Chapter 3

WhatDoInterestRatesMeanandWhatIsTheir
RoleinValuation?

.1

Multiple Choice Questions

1.

Aloanthatrequirestheborrowertomakethesamepaymenteveryperioduntilthe
maturitydateiscalleda
(a) simpleloan.
(b) fixedpaymentloan.
(c) discountloan.
(d) samepaymentloan.
(e) noneoftheabove.
Answer: B

2.

Acouponbondpaystheownerofthebond
(a) thesameamounteverymonthuntilmaturitydate.
(b) afixedinterestpaymenteveryperiodandrepaysthefacevalueatthematuritydate.
(c) thefacevalueofthebondplusaninterestpaymentoncethematuritydatehasbeen
reached.
(d) thefacevalueatthematuritydate.
(e) noneoftheabove.
Answer: B

3.

Abondsfuturepaymentsarecalledits
(a) cashflows.
(b) maturityvalues.

(c) discountedpresentvalues.
(d) yieldstomaturity.
Answer: A
4.

Acreditmarketinstrumentthatpaystheownerthefacevalueofthesecurityatthe
maturitydate
andnothingpriortotheniscalleda
(a) simpleloan.
(b) fixedpaymentloan.
(c) couponbond.
(d) discountbond.
Answer: D

5. (I)Asimpleloanrequirestheborrowertorepaytheprincipalatthematuritydatealong
withaninterestpayment.(II)Adiscountbondisboughtatapricebelowitsfacevalue,and
thefacevalueisrepaidatthematuritydate.
(a) (I)istrue,(II)false.
(b) (I)isfalse,(II)true.
(c) Botharetrue.
(d) Botharefalse.
Answer: C
6.

Whichofthefollowingaretrueofcouponbonds?
(a) Theownerofacouponbondreceivesafixedinterestpaymenteveryyearuntilthe
maturitydate,whenthefaceorparvalueisrepaid.
(b) U.S.Treasurybondsandnotesareexamplesofcouponbonds.
(c) Corporatebondsareexamplesofcouponbonds.
(d) Alloftheabove.

(e) Only(a)and(b)oftheabove.
Answer: D
7.

Whichofthefollowingaregenerallytrueofallbonds?
(a) Thelongerabondsmaturity,theloweristherateofreturnthatoccursasaresult
oftheincreaseinaninterestrate.
(b) Eventhoughabondhasasubstantialinitialinterestrate,itsreturncanturnoutto
benegativeifinterestratesrise.
(c) Pricesandreturnsforlongtermbondsaremorevolatilethanthoseforshorterterm
bonds.
(d) Alloftheabovearetrue.
(e) Only(a)and(b)oftheabovearetrue.
Answer: D

8.

(I)Adiscountbondrequirestheborrowertorepaytheprincipalatthematuritydate
plusaninterestpayment.(II)Acouponbondpaysthelenderafixedinterestpayment
everyyearuntilthematuritydate,whenaspecifiedfinalamount(faceorparvalue)is
repaid.
(a) (I)istrue,(II)false.
(b) (I)isfalse,(II)true.
(c) Botharetrue.
(d) Botharefalse.
Answer: B

9.

Ifa$5,000couponbondhasacouponrateof13percent,thenthecouponpayment
everyyearis
(a) $650.
(b) $1,300.
(c) $130.
(d) $13.
(e) Noneoftheabove.

Answer: A
10. An$8,000couponbondwitha$400annualcouponpaymenthasacouponrateof
(a) 5percent.
(b) 8percent.
(c) 10percent.
(d) 40percent.
Answer: A
11.

Theconceptof_________isbasedonthecommonsensenotionthatadollarpaidto
youinthefutureislessvaluabletoyouthanadollartoday.
(a) presentvalue
(b) futurevalue
(c) interest
(d) deflation
Answer: A

12.

Dollarsreceivedinthefutureareworth_________thandollarsreceivedtoday.The
processofcalculatingwhatdollarsreceivedinthefutureareworthtodayiscalled
_________
(a) more;discounting.
(b) less;discounting.
(c) more;inflating.
(d) less;inflating.
Answer: B

13.

Theprocessofcalculatingwhatdollarsreceivedinthefutureareworthtodayiscalled

(a) calculatingtheyieldtomaturity.
(b) discountingthefuture.
(c) compoundingthefuture.
(d) compoundingthepresent.
Answer: B
14.

