Interest Rates and Bond Market Overview
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Questions and Answers

Which of the following explains irrational investment behavior?

  • People are not very risk-averse and do not require a risk premium for stocks.
  • People are not efficient users of information. (correct)
  • People are irrational in their investment behavior, only focusing on positive outcomes. (correct)
  • Investing in stocks over the long run is not as risky as short-term holdings of stocks.

    • What should investors have done during the fast bear market decline in early 2020?

  • Moved investments out of the stock market.
  • Let year-to-year fluctuations in stock values guide investing.
  • Continued to hold stocks for the long run. (correct)
  • Switched to investing in bonds, which are less risky. (correct)

    • If the interest rate is zero, a promise to receive a $100 payment one year from now is

  • equal in value to receiving $101 today
  • equal in value to receiving $100 today (correct)
  • more valuable than receiving $100 today
  • less valuable than receiving $100 today

    • Present value is higher when the future value of the payment is

    <p>higher, the time until payment is shorter, and the interest rate is lower</p> Signup and view all the answers

    At a price of $400 in the bond market, we can expect

    <p>there is an excess supply of bonds</p> Signup and view all the answers

    How would robust economic growth for several years be reflected in the risk structure of interest rates?

    <p>an increase in yields on tax-exempt bonds</p> Signup and view all the answers

    When expected inflation increases, for any given nominal interest rate, it affects the bonds in which way?

    <p>yield on bonds will increase</p> Signup and view all the answers

    Which one of the following would lead to an increase in bond supply?

    <p>an improvement in general business conditions</p> Signup and view all the answers

    In the bond market, if the expected return on bonds falls relative to other assets, this will result in

    <p>a shift to the left of the bond demand curve</p> Signup and view all the answers

    Which one of the following statements about the result of a deterioration in business conditions is false?

    <p>neither bond demand nor bond supply will shift</p> Signup and view all the answers

    Which of the following is true of interest-rate risk?

    <p>individuals owning long-term bonds are exposed to greater interest-rate risk</p> Signup and view all the answers

    How would the expected raising of interest rates by the Federal Reserve affect the bond market?

    <p>Bond prices are likely to fall.</p> Signup and view all the answers

    If a bond's rating improves, we would expect

    <p>the demand for this bond to increase, all other factors constant</p> Signup and view all the answers

    Fatima holds a one-year $200 face value, taxable bond with a coupon rate of 5%. How much tax will she pay for income earned on the investment?

    <p>she will pay $2 in taxes and earn a return of 4%</p> Signup and view all the answers

    If I purchase a 10 percent coupon bond and calculate a yield to maturity of 8 percent, my return on this asset is

    <p>10 percent</p> Signup and view all the answers

    What is the present value of $500.00 to be paid in two years if the interest rate is 5 percent?

    <p>$453.51</p> Signup and view all the answers

    Which of the following $5,000 face-value securities has the highest yield to maturity?

    <p>a 12 percent coupon bond selling for $4,500</p> Signup and view all the answers

    If a $1,000 face value coupon bond has a coupon rate of 3.75 percent, then the coupon payment every year is

    <p>$37.50</p> Signup and view all the answers

    A $1,000 face value bond, with an annual coupon of $40, one year to maturity, and a purchase price of $980 has a

    <p>current yield that equals 4.08% and a market interest rate that equals 6.12%</p> Signup and view all the answers

    When the ________ is below the coupon rate, the bond sells at ________

    <p>market interest rate for a bond; a discount</p> Signup and view all the answers

    A 30-year Treasury bond has a face value of $1,000 and a price of $1,200 with a $50 coupon payment. If the price decreases to $1,100 over the next year, the one-year holding period return is equal to

    <p>−8.33%</p> Signup and view all the answers

    Suppose there is a decrease in the price at which a bondholder sells her bond. In this case, the holding period return will

    <p>decrease, since this lowers the capital gain</p> Signup and view all the answers

    Holding liquidity and default risk constant, an investor earning 6% from a tax-exempt bond who is in a 25% tax bracket would be indifferent between that bond and a taxable bond with a(n)

    <p>6.25% yield</p> Signup and view all the answers

    In examining the yield curve for U.S. Treasury securities, we find all of the following except

    <p>long-term rates tend to equal short-term rates</p> Signup and view all the answers

    The one-year holding period return on a $1,000 face value, 5 percent coupon bond that initially sells at par and sells for $950 next year is

    <p>-10 percent</p> Signup and view all the answers

    In which of the following situations would you prefer to be the borrower?

