + r3)3(1 + 3r1)


    (1.065)4 = (1.06)3(1 + 3r1)
    3r1 = 8.01%

    x. Expectations theory Answer: b

    r7 = 7 year rate today


    7r3 = 3 year rate, seven years from now
    r10 = 10 year rate today

    (1 + r10)10 = (1 + r7)7(1 + 7r3)3


    (1.062)10 = (1.058)7(1 + 7r3)3
    7r3 = 7.14%

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