Withaninterestrateof5percent,thepresentvalueof$100receivedoneyearfromnow
isapproximately
(a) $100.
(b) $105.
(c) $95.
(d) $90.
Answer: C

15.

Withaninterestrateof10percent,thepresentvalueofasecuritythatpays$1,100next
yearand$1,460fouryearsfromnowisapproximately
(a) $1,000.
(b) $2,000
(c) $2,560.
(d) $3,000.
Answer: B

16. Withaninterestrateof8percent,thepresentvalueof$100receivedoneyearfromnow
isapproximately
(a) $93.
(b) $96.

(c) $100.
(d) $108.
Answer: A
17.

Withaninterestrateof6percent,thepresentvalueof$100receivedoneyearfromnow
isapproximately
(a) $106.
(b) $100.
(c) $94.
(d) $92.
Answer: C

18.

Theinterestratethatequatesthepresentvalueofthecashflowreceivedfromadebt
instrumentwithitsmarketpricetodayisthe
(a) simpleinterestrate.
(b) discountrate.
(c) yieldtomaturity.
(d) realinterestrate.
Answer: C

19.

Theinterestratethatfinancialeconomistsconsidertobethemostaccuratemeasureis
the
(a) currentyield.
(b) yieldtomaturity.
(c) yieldonadiscountbasis.
(d) couponrate.
Answer: B

20.

Financialeconomistsconsiderthe_________tobethemostaccuratemeasureof
interestrates.
(a) simpleinterestrate
(b) discountrate
(c) yieldtomaturity
(d) realinterestrate
Answer: C

21.

Forasimpleloan,thesimpleinterestrateequalsthe
(a) realinterestrate.
(b) nominalinterestrate.
(c) currentyield.
(d) yieldtomaturity.
Answer: D

22. Forsimpleloans,thesimpleinterestrateis_________theyieldtomaturity.
(a) greaterthan
(b) lessthan
(c) equalto
(d) notcomparableto
Answer: C
23.

Theyieldtomaturityofaoneyear,simpleloanof$500thatrequiresaninterest
paymentof$40is
(a) 5percent.

(b) 8percent.
(c) 12percent.
(d) 12.5percent.
Answer: B
24.

Theyieldtomaturityofaoneyear,simpleloanof$400thatrequiresaninterest
paymentof$50is
(a) 5percent.
(b) 8percent.
(c) 12percent.
(d) 12.5percent.
Answer: D

25.

A$10,000,8percentcouponbondthatsellsfor$10,000hasayieldtomaturityof
(a) 8percent.
(b) 10percent.
(c) 12percent.
(d) 14percent.
Answer: A

26.

Whichofthefollowing$1,000facevaluesecuritieshasthehighestyieldtomaturity?
(a) A5percentcouponbondsellingfor$1,000
(b) A10percentcouponbondsellingfor$1,000
(c) A12percentcouponbondsellingfor$1,000
(d) A12percentcouponbondsellingfor$1,100

Answer: C
27.

Whichofthefollowing$1,000facevaluesecuritieshasthehighestyieldtomaturity?
(a) A5percentcouponbondsellingfor$1,000
(b) A10percentcouponbondsellingfor$1,000
(c) A15percentcouponbondsellingfor$1,000
(d) A15percentcouponbondsellingfor$900
Answer: D

28. Whichofthefollowingaretrueforacouponbond?
(a) Whenthecouponbondispricedatitsfacevalue,theyieldtomaturityequalsthe
couponrate.
(b) Thepriceofacouponbondandtheyieldtomaturityarenegativelyrelated.
(c) Theyieldtomaturityisgreaterthanthecouponratewhenthebondpriceisbelow
theparvalue.
(d) Alloftheabovearetrue.
(e) Only(a)and(b)oftheabovearetrue.
Answer: D
29.

Whichofthefollowingaretrueforacouponbond?
(a) Whenthecouponbondispricedatitsfacevalue,theyieldtomaturityequalsthe
couponrate.
(b) Thepriceofacouponbondandtheyieldtomaturityarenegativelyrelated.
(c) Theyieldtomaturityisgreaterthanthecouponratewhenthebondpriceisabove
theparvalue.
(d) Alloftheabovearetrue.
(e) Only(a)and(b)oftheabovearetrue.

Answer: E
30.

Whichofthefollowingaretrueforacouponbond?
(a) Whenthecouponbondispricedatitsfacevalue,theyieldtomaturityequalsthe
couponrate.
(b) Thepriceofacouponbondandtheyieldtomaturityarepositivelyrelated.
(c) Theyieldtomaturityisgreaterthanthecouponratewhenthebondpriceisabove
theparvalue.
(d) Alloftheabovearetrue.
(e) Only(a)and(b)oftheabovearetrue.
Answer: A

31.

