Interest Rates

Question 1

The required rate of return (RRR) is

Answer 1

the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.

Question 2

The first building block for assessing a required return is

Answer 2

the risk-free interest rate.

Question 3

Interest rates directly affect lending and borrowing because

Answer 3

higher interest rates make servicing loans more costly.

Question 4

Supply and demand impact affect interest rates when

Answer 4

the current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates.

Question 5

Required rate of return:

Answer 5

the minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.

Question 6

Yield:

Answer 6

commonly refers to the dividend, interest or return the investor receives from a security like a stock or bond, and is usually reported as an annual figure.

Question 7

Interest Rates:

Answer 7

the cost of borrowing money; generally refers to the interest charged by a lender such as a bank on a loan.

Question 8

Annual Percentage Rate (APR):

Answer 8

the annual rate charged for borrowing or earned through an investment, expressed as a percentage that represents the actual yearly cost of funds over the term of a loan.

Question 9

Effective APR:

Answer 9

The amount you pay after fees and compound interest have been added to the charges.

Question 10

A market interest rate is

Answer 10

the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market. Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference.

Question 11

A market interest rate is

Answer 11

the rate at which interest is paid by a borrower for the use of money that they borrow from a lender in the market.

Question 12

Economists generally agree that

Answer 12

the interest rates yielded by any investment take into account: the risk-free cost of capital, inflationary expectations, the level of risk in the investment, and the costs of the transaction.

Question 13

A basic interest rate pricing model for an asset is presented by the following formula

Answer 13

in=ir+pe+rp+lp.

Question 14

Abscond:

Answer 14

to flee; to withdraw from.

Question 15

Inflation:

Answer 15

an increase in the general level of prices or in the cost of living.

Question 16

Interest rate risk:

Answer 16

the potential for loss that arises for bond owners from fluctuating interest rates.

Question 17

Liquidity:

Answer 17

availability of cash over the short term; ability to service short-term debt.

Question 18

Deferred consumption:

Answer 18

When money is loaned, the lender delays spending the money on consumption goods. According to time preference theory, people prefer goods now to goods later. In a free market there will be a positive interest rate.

Question 19

Inflationary expectations:

Answer 19

Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. If the inflationary expectation goes up, then so does the market interest rate and vice versa.

Question 20

Alternative investments:

Answer 20

The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds, boosting the market interest rate up.

Question 21

Risks of investment:

Answer 21

There is always a risk that the borrower will abscond, die, go bankrupt, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that he is compensated for those that fail, across all his investments. The greater the risk, the higher the market interest rate will get.

Question 22

Liquidity preference:

Answer 22

People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. If people are willing to hold more money in hands for convenience, the money supply will contract, increasing the market interest rate.

Question 23

Term structure of interest rates describes

Answer 23

how rates change over time.

Question 24

Term structure of interest rates is often referred to as

Answer 24

the yield curve.

Question 25

The expectation hypothesis of the term structure of interest rates is

Answer 25

the proposition that the long-term rate is determined by the market’s expectation for the short-term rate plus a constant risk premium.

Question 26

The liquidity premium theory asserts that

Answer 26

long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds.

Question 27

In the segmented market hypothesis, financial instruments of different terms are not substitutable; therefore

Answer 27

supply and demand in the markets for short-term and long-term instruments is determined largely independently.

Question 28

Liquidity premium:

Answer 28

a term used to explain a difference between two types of financial securities (e.g., stocks), that have all the same qualities except liquidity.

Question 29

Premium:

Answer 29

the price above par value at which a security is sold.

Question 30

Premium bond:

Answer 30

a debt instrument bought at a price above par value.

Question 31

Risk premium:

Answer 31

a risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, or the expected return on a less risky asset, in order to induce an individual to hold the risky asset rather than the risk-free asset.

Question 32

Term structure of interest rates:

Answer 32

the relationship between the interest on a debt contract and the maturity of the contract.

Question 33

Yield Curve:

Answer 33

a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

Question 34

Term structure is a phrase used to describe

Answer 34

how a given quantity or variable changes with time. In the case of bonds, time to maturity, or terms, vary from short-term–usually less than a year–to long-term–10, 20, 30, 50 years, etc. Term structure of interest rates is often referred to as the yield curve.

Question 35

In finance, the yield curve is

Answer 35

a curve showing several yields or interest rates across different contract lengths (2 month, 2 year, 20 year, etc…) for a similar debt contract. The curve shows the relationship between the interest rate (or cost of borrowing) and the time to maturity—known as the “term”—of the debt for a given borrower in a given currency.

Question 36

The expectation hypothesis of the term structure of interest rates is

Answer 36

the proposition that the long-term rate is determined by the market’s expectation for the short-term rate plus a constant risk premium.

Question 37

The liquidity premium theory asserts that

Answer 37

long-term interest rates not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds (investors prefer short-term bonds to long-term bonds). This is called the term premium or the liquidity premium.

Question 38

In the segmented market hypothesis, financial instruments of different terms are

Answer 38

not substitutable.

Question 39

An interest rate is

Answer 39

the rate at which interest is paid by a borrower for the use of money that they borrow from a lender.

Question 40

In the U.S., the Federal Reserve (often referred to as ‘The Fed’) implements

Answer 40

monetary policies largely by targeting the federal funds rate.

Question 41

Expansionary monetary policy is traditionally used to

Answer 41

try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.

Question 42

Contractionary monetary policy is intended to

Answer 42

slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

Question 43

Crowding out is a phenomenon occurring when

Answer 43

expansionary fiscal policy causes interest rates to rise, thereby reducing investment spending.

Question 44

Monetary policy:

Answer 44

the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.

Question 45

Crowding out is a

Answer 45

phenomenon occurring when expansionary fiscal policy causes interest rates to rise, thereby reducing investment spending. That means increase in government spending crowds out investment spending.

Question 46

The cost of money is not related to the concept of

Answer 46

Depreciation - is an expense related to the value of an asset and is not affected by how the asset is financed.

Question 47

Government bonds have lower interest rates than do actively traded corporate bonds of the same maturity because the default premium is lower for government bonds. This illustrates which of the major factors influencing market interest rates?

Answer 47

Risk of Investment: Because the lower risk of default on the government bond results in that bond having a lower interest rate.

Question 48

Which yield curve theory is based on the premises that financial instruments of different terms are not substitutable and therefore the supply and demand in the markets for short-term and long-term instruments is determined largely independently?

Answer 48

The segmented market hypothesis

Question 49

Which answer is not a correct description of a type of yield curve?

Answer 49

When long-term yields fall below short-term yields, the curve is flat.