CHAPTER 07—INTEREST RATES

Multiple Choice: Conceptual

24. Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain
constant. Which of the following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk premium.
e. The expectations theory cannot hold if inflation is decreasing.
ANSWER: a

25. Which of the following factors would be most likely to lead to an increase in nominal interest rates?
a. Households reduce their consumption and increase their savings.
b. A new technology like the Internet has just been introduced, and it increases investment opportunities.
c. There is a decrease in expected inflation.
d. The economy falls into a recession.
e. The Federal Reserve decides to try to stimulate the economy.
ANSWER: b
RATIONALE: If the new technology were so efficient that it takes an underdeveloped economy from a subsistence level,
where savings are necessarily low and rates high, to a level where people can afford to save, this might
cause interest rates to decline. However, it would take time for this to occur.

27. Which of the following would be most likely to lead to a higher level of interest rates in the economy?
a. Households start saving a larger percentage of their income.
b. Corporations step up their expansion plans and thus increase their demand for capital.
c. The level of inflation begins to decline.
d. The economy moves from a boom to a recession.
e. The Federal Reserve decides to try to stimulate the economy.
ANSWER: b

29. Assume that interest rates on 20-year Treasury and corporate bonds are as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
ANSWER: b

30. 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.

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 b. The yield on 5-year Treasury securities must exceed the yield on 10-year corporate bonds.
c. The yield on 5-year corporate bonds must exceed the yield on 8-year Treasury bonds.
d. The yield curve must be "humped."
e. The yield curve must be upward sloping.
ANSWER: e
POINTS: 1

32. Assume the following: The real risk-free rate, r*, is expected to remain constant at 3%. Inflation is expected to be 3%
next year and then to be constant at 2% a year thereafter. The maturity risk premium is zero. Given this information,
which of the following statements is CORRECT?
a. The yield curve for U.S. Treasury securities will be upward sloping.
b. A 5-year corporate bond must have a lower yield than a 5-year Treasury security.
c. A 5-year corporate bond must have a lower yield than a 7-year Treasury security.
d. The real risk-free rate cannot be constant if inflation is not expected to remain constant.
e. This problem assumed a zero maturity risk premium, but that is probably not valid in the real world.
ANSWER: e

35. The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next
2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases
with years to maturity. Given these conditions, which of the following statements is CORRECT?
a. The yield on a 2-year T-bond must exceed that on a 5-year T-bond.
b. The yield on a 5-year Treasury bond must exceed that on a 2-year Treasury bond.
c. The yield on a 7-year Treasury bond must exceed that of a 5-year corporate bond.
d. The conditions in the problem cannot all be true—they are internally inconsistent.
e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive
or negative slope.
ANSWER: b

38. Which of the following statements is CORRECT?

a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero,
then the Treasury yield curve will have an upward slope.
b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope.
c. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be
higher than yields on short-term T-bonds.
d. If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
e. The yield curve can never be downward sloping.
ANSWER: a
RATIONALE: The slope of the yield curve depends primarily on expected inflation and the MRP. The greater the
expected increase in inflation, and the higher the MRP, the steeper the slope of the yield curve. If inflation
is expected to decline, then even if the MRP is positive, the curve could still have a downward slope.

43. Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now
and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk
premium equals zero. Which of the following statements is CORRECT?
a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%.
b. The interest rate today on a 2-year bond should be approximately 6%.
c. The interest rate today on a 2-year bond should be approximately 7%.
d. The interest rate today on a 3-year bond should be approximately 7%.
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 e. The interest rate today on a 3-year bond should be approximately 8%.
ANSWER: d

54. Short Corp just issued bonds that will mature in 10 years, and Long Corp issued bonds that will mature in 20 years.
Both bonds promise to pay a semiannual coupon, they are not callable or convertible, and they are equally liquid. Further
assume that the Treasury yield curve is based only on the pure expectations theory. Under these conditions, which of the
following statements is CORRECT?
a. If the yield curve for Treasury securities is flat, Short's bond must under all conditions have the same yield as
Long's bonds.
b. If the yield curve for Treasury securities is upward sloping, Long's bonds must under all conditions have a
higher yield than Short's bonds.
c. If Long's and Short's bonds have the same default risk, their yields must under all conditions be equal.
d. If the Treasury yield curve is upward sloping and Short has less default risk than Long, then Short's bonds
must under all conditions have a lower yield than Long's bonds.
e. If the Treasury yield curve is downward sloping, Long's bonds must under all conditions have the lower yield.
ANSWER: d

