283366 1 Exam 2 Review Sheet Ch 6 8 9 1 PDF

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FIN 300 FALL 2012

FIN 300, BUSINESS FINANCE EXAM 2 REVIEW CHAPTERS: 6, 8, 9 1. One of the four most fundamental factors that affect the cost of money as discussed in the text is the expected rate of inflation. If inflation is expected to be relatively high, then interest rates will tend to be relatively low, other things held constant. a. True b. False

2. If the demand curve for funds increased but the supply curve remained constant, we would expect to see the total amount of funds supplied and demanded increase and interest rates in general also increase. a. True b. False 3. During periods when inflation is increasing, interest rates tend to increase, while interest rates tend to fall when inflation is declining. a. True b. False 4. If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*. a. True b. False

5. If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upwardsloping yield curve. a. True b. False

6. The “yield curve” shows the relationship between bonds' maturities and their yields. a. True b. False

FIN 300 FALL 2012 7. Because the maturity risk premium is normally positive, the yield curve must have an upward slope. If you measure the yield curve and find a downward slope, you must have done something wrong. a. True b. False

8. If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill. a. True b. False

9. An upward-sloping yield curve is often call a “normal” yield curve, while a downward-sloping yield curve is called “abnormal.” a. True b. False 10.The Federal Reserve tends to take actions to increase interest rates when the economy is very strong and to decrease rates when the economy is weak. a. True b. False 11.

Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant? a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping. b. If the pure expectations theory holds, the corporate yield curve must be downward sloping. c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping. d. If inflation is expected to decline, there can be no maturity risk premium. e. The expectations theory cannot hold if inflation is decreasing.

12.

FIN 300 FALL 2012 Which of the following statements is CORRECT, other things held constant? a. If companies have fewer good investment opportunities, interest rates are likely to increase. b. If individuals increase their savings rate, interest rates are likely to increase. c. If expected inflation increases, interest rates are likely to increase. d. Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities. e. Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.

13.

Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72%

AAA = 8.72%

A = 9.64%

BBB = 10.18%

The differences in these rates were probably caused primarily by: a. b. c. d. e.

14.

Tax effects. Default and liquidity risk differences. Maturity risk differences. Inflation differences. Real risk-free rate differences.

If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? a. The yield on a 10-year bond would be less than that on a 1year bill. b. The yield on a 10-year bond would have to be higher than that on a 1year bill because of the maturity risk premium. c. It is impossible to tell without knowing the coupon rates of the bonds. d. The yields on the two securities would be equal. e. It is impossible to tell without knowing the relative risks of the two securities.

15.

The real risk-free rate is expected to remain constant at 3% in the future, a 2% rate of inflation is expected for the next 2 years, after which inflation is expected to increase to 4%, and there is a positive maturity risk premium that increases with years to maturity. Given these conditions, which of the following statements is CORRECT? a. The yield on a 2-year T-bond must exceed that on a 5-year Tbond.

FIN 300 FALL 2012 b. The yield on a 5-year Treasury bond must exceed that on a 2year Treasury bond. c. The yield on a 7-year Treasury bond must exceed that of a 5year corporate bond. d. The conditions in the problem cannot all be true--they are internally inconsistent. e. The Treasury yield curve under the stated conditions would be humped rather than have a consistent positive or negative slope. 16.

Which of the following statements is CORRECT? a. If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is greater than zero, then the Treasury yield curve will have an upward slope. b. If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an upward slope. c. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds. d. If the maturity risk premium (MRP) equals zero, the yield curve must be flat. e. The yield curve can never be downward sloping.

17.

Which of the following statements is CORRECT? a. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. b. The most likely explanation for an inverted yield curve is that investors expect inflation to increase. c. The most likely explanation for an inverted yield curve is that investors expect inflation to decrease. d. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. e. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve can never be inverted.

18.

Assuming that the term structure of interest rates is determined as posited by the pure expectations theory, which of the following statements is CORRECT? a. In equilibrium, long-term rates must be equal to short-term rates. b. An upward-sloping yield curve implies that future short-term rates are expected to decline. c. The maturity risk premium is assumed to be zero. d. Inflation is expected to be zero. e. Consumer prices as measured by an index of inflation are expected to rise at a constant rate.

FIN 300 FALL 2012

19.

