Chapter 6 TB Flashcards
An interest rate or a required rate of return represents the cost of money.
T or F?
TRUE
A real rate of interest is the compensation paid by the borrower of funds to the lender measured in today’s dollars.
T or F?
FALSE
Real interest rate is the rate of return on an investment measured not in dollars but in the increase in purchasing power the investment provides.
A nominal rate of interest is approximately equal to the sum of the real rate of interest plus the risk free rate of interest.
T or F?
FALSE
A nominal rate of interest is approximately equal to the sum of the real interest rate and the expected inflation rate.
The nominal interest rate on a risk-free investment is approximately equal to the sum of the real rate of interest plus an inflation premium.
T or F?
TRUE
The nominal interest rate on a risky investment equals the risk-free rate plus a risk premium.
T or F?
TRUE
The nominal rate of interest on a bond is 8% and the expected inflation premium is 4%. This results in an approximate real rate of interest of 4% on the bond.
T or F?
TRUE
Historically, the rate of return on U.S. Treasury bills is usually greater than the rate of inflation.
T or F?
TRUE
The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by demander.
T or F?
TRUE
The term structure of interest rates is a graphical presentation of the relationship between the maturity and rate of return.
T or F?
TRUE
An inverted yield curve is a downward-sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.
T or F?
TRUE
A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a normal yield curve.
T or F?
FALSE
A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a flat yield curve.
Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term loans relative to their respective demand.
T or F?
TRUE
A flat yield curve means that the rates do not vary much at different maturities.
T or F?
TRUE
A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
T or F?
TRUE
A flat yield curve indicates generally cheaper long-term borrowing costs than short-term borrowing costs.
T or F?
FALSE
An inverse yield curve indicates generally cheaper long-term borrowing costs than short-term borrowing costs.
The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.
T or F?
TRUE
The liquidity preference theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.
T or F?
FALSE
The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.
The liquidity preference theory suggests that short-term interest rates should be lower than long-term interest rates most of the time.
T or F?
TRUE
The expectations theory suggests that the shape of the yield curve reflects investors expectations about future interest rates.
T or F?
TRUE
A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
T or F?
FALSE
An upward-sloping yield curve indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
T or F?
FALSE
An normal yield curve is an upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
The liquidity preference theory suggests that long-term interest rates tend to be higher than short-term rates (and therefore the yield curve slopes up) due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities.
T or F?
TRUE
The components of risk premium includes business risk, financial risk, interest rate risk, liquidity risk, and tax risk.
T or F?
TRUE
The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called maturity risk.
T or F?
FALSE
Default risk
The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called default risk.
T or F?
TRUE
The ________ rate of interest is the rate that balances the supply of savings and the demand for investment funds.
A) Nominal
B) Real
C) Risk-free
D) Equilibrium
D
Generally, an increase in risk will result in ________.
A) a lower required return or interest rate
B) a higher required return or interest rate
C) a higher inflation premium
D) a lower real interest rate
B
Although no investment is truly risk free, ________ are generally viewed as the closest thing we can come to in the real world to a risk-free investment.
A) U.S. Treasury securities
B) AAA-rated corporate bonds
C) secured bonds
D) zero-coupon bonds
A
Ai Lun, a management trainee at a large New York-based bank, is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent , and consumer prices have been rising steadily at a 2% rate for several years. What should Ai Lun’s estimate of the real rate be?
A) 5%
B) 1%
C) 3%
D) 2%
B
Nico invested an amount a year ago and calculated his return on investment. He found that his purchasing power had increased by 15 percent as a result of his investment. If inflation during the year was 4 percent, then Nico’s ________.
A) real return on investment is more than 15 percent
B) nominal return on investment is more than 15 percent
C) nominal return on investment is less than 11 percent
D) real return on investment is equal to 4 percent
B
The ________ rate of interest is the actual rate charged by the supplier and paid by the demander of funds.
A) Nominal
B) Real
C) Risk-free
D) Inflationary
A
The ________ is the compound annual rate of interest earned on a debt security purchased on a given date and held to maturity.
A) risk premium
B) yield curve
C) risk-free rate
D) yield to maturity
D
A(n) ________ is a graphic depiction of the relation between the maturity and rate of return for bonds with similar risks.
A) yield curve
B) supply function
C) risk-return profile
D) aggregate demand curve
A
According to the expectations hypothesis, a(n) ________ yield curve reflects higher expected future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
A
According to the expectations hypothesis, a(n) ________ yield curve reflects lower expected future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
C
The term structure of interest rates is the relationship between ________.
A) the present value of principal and coupon rate of the bonds
B) the general expectation of inflation and nominal rate of return for bonds
C) the general expectation of inflation and real rate of return for bonds
D) the maturity and rate of return for bonds with similar level of risk
D
A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs is called ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) linear yield curve
B
A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs is called ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) linear yield curve
B
A yield curve that reflects relatively similar borrowing costs for both short-term and long-term loans is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal curve
C
The theory suggesting that for any given issuer, long-term interest rates tends to be higher than short-term rates is called ________.