Aconsolbondisabondthat
(a) paysinterestannuallyanditsfacevalueatmaturity.
(b) paysinterestinperpetuityandnevermatures.
(c) paysnointerestbutpaysfacevalueatmaturity.
(d) risesinvalueasitsyieldtomaturityrises.
Answer: B

32.

Theyieldtomaturityonaconsolbondthatpays$100yearlyandsellsfor$500is
(a) 5percent.
(b) 10percent.
(c) 12.5percent.
(d) 20percent.
(e) 25percent.
Answer: D

33.

Theyieldtomaturityonaconsolbondthatpays$200yearlyandsellsfor$1000is
(a) 5percent.
(b) 10percent.
(c) 20percent.
(d) 25percent.
Answer: C

34. Afrequentlyusedapproximationfortheyieldtomaturityonalongtermbondisthe
(a) couponrate.
(b) currentyield.
(c) cashflowinterestrate.
(d) realinterestrate.
Answer: B
35.

Thecurrentyieldonacouponbondisthebonds_________dividedbyits_________.
(a) annualcouponpayment;price
(b) annualcouponpayment;facevalue
(c) annualreturn;price
(d) annualreturn;facevalue
Answer: A

36.

Whenabondspricefalls,itsyieldtomaturity_________anditscurrentyield
_________.
(a) falls;falls

(b) rises;rises
(c) falls;rises
(d) rises;falls
Answer: B
37.

Theyieldtomaturityforaoneyeardiscountbondequals
(a) theincreaseinpriceovertheyear,dividedbytheinitialprice.
(b) theincreaseinpriceovertheyear,dividedbythefacevalue.
(c) theincreaseinpriceovertheyear,dividedbytheinterestrate.
(d) noneoftheabove.
Answer: A

38.

Ifa$10,000facevaluediscountbondmaturinginoneyearissellingfor$8,000,then
itsyieldtomaturityis
(a) 10percent.
(b) 20percent.
(c) 25percent.
(d) 40percent.
Answer: C

39.

Ifa$10,000facevaluediscountbondmaturinginoneyearissellingfor$9,000,then
itsyieldtomaturityis
(a) 9percent.
(b) 10percent.
(c) 11percent.
(d) 12percent.

Answer: C
40. Ifa$10,000facevaluediscountbondmaturinginoneyearissellingfor$5,000,thenits
yieldtomaturityis
(a) 5percent.
(b) 10percent.
(c) 50percent.
(d) 100percent.
Answer: D
41.

Ifa$5,000facevaluediscountbondmaturinginoneyearissellingfor$5,000,thenits
yieldtomaturityis
(a) 0percent.
(b) 5percent.
(c) 10percent.
(d) 20percent.
Answer: A

42.

TheFisherequationstatesthat
(a) thenominalinterestrateequalstherealinterestrateplustheexpectedrateof
inflation.
(b) therealinterestrateequalsthenominalinterestratelesstheexpectedrateof
inflation.
(c) thenominalinterestrateequalstherealinterestratelesstheexpectedrateof
inflation.
(d) both(a)and(b)oftheabovearetrue.
(e) both(a)and(c)oftheabovearetrue.
Answer: D

43.

Ifyouexpecttheinflationratetobe15percentnextyearandaoneyearbondhasa
yieldtomaturityof7percent,thentherealinterestrateonthisbondis
(a) 7percent.
(b) 22percent.
(c) 15percent.
(d) 8percent.
(e) noneoftheabove.
Answer: D

44.

Ifyouexpecttheinflationratetobe5percentnextyearandaoneyearbondhasayield
tomaturityof7percent,thentherealinterestrateonthisbondis
(a) 12percent.
(b) 2percent.
(c) 2percent.
(d) 12percent.
Answer: C

45. Thenominalinterestrateminustheexpectedrateofinflation
(a) definestherealinterestrate.
(b) isabettermeasureoftheincentivestoborrowandlendthanisthenominalinterest
rate.
(c) isamoreaccurateindicatorofthetightnessofcreditmarketconditionsthanisthe
nominalinterestrate.
(d) alloftheabove.
(e) only(a)and(b)oftheabove.
Answer: D

46.