    <p>the nominal interest rate is 9 percent, and the expected inflation rate is 7 percent</p> Signup and view all the answers

    The default-risk premium

    <p>should vary directly with the bond's yield and inversely with its price</p> Signup and view all the answers

    A decrease in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant.

    <p>increase; increase</p> Signup and view all the answers

    Which of the following securities has the lowest interest rate?

    <p>U.S. Treasury bonds</p> Signup and view all the answers

    Corporate bonds are not as liquid as Treasury bonds because

    <p>fewer corporate bonds for any one corporation are traded, making them more costly to sell</p> Signup and view all the answers

    When the Treasury bond market becomes less liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________.

    <p>right; left</p> Signup and view all the answers

    A(n) ________ in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

    <p>decrease; increase; increase</p> Signup and view all the answers

    Which of the following statements is TRUE?

    <p>bonds issued by state and local governments are called municipal bonds</p> Signup and view all the answers

    Everything else held constant, if federal income tax rates were lowered, then

    <p>the interest rate on municipal bonds would fall</p> Signup and view all the answers

    Three factors explain the risk structure of interest rates

    <p>maturity, default risk, and the income tax treatment of a security</p> Signup and view all the answers

    The term structure of interest rates is

    <p>the relationship among interest rates on bonds with different maturities</p> Signup and view all the answers

    If the expectations hypothesis regarding the term structure of interest rates is correct, the current two-year interest rate should be

    <p>4%</p> Signup and view all the answers

    The addition of the liquidity premium theory to the expectations hypothesis allows us to explain why

    <p>yield curves usually slope upward</p> Signup and view all the answers

    What is the risk premium for an investor who sees a current one-year rate at 4% and expects future rates?

    <p>The risk premium can be calculated using the liquidity premium theory formulas.</p> Signup and view all the answers

    An inverted yield curve predicts that short-term interest rates

    <p>will fall in the future</p> Signup and view all the answers

    What can be inferred when comparing GDP growth to the risk spread on Baa bonds compared to 10-year U.S. Treasury bonds?

    <p>There typically is a correlation between economic growth and the risk perception reflected in bond spreads.</p> Signup and view all the answers

    Two characteristics that make owning stock attractive are:

    <p>share prices that are relatively inexpensive and transferable</p> Signup and view all the answers

    The fact that common stockholders are residual claimants means they:

    <p>have a claim against the revenue that remains after everyone else is paid</p> Signup and view all the answers

    Which one of the following stock price indexes is a price-weighted index?

    <p>Dow Jones Industrial Average</p> Signup and view all the answers

    The Standard & Poor's 500 Index

    <p>gives more weight to large companies than small companies</p> Signup and view all the answers

    The Nasdaq Composite Index is

    <p>a value-weighted index</p> Signup and view all the answers

    In the one-period valuation model, an increase in the required rate of return

    <p>reduces the expected sales price of a stock</p> Signup and view all the answers

    Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate of return of 10%, what is the current price of the stock?

    <p>$100.10</p> Signup and view all the answers

    Using the Gordon constant growth model, a stock's current price decreases when

    <p>the growth rate of dividends decreases</p> Signup and view all the answers

    A company currently pays a dividend of $4.00 per share. It expects the growth rate of the dividend to be 3% (0.03) annually. If the required return on investments in equity is 6% (0.06), what does the Gordon constant growth model predict the current price of the stock should be?

    <p>$103.33</p> Signup and view all the answers

    Discuss how changes in economic conditions can affect the equity risk premium and stock prices.