A) expectation hypothesis
B) liquidity preference theory
C) market segmentation theory
D) interest parity theory
B
Which of the following explains the general shape of the yield curve?
A) Expectations theory
B) Perfect market theory
C) Capital asset pricing theory
D) Securities market theory
A
Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based on this information, the shape of the yield curve is ________.
A) upward sloping
B) downward sloping
C) flat
D) normal
B
________ mainly explains the tendency for the yield curve to be upward sloping.
A) Expectations theory
B) Liquidity preference theory
C) Market segmentation theory
D) Investor perception theory
B
Which of the following affects the slope of yield curve?
A) tax rates
B) dividend policy
C) selection of accounting standards
D) liquidity preferences
D
Which of the following is true of the risk premium?
A) T-bills have a have a higher risk premium compared with Treasury bonds.
B) Government bonds have a higher risk premium compared with corporate bonds.
C) Junk bonds have a lower risk premium investment-grade bonds.
D) The lower-rated corporate issues have a higher risk premium than that of the higher rated corporate issues
D
Suppose the expectations hypothesis is true. If the yield curve is flat this means that ________.
A) investors do not expect interest rates to change in the future
B) investors expect interest rates to rise in the future
C) investors expect interest rates to fall in the future
D) investors do not require a premium for expected inflation
A
The coupon rate on a bond represents the percentage of the bond’s par value that will be paid annually, typically in two equal semiannual payments, as interest.
T or F?
TRUE
Restrictive covenants are contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower
T or F?
TRUE
The reason for a difference in the yield between a Aaa corporate bond and an otherwise identical Baa bond is the risk premium; other things being equal.
T or F?
TRUE
Standard debt provisions specify certain record keeping and general business practices that must be followed by the bond issuer.
T or F?
TRUE
A trustee is a paid party representing the bond issuer in the bond indenture.
T or F?
FALSE
Restrictive covenants, coupled with standard debt provisions, help the lender to monitor the borrower’s activities to ensure efficient use of funds.
T or F?
TRUE
In a bond indenture, subordination is the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied.
T or F?
TRUE
The bond indenture identifies any collateral pledged against a bond and specifies how it is to be maintained.
T or F?
TRUE
A sinking-fund requirement requires a corporate to make semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.
T or F?
TRUE
Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied.
T or F?
TRUE
Restrictive covenants place operating and financial constraints on the borrower.
T or F?
TRUE
In most cases, the longer the maturity of a bond, the higher is the cost of a bond to the issuer.
T or F?
TRUE
The lower a bond’s default risk, the higher is the interest rate.
T or F?
FALSE
High risk = High returns (interest)
The legal contract setting forth the terms and provisions of a corporate bond is a(n) ________.
A) indenture
B) debenture
C) loan document
D) promissory note
A
A debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms is called a(n) ________.
A) common stock
B) corporate bond
C) indenture
D) preferred stock
B
A(n) ________ is a paid individual, corporation, or a commercial bank trust department that acts as a third party to a bond indenture.
A) trustee
B) investment banker
C) bond issuer
D) bond rating agency
A
A ________ is a restrictive provision in a bond indenture, providing for the systematic retirement of the bonds prior to their maturity.
A) redemption clause
B) sinking-fund requirement
C) conversion feature
D) subordination clause
B
Bond indentures include restrictive covenants.These provisions protect the bondholders against ________.
A) increase in inflation rate
B) increase in borrower’s risk
C) decrease in liquidity risk
D) maturity risk
B
Which of the following is a restrictive covenant?
A) to maintain satisfactory accounting records
B) to pay the taxes due
C) to supply audited financial statements
D) to impose fixed asset restrictions
D
The purpose of the debt covenant that requires maintaining a minimum level of net working capital is to ________.
A) protect the lender by controlling the risk and marketability of the borrower’s security investment alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) limit the annual cash dividends paid by the firm
C
The purpose of the debt covenant that prohibits borrowers from entering into certain types of leases is to ________.
A) protect the lender by controlling the risk and marketability of the borrower’s security investments alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) limit the annual cash dividends paid by the firm
B
The purpose of the restrictive debt covenant that imposes fixed assets restrictions is to ________.
A) protect the lender by controlling the risk and marketability of the borrower’s security investment alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) prevent the firm from liquidation and ensure its ability to repay the debt
D
The purpose of the restrictive debt covenant that prohibits the sale of accounts receivable is to ________.
A) assure the lender that additional borrowing is constrained
B) limit the amount of fixed-payment obligations
C) prevent the firm from selling current assets to raise cash to pay current obligations
D) limit the payment of annual cash dividends
C
The purpose of the restrictive debt covenant that requires that subsequent borrowing be subordinated to the original loan is to ________.
A) maintain a minimum level of liquidity
B) limit the amount of fixed-payment obligations
C) ensure a long-run cash shortage does not cause an inability to meet current obligations
D) protect the original lender in the priority of claims during liquidation
D
________ means that subsequent creditors agree to wait until all claims of the are senior debt satisfied before having their claims satisfied.
A) Security interest
B) Subordination
C) Sinking fund requirement
D) Bond indenture
B