Thenominalinterestrateminustheexpectedrateofinflation
(a) definestherealinterestrate.
(b) isalessaccuratemeasureoftheincentivestoborrowandlendthanisthenominal
interestrate.
(c) isalessaccurateindicatorofthetightnessofcreditmarketconditionsthanisthe
nominalinterestrate.
(d) definesthediscountrate.
Answer: A

47.

Inwhichofthefollowingsituationswouldyouprefertobemakingaloan?
(a) Theinterestrateis9percentandtheexpectedinflationrateis7percent.
(b) Theinterestrateis4percentandtheexpectedinflationrateis1percent.
(c) Theinterestrateis13percentandtheexpectedinflationrateis15percent.
(d) Theinterestrateis25percentandtheexpectedinflationrateis50percent.
Answer: B

48.

Inwhichofthefollowingsituationswouldyouprefertobeborrowing?
(a) Theinterestrateis9percentandtheexpectedinflationrateis7percent.
(b) Theinterestrateis4percentandtheexpectedinflationrateis1percent.
(c) Theinterestrateis13percentandtheexpectedinflationrateis15percent.
(d) Theinterestrateis25percentandtheexpectedinflationrateis50percent.
Answer: D

49.

Whatisthereturnona5percentcouponbondthatinitiallysellsfor$1,000andsellsfor
$1,200oneyearlater?
(a) 5percent
(b) 10percent

(c) 5percent
(d) 25percent
(e) Noneoftheabove
Answer: D
50. Whatisthereturnona5percentcouponbondthatinitiallysellsfor$1,000andsellsfor
$900oneyearlater?
(a) 5percent
(b) 10percent
(c) 5percent
(d) 10percent
(e) Noneoftheabove
Answer: C
51.

Thereturnona5percentcouponbondthatinitiallysellsfor$1,000andsellsfor$1,100
oneyearlateris
(a) 5percent.
(b) 10percent.
(c) 14percent.
(d) 15percent.
Answer: D

52.

Thereturnona10percentcouponbondthatinitiallysellsfor$1,000andsellsfor$900
oneyearlateris
(a) 10percent.
(b) 5percent.

(c) 0percent.
(d) 5percent.
Answer: C
53.

Whichofthefollowingaregenerallytrueofallbonds?
(a) Theonlybondwhosereturnequalstheinitialyieldtomaturityisonewhosetimeto
maturityisthesameastheholdingperiod.
(b) Ariseininterestratesisassociatedwithafallinbondprices,resultingincapital
lossesonbondswhosetermtomaturitiesarelongerthantheholdingperiod.
(c) Thelongerabondsmaturity,thegreateristhepricechangeassociatedwitha
giveninterestratechange.
(d) Alloftheabovearetrue.
(e) Only(a)and(b)oftheabovearetrue.
Answer: D

54.

Whichofthefollowingaretrueconcerningthedistinctionbetweeninterestratesand
return?
(a) Therateofreturnonabondwillnotnecessarilyequaltheinterestrateonthat
bond.
(b) Thereturncanbeexpressedasthesumofthecurrentyieldandtherateofcapital
gains.
(c) Therateofreturnwillbegreaterthantheinterestratewhenthepriceofthebond
fallsbetweentimetandtimet+1.
(d) Alloftheabovearetrue.
(e) Only(a)and(b)oftheabovearetrue.
Answer: E

55. Iftheinterestratesonallbondsrisefrom5to6percentoverthecourseoftheyear,
whichbondwouldyouprefertohavebeenholding?
(a) Abondwithoneyeartomaturity
(b) Abondwithfiveyearstomaturity

(c) Abondwithtenyearstomaturity
(d) Abondwithtwentyyearstomaturity
Answer: A
56.

Supposeyouareholdinga5percentcouponbondmaturinginoneyearwithayieldto
maturityof15percent.Iftheinterestrateononeyearbondsrisesfrom15percentto20
percentoverthecourseoftheyear,whatistheyearlyreturnonthebondyouare
holding?
(a) 5percent
(b) 10percent
(c) 15percent
(d) 20percent
Answer: C

57.

(I)Pricesoflongermaturitybondsrespondmoredramaticallytochangesininterest
rates.(II)Pricesandreturnsforlongtermbondsarelessvolatilethanthoseforshort
termbonds.
(a) (I)istrue,(II)false.
(b) (I)isfalse,(II)true.
(c) Botharetrue.
(d) Botharefalse.
Answer: A

58.