Multiple Choice: Problems

55. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year.
What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the
arithmetic average.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%
ANSWER: a
RATIONALE: 1-year T-bill rate 7.00%
Inflation 3.20%
Difference = real risk-free rate, r* 3.80%

58. The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero.
Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond?
a. 5.51%
b. 5.80%
c. 6.09%
d. 6.39%
e. 6.71%
ANSWER: b
RATIONALE: Real risk-free rate, r* 3.05%
Inflation this year 2.75%
1-year bond yield: rRF = r* + IP 5.80%
The theoretically more precise answer is (1 + r*)(1 + IP) − 1 = 5.884%

59. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk
premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the number of years to maturity. What
rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid?
Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 5.08%
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 b. 5.35%
c. 5.62%
d. 5.90%
e. 6.19%
ANSWER: b
RATIONALE: Real risk-free rate, r* 3.00%
Inflation 2.25%
Per year: 0.10%
MRP Years: 1
0.10%
1-year bond yield: rRF = r* + IP + MRP 5.35%
POINTS: 1

65. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-
year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds,
what is the default risk premium on the corporate bond?
a. 1.90%
b. 2.09%
c. 2.30%
d. 2.53%
e. 2.78%
ANSWER: a
RATIONALE: Basic equation: r = r* + IP + MRP + DRP + LP
r*, IP, and MRP are included in both bonds, hence are not relevant.
Liquidity risk premium = LP is included in corporate only 0.40%
Corporate bond yield = r = r* + IP + MRP + DRP + LP 8.50%
T-bond yield = rRF = r* + IP + MRP + 0 + 0 6.20%
Difference = DRP + LP = DRP + 0.40% = 2.30%
DRP = Difference − LP = 1.90%

67. 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. What is the default risk premium (DRP) on Keys' bonds?
a. 1.17%
b. 1.30%
c. 1.43%
d. 1.57%
e. 1.73%
ANSWER: b
RATIONALE: Maturity 5
rKeys Yield 6.20%
rT-bond Yield 4.40%
r* Included in both bonds 2.50%
IP Included in both bonds 1.50%
MRP Included in both bonds (t − 1) × 0.1% 0.40%
LP Included in Keys only 0.50%
DRP Included in Keys only. Must find.
rT-bond = r* + IP + MRP + DRP + LP
rKeys = r* + IP + MRP + DRP + LP
DRP = rKeys − r* − IP − MRP − LP = 1.30%

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 Or, rKeys − rT-bond − LP = 1.30%

68. 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. 0.45%
d. 0.50%
e. 0.55%
ANSWER: d
RATIONALE: Maturity 5
rKay Yield 6.20%
rT-bond 4.40%
Yield
r* Included in both bonds 2.50%
IP Included in both bonds 1.50%
DRP Included in Kay's only 1.30%
MRP Included in both bonds (t − 1) × 0.1% 0.40%
rT-bond = r* + IP + MRP + DRP + LP
rKay = r* + IP + MRP + DRP + LP
LP = rKay − r* − IP − MRP − DRP = 0.50%
Or, rKay − rT-bond − DRP = 0.50%

72. 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%. What is the maturity risk premium (MRP) on all 5-year bonds?
a. 0.73%
b. 0.81%
c. 0.90%
d. 0.99%
e. 1.09%
ANSWER: c
RATIONALE: Maturity 5
rKelly Yield 7.50%
rT-bond Yield 4.90%
r* Included in both bonds 2.50%
LP Included in Kelly's only 2.20%
DRP Included in Kelly's only 0.40%
IP Included in both bonds 1.50%
rT-bond = r* + IP + MRP + DRP + LP
rKelly = r* + IP + MRP + DRP + LP
MRP = rKelly − r* − IP − LP − DRP = 0.90%
Or, MRP = rT-bond − r* − IP = 0.90%

73. 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%. What is the real
risk-free rate, r*?

