Chapter 3 – Interest Rates and Rates of Return

(Multiple-Choice Flashcards)

How are opportunity costs related to interest rates? What else are you compensated for?
A) Interest rates reflect inflation only
B) Interest rates represent opportunity cost and risk compensation
C) Interest rates have no opportunity cost
D) Interest rates are fixed by inflation

B) Interest rates measure the opportunity cost of holding money instead of investing — they compensate for time, risk, and inflation.

“The interest rate is a link between the financial present and the financial future.” What concept does this describe?
A) Law of demand
B) Time value of money (TVM)
C) Monetary neutrality
D) Liquidity preference

B) The time value of money shows how present money can grow over time through interest — linking present and future values.

What is compounding?
A) Calculating depreciation
B) Earning interest on both principal and previously earned interest
C) Paying only simple interest
D) Inflation adjustment

B) Compounding means earning “interest on interest,” where returns grow exponentially over time.

What is discounting?
A) Finding a future value
B) Converting a future payment into its present value
C) Reducing prices
D) Ignoring inflation

B) Discounting reverses compounding — it determines today’s value of a future cash flow using an interest rate.

How do we find the price of any financial asset?
A) Add its interest to its face value
B) Sum of future cash flows discounted to present value
C) Multiply principal by interest
D) Divide coupon by time

B) Asset prices equal the present value of expected future cash flows, discounted at the market interest rate.

What’s the key difference between debt and equity?
A) Debt provides ownership; equity is borrowed
B) Debt must be repaid; equity gives ownership
C) Both require interest payments
D) Equity is less risky

B) Debt involves repayment with interest, while equity represents ownership with profit sharing and higher risk.

Which of the following is not a type of loan?
A) Simple loan
B) Discount bond
C) Coupon bond
D) Stock dividend

D) Stocks are equity, not loans. The main loan types are simple loans, discount bonds, coupon bonds, and fixed-payment loans.

How is a bond’s price determined?
A) By the Federal Reserve
B) By discounting its future payments (coupons + face value)
C) By multiplying its coupon by maturity
D) By dividing interest rate by coupon

B) A bond’s price is the present value of all future payments, discounted at the market rate.

How is a bond’s Yield to Maturity (YTM) found?
A) Through compounding
B) The interest rate that equates the bond’s price to its future cash flows
C) Through coupon division
D) By guessing

B) YTM is the rate that sets the bond’s price equal to the present value of all future coupon and principal payments.

What is a typical bond maturity and when is the coupon rate set?
A) Maturity usually 10–30 years; coupon rate fixed at issuance
B) Maturity 1 year; coupon changes annually
C) Maturity 50 years; floating rate
D) No maturity; rate changes monthly

A) Most bonds mature in 10–30 years, and the coupon rate is fixed when the bond is issued.

If a bond’s coupon equals the market rate, what will it sell for?
A) Premium
B) Discount
C) At par value
D) Below market

C) When coupon = market rate, the bond sells at par value (face value).

If interest rates rise after a bond is issued, what happens to its price?
A) Price rises
B) Price falls
C) Price stays the same
D) It gains value

B) When market rates rise, existing bond prices fall, because new bonds offer higher returns.

If interest rates fall after a bond is issued, what happens to its price?
A) Price falls
B) Price rises
C) Price remains the same
D) It defaults

B) When rates fall, existing bonds with higher coupons become more valuable — price rises.

What’s the general relationship between bond prices and YTM?
A) Direct relationship
B) Inverse relationship
C) No relationship
D) Equal relationship

B) Bond prices and YTM move inversely — when rates rise, prices fall, and vice versa.

How do investors make money in bond markets?
A) Only by holding bonds to maturity
B) Through coupon payments and capital gains from selling at higher prices
C) By avoiding taxes
D) Through dividends

B) Investors earn coupon income and may gain capital appreciation if bond prices rise before selling.

What is financial arbitrage?
A) Risk-free profit by exploiting price differences
B) Long-term investing
C) Government bond trading
D) Currency speculation

A) Arbitrage means buying low and selling high in different markets to profit from mispricing — it’s rare due to efficiency.

What does the law of one price state?
A) Identical assets must sell for the same price
B) Prices depend on demand
C) All goods have equal value
D) Inflation always equals price

A) The law of one price ensures identical assets with identical cash flows have the same price, preventing arbitrage.

What does it mean if a bond’s YTM ≠ current yield?
A) The bond is worthless
B) The rate of return earned may differ from the simple yield due to capital gains or losses
C) The bond has defaulted
D) The coupon rate changed

B) YTM accounts for both coupon income and price changes, so it can differ from the current yield, which only measures coupon return.

What is interest rate risk?
A) Risk that interest rates change, affecting bond prices
B) Risk of company default
C) Risk of inflation only
D) Risk of no interest

A) Interest rate risk is the chance that bond prices will change due to fluctuations in market interest rates — longer maturities face greater risk.

Which bonds are most exposed to interest rate risk?
A) Short-term bonds
B) Long-term bonds
C) Treasury bills
D) Floating-rate bonds

B) Long-term bonds have greater exposure to rate changes because their payments occur further in the future.

What type of risk do Treasury bonds mainly face?
A) Default risk
B) Interest rate risk
C) Inflation risk
D) Political risk

B) U.S. Treasuries have almost zero default risk but face interest rate risk, as their market value fluctuates with rates.

What’s a nominal interest rate?
A) Interest rate adjusted for inflation
B) Rate before adjusting for inflation
C) Always equal to real rate
D) Inflation rate itself

B) Nominal rate is the stated interest rate; real rate = nominal rate − inflation.

If inflation is greater than expected, what happens to the real interest rate?
A) It rises; borrowers lose
B) It falls; borrowers gain, lenders lose
C) It remains the same
D) Both gain

B) Higher-than-expected inflation reduces the real interest rate, helping borrowers and hurting lenders.

If inflation is less than expected, what happens to the real interest rate?
A) It rises; lenders gain, borrowers lose
B) It falls; borrowers gain
C) It stays constant
D) Both lose

A) Lower-than-expected inflation raises real rates, benefiting lenders since the money repaid has greater purchasing power.

What is deflation and what effect does it have on real interest rates?
A) Deflation lowers real rates
B) Deflation increases real rates, discouraging borrowing
C) Deflation causes hyperinflation
D) Deflation erases interest

B) When prices fall (deflation), real interest rates rise, making borrowing costly and encouraging people to save instead of spend.