If the pure expectations theory of the term structure is correct, which of the following statements would be CORRECT? a. An upward-sloping yield curve would imply that interest rates are expected to be lower in the future. b. If a 1-year Treasury bill has a yield to maturity of 7% and a 2-year Treasury bill has a yield to maturity of 8%, this would imply the market believes that 1-year rates will be 7.5% one year from now. c. The yield on a 5-year corporate bond should always exceed the yield on a 3-year Treasury bond. d. Interest rate (price) risk is higher on long-term bonds, but reinvestment rate risk is higher on short-term bonds. e. Interest rate (price) risk is higher on short-term bonds, but reinvestment rate risk is higher on long-term bonds.

Which of the following statements is CORRECT? a. Even if the pure expectations theory is correct, there might at times be an inverted Treasury yield curve. b. If the yield curve is inverted, short-term bonds have lower yields than long-term bonds. c. The higher the maturity risk premium, the higher the probability that the yield curve will be inverted. d. Inverted yield curves can exist for Treasury bonds, but because of default premiums, the corporate yield curve cannot become inverted. e. The most likely explanation for an inverted yield curve is that investors expect inflation to increase in the future. 20.

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? (Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average). a. b. c. d. e.

21.

3.80% 3.99% 4.19% 4.40% 4.62%

The real risk-free rate is 3.05%, inflation is expected to be 2.75% this year, and the maturity risk premium is zero. Ignoring any cross-product terms, what is the equilibrium rate of return on a 1-year Treasury bond? a. b. c. d.

5.51% 5.80% 6.09% 6.39%

FIN 300 FALL 2012 e. 6.71%

22.

Suppose the real risk-free rate is 4.20%, the average expected future inflation rate is 3.10%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10% (t), where t is the years to maturity, hence the pure expectations theory is NOT valid. What rate of return would you expect on a 4year Treasury security? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. b. c. d. e.

23.

The real risk-free rate is 3.55%, inflation is expected to be 3.15% this year, and the maturity risk premium is zero. Taking account of the cross-product term, i.e., not ignoring it, what is the equilibrium rate of return on a 1-year Treasury bond? a. b. c. d. e.

24.

5.840% 6.148% 6.471% 6.812% 7.152%

Suppose the yield on a 10-year T-bond is currently 5.05% and that on a 10-year Treasury Inflation Protected Security (TIPS) is 2.15%. Suppose further that the MRP on a 10-year T-bond is 0.90%, that no MRP is required on a TIPS, and that no liquidity premium is required on any Tbond. Given this information, what is the expected rate of inflation over the next 10 years? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. a. b. c. d. e.

25.

6.60% 6.95% 7.32% 7.70% 8.09%

1.81% 1.90% 2.00% 2.10% 2.21%

Suppose 10-year T-bonds have a yield of 5.30% and 10-year corporate bonds yield 6.75%. Also, corporate bonds have a 0.25% liquidity premium versus a zero liquidity premium for T-bonds, and the maturity risk premium on both Treasury and corporate 10-year bonds is 1.15%. What is the default risk premium on corporate bonds? a. b. c. d.

1.08% 1.20% 1.32% 1.45%

FIN 300 FALL 2012 e. 1.60%

26.

Koy Corporation's 5-year bonds yield 7.00%, and 5-year Tbonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Koy's bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) × 0.1%, where t = number of years to maturity. What is the default risk premium (DRP) on Koy's bonds? a. b. c. d. e.

5.94% 6.60% 7.26% 7.99% 8.78%

27.Kay Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%. The real risk-free rate is r* = 2.5%, the inflation premium for 5-year bonds is IP = 1.50%, the default risk premium for Kay's bonds is DRP = 1.30% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) × 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Kay's bonds? a. b. c. d. e. 28.

Kern Corporation's 5-year bonds yield 7.30% and 5-year Tbonds yield 4.10%. The real risk-free rate is r* = 2.5%, the default risk premium for Kern's bonds is DRP = 1.90% versus zero for T-bonds, the liquidity premium on Kern's bonds is LP = 1.3%, and the maturity risk premium for all bonds is found with the formula MRP = (t – 1) × 0.1%, where t = number of years to maturity. What is the inflation premium (IP) on all 5-year bonds? a. b. c. d. e.

