Chapter 6

Question 1

Interest rates can be thought of as the ___1___ of ___2____. They are ultimately determined by the forces of _____3_____ and ___4___ for __5__ funds.

Answer 1

1. Price
2. Money
3. Supply
4. Demand
5. Loanable

Question 2

The main factor that influences a business’ willingness to borrow is______________________.

The three factors that influence potential lenders to provide funds are: 1, 2, 3.

Answer 2

Business Prospects and their returns.

1) Time preference for spending
2) Perceived risk of business prospects
3) Expected Inflation

Question 3

All else remaining the same, if businesses have a desire to borrow more, interest rates will ____________.

Answer 3

Increase

Question 4

All else remaining the same, if lenders become less willing to provide funds, interest rates will _____________.

Answer 4

Increase

Question 5

When interest rates rise, the value of financial assets (such as bonds) ____1______. Because of a negative _____2___ effect, this will likely lead to ___3_____ consumer spending. If this happens, the profitability of businesses ____4____, and businesses tend to___5___, leading also to less consumer spending.

Answer 5

1. decrease
2. wealth
3. reduced
4. declines
5. downsize

Question 6

Interest rates vary by the terms (time to maturity) of financial assets such as bonds. These three basic terms are:

Answer 6

1. Short Term
2. Intermediate Term
3. Long Term

Question 7

Interest rates vary by the terms (time to maturity) of financial assets such as bonds. One of the three basic terms, [Short Term] definition is

Answer 7

Maturity less than 1 year

Question 8

Interest rates vary by the terms (time to maturity) of financial assets such as bonds. One of the three basic terms, [Intermediate Term] definition is

Answer 8

Maturity between 1 and 10 years

Question 9

Interest rates vary by the terms (time to maturity) of financial assets such as bonds. One of the three basic terms, [Long Term] definition is

Answer 9

Maturity more than 10 years

Question 10

Interest rates tend to __1__ during recessions, and __2__ during business expansions. Also, short term rates are more ___3__ than long term interest rates.

Answer 10

1. decline
2. increase
3. volatile

Question 11

Something called the ___1___ rate of interest is equal to nominal interest rates minus ________2____________.

Answer 11

1. real

2. the inflation rate

Question 12

r* can be defined as the ____1_______.
When analyzing interest rates, this is the lowest possible rate to which we add various __2___ to compensate lenders for various risks.

Answer 12

1. real, risk free rate of return

2. Risk Premiums

Question 13

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. These are:

Answer 13

1. IP
2. DRP
3. LP
4. MRP

Question 14

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “IP” what it stands for and what it compensates for

Answer 14

stands for:
Inflation
Premium

compensates for:
Inflation, reduction in purchasing
power

Question 15

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “DRP” what it stands for and what it compensates for

Answer 15

stands for:
Default risk
premium

compensates for:
The risk that the borrower may not
be able to make interest payments
or repay the bond principal

Question 16

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “LP” what it stands for and what it compensates for

Answer 16

stands for:
Liquidity
Premium

compensates for:
The risk that you may not be able
to dispose of a bond when you
need to.

Question 17

There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “MRP” what it stands for and what it compensates for

Answer 17

stands for:
Maturity Risk
Premium

compensates for:
The risk that, during a bond’s
term, market interest rates might
rise, and thus the value of your
bond decline.

Question 18

When the term ‘risk-free rate’ is used, it normally refers to ___ + ___, and is labeled Rrf.

Answer 18

( r* + IP ) = Real, risk free rate of return + Inflation premium

Question 19

Which of the 4 Risk Premiums vary directly with the years to maturity (term) of bonds?

Answer 19

DRP - Default Risk Premium
LP - Liquidity Premium
MRP - Maturity Risk Premium

Question 20

What are the two main classifications of bonds in respect to their ratings by Standard & Poor’s? At what rating does the higher (less risky) of the two classifications end?

Answer 20

Investment Grade Bonds & Junk Bonds

Investment Grade Bond classification ends at BBB (BB is Junk)

Question 21

What is the normal slope of a Yield Curve, and why?

Answer 21

Upward Sloping due to risks such as DRP, LP, and MRP.

Question 22

Why might a Yield Curve be inverted?

Answer 22

If inflation rates are expected to decrease in the future.

Question 23

How would you compare the Yield Curve for Corporate Bonds to a Yield Curve for a U.S. Treasury Bonds (all else the same)? What differences should exist?

Answer 23

The Yield Curve for Corporate Bonds would lie above the Yield Curve for Treasuries. This would imply
higher interest rates, which compensate for higher risks

Question 24

How would a Federal Government budget deficit impact market interest rates?

Answer 24

A Federal Deficit leads to more Federal Government borrowing. This increases the demand for loan-able
funds, and increases interest rates.

Question 25

Which of the Risk Premiums has the largest impact on the slope of (any) Yield Curve, and why?

Answer 25

Expected inflation (Inflation Premium)

Question 26

Corp Bond yield

Quoted interest rate =

Answer 26

r = r* + IP + DRP + LP + MRP

Question 27

U.S Treasury Bond yield =

Answer 27

r* + IP + MRP