    <p>During economic downturns, risk premiums generally rise, leading to lower stock prices.</p> Signup and view all the answers

    What inefficiencies can be caused by stock market bubbles, especially focusing on firms and consumers?

    <p>Bubbles misallocate resources, leading to unsustainable valuations and eventual market corrections.</p> Signup and view all the answers

    A company currently has $5 in dividends per year. It commits to paying $5.30 one year from the current date. What is the required stock return using the Gordon constant growth model at a yield of 8% plus an equity-risk premium of 2.5%?

    <p>10.5%</p> Signup and view all the answers

    According to the efficient markets hypothesis, the current price of a financial security is

    <p>fully reflects all available relevant information</p> Signup and view all the answers

    The efficient markets hypothesis implies that future changes in stock prices should for all practical purposes be

    <p>unpredictable</p> Signup and view all the answers

    In the event of bankruptcy, stockholders

    <p>are the last to be paid and could end up losing what they have invested</p> Signup and view all the answers

    In the first calendar quarter, a company issues a surprising report expecting profits to rise in the fourth quarter. According to efficient market theory, we should expect the price of the company's stock to

    <p>rise immediately on the expectation of higher profits in the future</p> Signup and view all the answers

    Stock market bubbles are

    <p>persistent and expanding gaps between stocks' actual prices and the prices warranted by the fundamentals</p> Signup and view all the answers

    Stock market bubbles are costly for the economy because they

    <p>lead to a misallocation of resources in both the short term and long term</p> Signup and view all the answers

    Discuss why stocks present risk yet many people invest significant parts of their wealth in them.

    <p>Stocks offer the potential for high returns, which can justify their risks during growth periods.</p> Signup and view all the answers

    What is the expected increase in interest rates by the Federal Reserve likely to cause?

    <p>Decrease in bond prices</p> Signup and view all the answers

    What effect does growth in the economy have on the supply of bonds?

    <p>Greater supply of bonds, shifting the bond supply curve right.</p> Signup and view all the answers

    What happens to bond prices if supply shifts greater than demand?

    <p>Bond prices will fall and yields will rise.</p> Signup and view all the answers

    True or False: An increase in wealth decreases bond demand.

    <p>False</p> Signup and view all the answers

    Which of the following can lead to an increase in the equity-risk premium?

    <p>Expectation of a recession</p> Signup and view all the answers

    What is the relationship between GDP growth and the size of the risk spread?

    <p>Inverse relationship.</p> Signup and view all the answers

    How is the required stock return calculated if the rate is 8% and the risk premium is 2.5%?

    <p>10.5%</p> Signup and view all the answers

    What is the formula to compute the current price of the stock using dividends?

    <p>Ptoday = Dtoday(1 + g)/(k - g)</p> Signup and view all the answers

    What happens when a stock market bubble bursts?

    <p>Inefficient allocation of investment funds</p> Signup and view all the answers

    What is the price of the stock if dividends are $5 and growth rate is 6%?

    <p>$117.78</p> Signup and view all the answers

    Study Notes

    Interest Rates and Present Value

    • Receiving a $100 payment one year from now is less valuable than receiving $100 today, if the interest rate is zero.
    • Present value is higher when the future value of the payment is higher, the time until payment is shorter, and the interest rate is lower.
    • The present value of a future payment is the amount of money that, if invested today at a given interest rate, will grow to the future payment in the specified time.

    Bond Market Equilibrium

    • At a price of $400, there is an excess supply of bonds.
    • The bond market is in equilibrium when the quantity demanded equals the quantity supplied.

    Risk Structure of Interest Rates

    • Robust economic growth is reflected in a decrease in the term spread in the risk structure of interest rates.
    • The term spread is the difference between the yield on a long-term bond and the yield on a short-term bond.

    Bond Supply and Demand

    • An increase in expected inflation leads to an increase in the yield on bonds.
    • Decreases in government spending and national wealth lead to a decrease in bond supply.
    • Improvements in general business conditions lead to an increase in bond supply.
    • A decrease in the expected return on bonds relative to other assets results in a shift to the left of the bond demand curve.
    • Deterioration in business conditions and decreases in national wealth both shift the bond demand and supply curves left.
    • Interest rates increase when bond demand decreases more than bond supply.