(I)Pricesoflongermaturitybondsrespondlessdramaticallytochangesininterest
rates.(II)Pricesandreturnsforlongtermbondsarelessvolatilethanthoseforshorter
termbonds.
(a) (I)istrue,(II)false.
(b) (I)isfalse,(II)true.
(c) Botharetrue.
(d) Botharefalse.
Answer: D

59.

Theriskinessofanassetsreturnthatresultsfrominterestratechangesiscalled
(a) interestraterisk.
(b) couponraterisk.
(c) reinvestmentrisk.
(d) yieldtomaturityrisk.
Answer: A

60.

Ifaninvestorsholdingperiodislongerthanthetermtomaturityofabond,heorsheis
exposedto
(a) interestraterisk.
(b) reinvestmentrisk.
(c) bondmarketrisk.
(d) yieldtomaturityrisk.
Answer: B

61. Reinvestmentriskistheriskthat
(a) abondsvaluemayfallinthefuture.
(b) abondsfuturecouponpaymentsmayhavetobeinvestedataratelowerthanthe
bondsyieldtomaturity.
(c) aninvestorsholdingperiodwillbeshortandequalinlengthtothematurityofthe
bondsheorsheholds.
(d) abondsissuermayfailtomakethefuturecouponpaymentsandaninvestorwill
havenocashtoreinvest.
Answer:
62.

(I)Theaveragelifetimeofadebtsecuritysstreamofpaymentsiscalledduration.(II)
Thedurationofaportfolioistheweightedaverageofthedurationsoftheindividual
securities,withtheweightsreflectingtheproportionoftheportfolioinvestedineach.
(a) (I)istrue,(II)false.

(b) (I)isfalse,(II)true.
(c) Botharetrue.
(d) Botharefalse.
Answer: C
63.

Thedurationofatenyear,10percentcouponbondwhentheinterestrateis10percent
is6.76years.Whathappenstothepriceofthebondiftheinterestratefallsto8
percent?
(a) itrises20percent
(b) itrises12.3percent
(c) itfalls20percent
(d) itfalls12.3percent
Answer: B

True/False
1.

Abondscurrentmarketvalueisequaltothepresentvalueofthecouponpayments
plusthepresentvalueofthefaceamount.
Answer:

2.

Discountingthefutureistheprocedureusedtofindthefuturevalueofadollarreceived
today.
Answer:

3.

FALSE

Unlessabonddefaults,aninvestorcannotlosemoneyinvestinginbonds.
Answer:

5.

FALSE

Thecurrentyieldisthebestmeasureofaninvestorsreturnfromholdingabond.
Answer:

4.

TRUE

FALSE

Thecurrentyieldistheyearlycouponpaymentdividedbythecurrentmarketprice.

Answer:
6.

Pricesforlongtermbondsaremorevolatilethanforshortertermbonds.
Answer:

7.

FALSE

Therealinterestrateisequaltothenominalrateminusinflation.
Answer:

12.

FALSE

Interestrateriskistheuncertaintythataninvestorfacesbecausetheinterestrateat
whichabondsfuturecouponpaymentscanbeinvestedisunknown.
Answer:

11.

TRUE

Allelsebeingequal,thegreatertheinterestratethegreateristheduration.
Answer:

10.

FALSE

Increasingdurationimpliesthatinterestrateriskhasincreased.
Answer:

9.

TRUE

Alongtermbondspriceislessaffectedbyinterestratemovementsthanisashort
termbondsprice.
Answer:

8.

TRUE

TRUE

Thecurrentyieldgoesupasthepriceofabondfalls.
Answer:

TRUE

Essay
1.

Distinguishbetweencouponrate,yieldtomaturity,andcurrentyield.

2.

Describethecashflowsreceivedfromowningacouponbond.

3.

Whatconceptisusedtovalueabond?

4.

Howisabondscurrentyieldcalculated?Whyiscurrentyieldamoreaccurate
approximationofyieldtomaturityforalongtermbondthanforashorttermbond?

5.

Whyarelongtermbondsmoreriskythanshorttermbonds?

6.

Whatisinterestrateriskandhowisitmeasured?

7.

Whymayabondsrateofreturndifferfromitsyieldtomaturity?

8.

Howdoesreinvestmentriskdifferfrominterestraterisk?

9.

Whatisthedistinctionbetweenthenominalinterestrateandtherealinterestrate?
Whichisabetterindicatorofincentivestoborrowandlend?Why?

10.

DescribehowTreasuryInflationProtectionSecurities(TIPS)workandhowtheyhelp
policymakersestimateexpectedinflation.