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 a. 2.04%
b. 2.14%
c. 2.26%
d. 2.38%
e. 2.50%
ANSWER: e
RATIONALE: Maturity 5
rKop Yield 6.50%
rT-bond Yield 4.40%
DRP Included in Kop's only 0.40%
LP Included in Kop's only 1.70%
IP Included in both bonds 1.50%
MRP Included in both bonds 0.40%
rT-bond = r* + IP + MRP + DRP + LP
rKop = r* + IP + MRP + DRP + LP
r* = rKop − IP − LP − MRP − DRP = 2.50%
Or, r* = rT-bond − MRP − IP = 2.50%

77. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk
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 1-year Treasury security, assuming the pure expectations theory is NOT valid? Include the cross-
product term, i.e., if averaging is required, use the geometric average.
a. 5.15%
b. 5.42%
c. 5.69%
d. 5.97%
e. 6.27%
ANSWER: b
RATIONALE: Real risk-free rate, r* 3.00%
Inflation 2.25%
MRP Years: 1 Per year: 0.10% 0.10%
Yield on 1-year T-bond = (1 + r*)(1 + IP) − 1 + MRP 5.42%

78. Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bond is 7.0%. Assuming the pure
expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?
a. 7.36%
b. 7.75%
c. 8.16%
d. 8.59%
e. 9.04%
ANSWER: e
RATIONALE: 1-year rate today 5.00%
2-year rate today 7.00%
Maturity of longer bond 2
Ending return if buy the 2-year bond
= needed return on series of 1-year bonds 1.1449
Rate of return, or yield, on a 1-year bond 1 year from now:
X in this equation: (1.05)(1 + X) = 1.1449
X = 1.1449/1.05 − 1 = 9.04%

81. Suppose the real risk-free rate is 3.50%, the average future inflation rate is 2.50%, a maturity premium of 0.20% per
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year to maturity applies, i.e., MRP = 0.20%(t), where t is the number of 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. 0.85%
d. 0.89%
e. 0.94%
ANSWER: c
RATIONALE: Real risk-free rate, r* 3.50%
IP 2.50%
MRP, 10-year T-bond Per year: 0.20% Years: 10 2.00%
MRP, 5-year corporate Per year: 0.20% Years: 5 1.00%
LP 0.50%
DRP 1.35%
T-bond yield rT-bond = r* + IP + MRP + DRP + LP 8.00%
A bond yield rCorp = r* + IP + MRP + DRP + LP 8.85%
Difference 0.85%

Problems:
1.

Answer:

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2.

Answer:

Page 8
3.

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Answer:

a. The average rate of inflation for the 5-year period is calculated as:
IP5 = (0.13 + 0.09 + 0.07 + 0.06 + 0.06)/5 = 8.20%.

b. rT5 = r* + IP5 = 2% + 8.2% = 10.20%.

c. Here is the general situation:

Expected
Year Annual Inflation IPt r* MRPt rt
(It)
1 13% 13.0% 2% 0.1% 15.1%
2 9 11.0 2 0.2 13.2
5 6 8.2 2 0.5 10.7
. . . . . .
. . . . . .
. . . . . .
10 6 7.1 2 1.0 10.1
20 6 6.6 2 2.0 10.6

Interest Rate
(%)
15.0

12.5

10.0

7.5

5.0

2.5

0 2 4 6 8 10 12 14 16 18 20
Years to Maturity

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d. The “normal” yield curve is upward sloping because, in “normal” times, inflation is not expected to
trend either up or down, so IP is the same for debt of all maturities, but the MRP increases with
years, so the yield curve slopes up. During a recession, the yield curve typically slopes up
especially steeply, because inflation and consequently short-term interest rates are currently low,
yet people expect inflation and interest rates to rise as the economy comes out of the recession.

e. If inflation rates are expected to be constant, then the expectations theory holds that the yield curve should
be horizontal. However, in this event it is likely that maturity risk premiums would be applied to long-term
bonds because of the greater risks of holding long-term rather than short-term bonds:

Percent
(%)
Actual yield curve

Maturity
risk
premium

Pure expectations yield curve

Years to Maturity

If maturity risk premiums were added to the yield curve in Part e above, then the yield curve would
be more nearly normal; that is, the long-term end of the curve would be raised. (The yield curve
shown in this answer is upward sloping; the yield curve shown in Part c is downward sloping.)

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