    Interest-Rate Risk

    • Interest-rate risk is the risk that the value of a bond will change due to changes in interest rates.
    • Investors owning long-term bonds have greater interest-rate risk because they are locked into receiving a lower coupon rate as interest rates rise.

    Bond Ratings and Yields

    • If a bond’s rating improves, the demand for the bond increases and the yield decreases, all other factors constant.

    Taxable Bonds

    • A taxable bond is a bond on which the interest income is subject to taxation.
    • The taxable yield is the interest rate on a taxable bond, taking into account the tax rate.

    Yield to Maturity

    • The yield to maturity (YTM) is the annual rate of return an investor can expect to receive if they hold a bond until maturity.
    • The YTM of a bond is inversely related to its price.

    Bond Prices and Interest Rates

    • When the market interest rate is below the coupon rate, the bond sells at a premium.
    • A premium means the bond's price is higher than its face value.
    • When the market interest rate is above the coupon rate, the bond sells at a discount.
    • A discount means the bond's price is lower than its face value.

    Holding Period Return

    • The holding period return is the total return earned on an investment over a given holding period.
    • It includes both the coupon payments and the change in price of the bond.
    • A decreasing price on a bond will decrease the holding period return.

    Tax-Exempt Bonds

    • Tax-exempt bonds are bonds that are not subject to federal income tax.
    • Municipal bonds are a type of tax-exempt bond.

    Risk Structure of Interest Rates

    • The risk structure of interest rates refers to the relationship between the interest rates on bonds with different levels of risk, holding maturity constant.
    • Three factors explain the risk structure:
      • Maturity
      • Default risk
      • Liquidity

    Term Structure of Interest Rates

    • The term structure of interest rates refers to the relationship between the interest rates on bonds with different maturities, holding risk constant.
    • The expectations hypothesis suggests that the shape of the yield curve reflects market expectations about future interest rates.
    • The liquidity premium theory suggests that investors require a premium for holding longer-term bonds due to their lower liquidity.

    Stock Market Indexes

    • The Dow Jones Industrial Average (DJIA) is a price-weighted index.
    • The Standard & Poor's 500 Index is a value-weighted index.
    • The Nasdaq Composite Index is a value-weighted index focused on technology companies.

    Equity Valuation

    • The one-period valuation model states that the current price of a stock is equal to the present value of the next year's dividend plus the present value of the expected sales price.
    • The Gordon constant growth model suggests that the current price of a stock is equal to the next dividend payment divided by the required rate of return minus the expected dividend growth rate.

    Stock Market Bubbles

    • Stock market bubbles occur when the price of a stock rises above its intrinsic value.
    • Bubbles are costly for the economy because they lead to a misallocation of resources.

    Efficient Market Hypothesis

    • The efficient market hypothesis states that asset prices fully reflect all available information, including past prices, current prices, and expected future events.
    • The hypothesis suggests that it is impossible to consistently outperform the market, as any information that could be used to predict future price movements is already incorporated into the current price.

    Stock Market Risk

    • Stocks are risky investments because their prices fluctuate.
    • Investors are risk-averse, meaning they prefer a certain return to a risky return.
    • Long-term investing in stocks is typically less risky than short-term investing.