29.

0.36% 0.41% 0.45% 0.50% 0.55%

1.20% 1.32% 1.45% 1.60% 1.68%

Kelly Inc's 5-year bonds yield 7.50% and 5-year T-bonds yield 4.90%. The real risk-free rate is r* = 2.5%, the default risk premium for Kelly's bonds is DRP = 0.40%, the liquidity premium on Kelly's bonds is LP = 2.2% versus zero on T-bonds, and the inflation premium (IP) is 1.5%. What is the maturity risk premium (MRP) on all 5-year bonds? a. 0.73%

FIN 300 FALL 2012 b. c. d. e. 30.

Kop Corporation's 5-year bonds yield 6.50%, and T-bonds with the same maturity yield 4.40%. The default risk premium for Kop's bonds is DRP = 0.40%, the liquidity premium on Kop's bonds is LP = 1.70% versus zero on T-bonds, the inflation premium (IP) is 1.50%, and the maturity risk premium (MRP) on 5-year bonds is 0.40%. What is the real risk-free rate, r*? a. b. c. d. e.

31.

5.21% 5.49% 5.78% 6.07% 6.37%

Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10% (t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Include the cross-product term, i.e., if averaging is required, use the geometric average. a. b. c. d. e.

33.

2.04% 2.14% 2.26% 2.38% 2.50%

Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? a. b. c. d. e.

32.

0.81% 0.90% 0.99% 1.09%

5.15% 5.42% 5.69% 5.97% 6.27%

Suppose the interest rate on a 1-year T-bond is 5.0% and that on a 2year T-bond is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now? a. b. c. d. e.

7.36% 7.75% 8.16% 8.59% 9.04%

FIN 300 FALL 2012

34.Suppose the real risk-free rate is 3.25%, the average future inflation rate is 4.35%, and a maturity risk premium of 0.07% per year to maturity applies to both corporate and T-bonds, i.e., MRP = 0.07%(t), where t is the years to maturity. Suppose also that a liquidity premium of 0.50% and a default risk premium of 0.90% apply to A-rated corporate bonds but not to T-bonds. How much higher would the rate of return be on a 10-year A-rated corporate bond than on a 5-year Treasury bond? a. b. c. d. e.

35.

1.75% 1.84% 1.93% 2.03% 2.13%

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. a. True b. False

36.

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly. a. True b. False

37.

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False

38.

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False

39.

The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

FIN 300 FALL 2012 a. True b. False

40.

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0. a. True b. False

41.

According to the Capital Asset Pricing Model, investors are primarily concerned with portfolio risk, not the risks of individual stocks held in isolation. Thus, the relevant risk of a stock is the stock's contribution to the riskiness of a welldiversified portfolio. a. True b. False

42.

Variance is a measure of the variability of returns, and since it involves squaring the deviation of each actual return from the expected return, it is always larger than its square root, the standard deviation. a. True b. False

43.

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk. a. True b. False

44.

“Risk aversion” implies that investors require higher expected returns on riskier than on less risky securities. a. True b. False

45.

A stock's beta is more relevant as a measure of risk to an investor who holds only one stock than to an investor who holds a well-diversified portfolio. a. True b. False

FIN 300 FALL 2012 A portfolio's risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

46.

a. True b. False

47.

Bad managerial judgments or unforeseen negative events that happen to a firm are defined as “company-specific,” or “unsystematic,” events, and their effects on investment risk can in theory be diversified away. a. True b. False

48.

The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM. a. True b. False

49.

The slope of the SML is determined by investors' aversion to risk. The greater the average investor's risk aversion, the steeper the SML. a. True b. False

50.

Since the market return represents the expected return on an average stock, the market return reflects a certain amount of risk. As a result, there exists a market risk premium, which is the amount over and above the risk-free rate, that is required to compensate stock investors for assuming an average amount of risk. a. True b. False

51.

You have the following data on three stocks: Stock A B C

Standard Deviation 20% 10% 12%

Beta 0.59 0.61 1.29

If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; A. b. A; B.

FIN 300 FALL 2012 c. B; A. d. C; A. e. C; B.

52.

A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter? a. Either A or B, i.e., the investor should be indifferent between the two. b. Stock A. c. Stock B. d. Neither A nor B, as neither has a retu...