Gypsy

The six-month spot rate is 4% and the 1 year annualized spot rate is 9% (4.5% on a semiannual basis). Based on the pure expectations theory of interest rates, the implied six-month rate six months from now is closest to:

A) 5%.

B) 6%.

C) 4%.

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1r1 = [(1 + R2)2 / (1 + R1)1] - 1 = [(1.045)2/(1.04)1] - 1
[1.092 / 1.04] - 1 = 0.05

Gypsy

Generally speaking, an upward-sloping yield curve can be expected when:

A) the supply of long-term funds falls short of demand.

B) the supply of long-term funds falls short of demand and investors begin to show a preference for more liquid/less risky short-term securities.

C) inflationary expectations are beginning to subside and investors begin to show a preference for more liquid/less risky short-term securities.

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When demand for loanable funds outstrips supply, interest rates can be expected to rise in that (long-term) segment of the market; also, more preference for short-term securities can be expected to drive up long-term rates as the liquidity premium rises. Thus, both circumstances in the answer can be expected to put upward pressure on the long end of the yield curve.

Gypsy

The liquidity preference theory of the term structure of interest rates implies that the shape of the yield curve should be:

A) variable.

B) upward-sloping.

C) flat or humped.

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The liquidity preference theory definitely puts upward pressure on the long end of the term structure and, by itself, would lead to an upward-sloping yield curve.

Gypsy

If the slope of the yield curve begins to rise sharply, it is usually an indication that:

A) stocks are offering abnormally high rates of return.

B) the Fed has been aggressively driving up short-term interest rates.

C) the rate of inflation is starting to increase or is expected to do so in the near future.

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According to the expectations hypothesis, higher long-term interest rates and, therefore, upward-sloping yield curves will occur if the rate of inflation starts to heat up or is expected to do so in the near future.

Gypsy

James McDonald and Veasna Lu were discussing different ways of valuing a Treasury security. During their discussion Lu made the following statements:
Statement 1: It is inappropriate to discount the cash flows of a Treasury security by a single discount rate because that is implicitly assuming that the yield curve is flat. Therefore, each individual cash flow should be discounted by its corresponding spot rate.
Statement 2: The spot rates used for different time periods that produce a value equal to the market price of a Treasury bond are called forward rates or future expected spot rates.
With regard to the statements made by Lu:

A) only one is correct.

B) both are correct.

C) both are incorrect.

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Statement 2 is incorrect because the spot rates used for different time periods that produce a value equal to the market price of a Treasury bond are called arbitrage-free Treasury spot rates. Statement 1 is correct.

Gypsy

The Treasury spot rate yield curve is closest to which of the following curves?

A) Zero-coupon bond yield curve.

B) Par bond yield curve.

C) Forward yield curve rate.

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The spot rate yield curve shows the appropriate rates for discounting single cash flows occuring at different times in the future. Conceptually, these rates are equivalent to yields on zero-coupon bonds. The par bond yield curve shows the YTMs on coupon bonds by maturity. Forward rates are expected future short-term rates.

Gypsy

Bond A has a yield of 8.75%. Bond B, the reference bond, has a yield of 7.45%. Assuming both bonds have the same maturity, the relative yield spread is closest to:

A) 13%.

B) 17%.

C) 15%.

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Relative yield spread = absolute yield spread / yield on reference bond
Relative yield spread = (8.75% − 7.45%) / 7.45% = 0.17 = 17%

Gypsy

A Treasury bond due in one-year has a yield of 8.5%. A Treasury bond due in 5 years has a yield of 9.3%. A bond issued by General Motors due in 5 years has a yield of 9.9%. A bond issued by Exxon due in one year has a yield of 9.4%. The default risk premiums on the bonds issued by Exxon and General Motors are:

Exxon

General Motors

A) 0.1% 0.6%

B) 0.9% 0.6%

C) 0.1% 1.4%

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9.4 − 8.5 = 0.9
9.9 − 9.3 = 0.6

Gypsy

Assume the following corporate yield curve.

One-year rate: 5%
Two-year rate: 6%
Three-year rate: 7%

If a 3-year annual-pay corporate bond has a coupon of 6%, its yield to maturity is closest to:

A) 6.08%.

B) 7.00%.

C) 6.92%.

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First determine the current price of the corporate bond:
= 6 / 1.05 + 6 / (1.06)2 + 106 / (1.07)3 = 5.71 + 5.34 + 86.53 = 97.58
Then compute the yield of the bond:
N = 3; PMT = 6; FV = 100; PV = -97.58; CPT → I/Y = 6.92%

Gypsy

A Treasury security carries a yield of 4.2% and a non-Treasury security carries a yield of 6.4%. Using the Treasury rate as the reference rate, which of the following statements is least accurate?

A) If the Treasury rate rises and the absolute spread stays the same, the yield ratio declines.

B) The absolute yield spread is 2.2%.

C) The yield ratio is 1.022.

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The yield ratio is (6.4%) / (4.2%) = 1.524, or one plus the relative yield spread.