    Stock Valuation Example

    • A company with a dividend of $5.00 per year and a growth rate of 6% has a required stock return of 10.5% (8% risk-free rate + 2.5% equity risk premium).
    • The current price of the stock is 100.00usingtheconstantgrowthmodel:100.00 using the constant growth model: 100.00usingtheconstantgrowthmodel:5.30/ (0.105-0.06) = $100.00

    Multiple Choice Questions

    • Question 1: Correct answer is C
    • Question 2: Correct answer is A
    • Question 3: Correct answer is C
    • Question 4: Correct answer is C
    • Question 5: Correct answer is D
    • Question 6: Correct answer is D
    • Question 7: Correct answer is C
    • Question 8: Correct answer is D
    • Question 9: Correct answer is D
    • Question 10: An increase in interest rates expected by the Federal Reserve causes a decrease in bond value. Higher future interest rates make bonds less attractive, decreasing demand, and causing bond prices to decrease and yields to increase.
    • Question 11: Economic growth leads to increased bond supply, as firms expand and need financing, shifting the supply curve right. This would lower bond prices and increase interest rates. However, economic growth also leads to increased wealth, increasing demand, and shifting the demand curve right, leading to higher bond prices and lower interest rates. The net effect depends on the magnitude of these shifts, with larger supply shifts leading to lower prices and yields, and larger demand shifts leading to higher prices and yields.
    • Question 12: Correct answer is A
    • Question 13: Correct answer is A
    • Question 14: Correct answer is B
    • Question 15: Correct answer is A
    • Question 16: Correct answer is D
    • Question 17: Correct answer is A
    • Question 18: Correct answer is C
    • Question 19: Correct answer is A
    • Question 20: Correct answer is C
    • Question 21: Correct answer is B
    • Question 22: Correct answer is A
    • Question 23: Correct answer is C
    • Question 24: Correct answer is C
    • Question 25: Correct answer is D
    • Question 26: Correct answer is A
    • Question 27: Correct answer is D
    • Question 28: Correct answer is B
    • Question 29: Correct answer is A
    • Question 30: Correct answer is B
    • Question 31: Correct answer is A
    • Question 32: Correct answer is B
    • Question 33: Correct answer is C
    • Question 34: Correct answer is C
    • Question 35: Correct answer is D
    • Question 36: Correct answer is C
    • Question 37: Correct answer is A
    • Question 38: The answer is 0.65%
    • Question 39: Correct answer is D
    • Question 40: There is an inverse relationship between GDP growth and the risk spread. As GDP growth slows, the risk spread increases, and vice versa.
    • Question 41: Correct answer is B
    • Question 42: Correct answer is A
    • Question 43: Correct answer is A
    • Question 44: Correct answer is A
    • Question 45: Correct answer is C
    • Question 46: Correct answer is D
    • Question 47: Correct answer is C
    • Question 48: Correct answer is D
    • Question 49: Correct answer is D
    • Question 50: In the scenario of an expected recession, the equity-risk premium is likely to increase. During economic downturns, the potential losses associated with stocks are higher, leading to a higher required return on stocks. This would cause a decrease in stock prices. Consequently, investors would favor U.S. Treasury securities over stocks during a recession, given their relative safety. This preference stems from the fact that stockholders are residual claimants, and the expected losses associated with being a residual claimant are higher during recessions, as bankruptcy becomes more likely.
    • Question 51: Stock market bubbles lead to inefficient allocation of investment funds. Firms favored by the bubble find it easier to raise funds and may overinvest, while those not in favor find it harder to attract funds and may underinvest. For consumers, bubbles can lead to increased wealth and higher consumption, savings decline, and purchases of luxury goods. When the bubble bursts, both companies and individuals face adjustments, leading to inefficient investment and spending patterns.
    • Question 52: The required stock return is 10.5% (8% + 2.5%). The growth rate of dividends is 6% based on the formula: (current dividend - previous dividend) / previous dividend. The current stock price is $117.78, calculated using the formula: Ptoday = Dtoday(1 + g)/(𝑘 - g).
    • Question 53: Correct answer is C
    • Question 54: Correct answer is A
    • Question 55: Correct answer is D
    • Question 56: Correct answer is C
    • Question 57: Correct answer is B
    • Question 58: Correct answer is D
    • Question 59: Correct answer is C
    • Question 60: Correct answer is A

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    Description

    Explore the fundamental concepts of interest rates, present value, and the dynamics of the bond market. This quiz covers essential topics such as bond supply and demand, market equilibrium, and the risk structure of interest rates. Test your understanding of how these financial principles interact in different economic conditions.

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