Elements of Interest Rates

Question 1

. The investment opportunities in productive assets

Answer 1

Production Opportunities.

Question 2

The preferences of consumers for current

consumption as opposed to saving for future consumption.

Answer 2

Time Preferences for Consumption.

Question 3

. In a financial market context, the chance that an investment will provide a low or
negative return

Answer 3

Risk.

Question 4

The amount by which prices increase over time.

Answer 4

Inflation

Question 5

The rate of interest on a security that is free

of all risk. (r* + IP)

Answer 5

Nominal (Quoted) Risk-Free Rate, rRF

Question 6

A premium equal to expected inflation that investors add to

the real risk-free rate of return

Answer 6

Inflation Premium (IP)

Question 7

The difference between the interest rate on a Treasury

Bond and a Corporate Bond of equal maturity and marketability

Answer 7

Default Risk Premium (DRP).

Question 8

A premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash on short notice and at close to its
fair market value

Answer 8

Liquidity Premium (LP)

Question 9

The risk of capital losses to which investors are exposed because
of changing interest rates

Answer 9

Interest Rate Risk.

Question 10

A premium that reflects interest rate risk.

Answer 10

. Maturity Risk Premium (MRP)

Question 11

. The risk that a decline in interest rates will lead to lower
income when bonds mature and funds are reinvested.

Answer 11

Reinvestment Rate Risk

Question 12

A graph showing the relationship between bond yields and maturities

Answer 12

. Yield Curve.

Question 13

An upward-sloping yield curve.

Answer 13

Normal Yield Curve

Question 14

A downward-sloping yield curve

Answer 14

. Inverted Yield Curve

Question 15

A theory that states that the shape of the yield curve

depends on investors’ expectations about future interest rates

Answer 15

Pure Expectations Theory.

Question 16

The situation that exists when a country imports more than it
exports

Answer 16

. Foreign Trade Deficit.

Question 17

These are investment opportunities in productive (cash generating) asset

Answer 17

Production Opportunities

Question 18

The preferences of consumers for current

consumption as opposed to saving for future consumption.

Answer 18

Time Preferences for consumption

Question 19

. In a financial market context, the chance that an investment will provide a low or
negative return.

Answer 19

Risk

Question 20

The amount by which prices increase over time

Answer 20

Inflation

Question 21

In general, the quoted (or nominal) interest rate on a
debt security, r, is composed of a real risk-free rate of interest, r*, plus several premiums
that reflect inflation, the security’s risk, and its marketability (or liquidity)

Answer 21

Determinants of Interest Rates

Question 22

This is the required return on a debt security

Answer 22

Quoted or Nominal Rate (r).

Question 23

It is pronounced as “r-star”, and it is the rate that would exist on a riskless security in a world with no inflation

Answer 23

Real Risk-Free Rate (r*).

Question 24

It is the quoted rate on a risk-free security such as government
bills, which are mostly very liquid and free of most types of risk. It is the real risk-free
rate added with inflation premium (r* + IP).

Answer 24

3 Risk-Free Rate (rRF)

Question 25

It is equal to the average expected inflation rate over the life
of the security

Answer 25

4 Inflation Premium (IP)

Question 26

The risk that a borrower will default, which means not

make scheduled interest or principal payments

Answer 26

Default Risk Premium (DRP)

Question 27

A premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash on short notice and at close to its
fair market value. Generally, real assets are less liquid than financial assets.

Answer 27

Liquidity Premium (LP)

Question 28

It is the premium that reflects interest rate risk. it
varies somewhat over time, rising when interest rates are more volatile and uncertain,
then falling when interest rates are more stable

Answer 28

Maturity Risk Premium (MRP).

Question 29

The risk of capital losses to which investors are exposed

because of changing interest rates.

Answer 29

Interest Rate Risk

Question 30

what is the relationship between interest rate risk and maturity of the security

Answer 30

The more interest rate risk, the longer the

maturity of the security.

Question 31

The risk that a decline in interest rates will lead to lower
income when bonds mature and funds are reinvested. Short-term securities are
heavily exposed to reinvestment rate risk

Answer 31

Reinvestment Rate Risk

Question 32

Premiums Added to short term treasury

Answer 32

Inflation Premium

Question 33

Premiums Added to long term treasury

Answer 33

inflation premium, maturity risk premium

Question 34

Premiums Added to short term corporate

Answer 34

IP, DRP, LP

Question 35

Premiums Added to long term corporate

Answer 35

IP, MRP, DRP, LP

Question 36

contends that the shape of the yield curve depends on investors’ expectations about future interest
rates

Answer 36

The pure expectations theory

Question 37

Assumptions of Pure Expectations.

Answer 37

• Assumes that the maturity risk premium for Treasury securities is zero.
• Long-term rates are an average of current and future short-term rates.
• If the pure expectations theory is correct, you can use the yield curve to “back out” expected future interest rates

Question 38

Macroeconomic Factors That Influence Interest Rate Levels.

Answer 38

8. 1 Federal Reserve Policy
9. 2 Federal Budget Deficits or Surpluses
10. 3 International Factors
11. 4 Level of Business Activity