Fin 141 Test 1 (real one)

In spring 2020, relief cheques increased household cash. Holding everything else constant, what happens in the bond market?

Rightward shift in bond demand → bond prices rise and interest rates fall.
Why: More wealth increases demand for bonds.

A safe government bond pays 3%, while tech shares return 25% and are expected to continue. What happens in the bond market?

Demand for bonds falls, bond prices fall, interest rates rise.
Why: Higher expected return on stocks makes bonds less attractive.

Which would DECREASE investors’ demand for a particular bond?

The chance that the issuer fails to repay rises.
Why: Higher default risk reduces demand.

Which would most likely push nominal interest rates UP?

Households and firms revise inflation expectations sharply upward.
Why: Fisher effect: nominal rate ≈ real rate + expected inflation.

: A 10-year Treasury yields 4%, and a 10-year BBB corporate yields 6–7%. Explaining this gap is the job of:

The risk structure of interest rates.
Why: Same maturity, different risk.

To measure the risk premium on a 10-year Baa corporate bond, you subtract from its yield the yield on:

A 10-year Treasury note, so maturity is held constant.
Why: Risk structure compares same maturity.

Why is a downgrade from Baa to Ba more disruptive than Aa to A?

It crosses from investment grade into speculative grade, and many banks/pension funds may hold ONLY investment-grade bonds.

The Baa–Treasury spread jumped in 2008 and March 2020. Most complete explanation?

Perceived default risk rose AND investors fled to the most liquid asset.
Why: Flight to quality/liquidity.

Bond A is large and liquid; Bond B trades rarely. Same maturity, rating, tax treatment. Compared with A, Bond B will have:

A lower price and a higher yield.
Why: Less liquid bonds must offer higher yield.

40% tax bracket. A muni yields 4.8% tax-free. What is the tax-equivalent yield?

D. 8.00%.
Formula: 4.8% / (1 − 0.40) = 8%.

Munis are less liquid and can default, yet often yield less than Treasuries. Best explanation?

Muni interest escapes federal income tax, so investors compare after-tax returns.

2-year Treasury yields 4.9%; 10-year Treasury yields 4.1%. This yield curve is:

Inverted, a rare shape that is closely watched.
Why: Short-term rate > long-term rate.

Which is one of the three empirical facts any term structure theory must explain?

Short-term and long-term interest rates tend to move up and down together.

Expected 1-year rates over next four years: 3%, 4%, 5%, 8%. Under pure expectations theory, today’s 4-year rate is:

B. 5.0%.
Calculation: (3 + 4 + 5 + 8) / 4 = 5.

1-year rate is 4%; 2-year rate is 5%. Under pure expectations theory, the expected 1-year rate next year is:

6.0%.
Calculation: (1.05² / 1.04) − 1 ≈ 6%.

Expected 1-year rates: 4%, 5%, 6%. Liquidity premium on 3-year bond is 0.50%. Under liquidity premium theory, today’s 3-year rate is:

5.50%.
Calculation: Average = 5% + 0.50% = 5.50%.

In liquidity premium theory, the premium compensates investors for:

The greater interest rate risk of a longer bond, whose price swings more when yields move.

The yield curve inverts. Under liquidity premium theory, the market expects short-term rates to:

Fall by more than the positive liquidity premium.

The core function of financial markets is to:

Channel funds from those with surpluses to those with shortages.

Which is an example of monetary policy?

The Federal Reserve lowers interest rates to encourage borrowing, spending, and investment.

If the U.S. dollar becomes stronger against foreign currencies, then:

Imported goods become cheaper for Americans, and U.S. exports become more expensive abroad.

You deposit $10,000 in a bank, and the bank lends it to someone buying a house. This is:

Indirect finance, because funds pass through a financial intermediary.

Which statement about primary and secondary markets is correct?

In a primary market, new securities are issued and the issuer receives the funds.

Which is an example of a Eurobond?

A U.S. dollar-denominated bond is sold in London.
Why: Eurobond is sold outside the country whose currency it is denominated in.

Which statement about U.S. Treasury bills is correct?

They are sold at a discount, repaid at face value at maturity, and have no default risk.

5,000 depositors each place $1,000 in a bank. The bank makes risky loans. Depositors still hold safe, liquid deposits. This is:

Asset transformation.

Which is an example of adverse selection?

People who know they are seriously ill are the most eager to buy health insurance.

“I have a lot of money because I earn $200,000 a year.” In economics, this is really about:

Income, because it is a flow measured over a period of time.

Houses, stocks, and art can store value, but none is money. Which function is the defining one?

Medium of exchange.

Paper currency with no intrinsic value, accepted because government declares it legal tender, is called:

Fiat money.

Which is included in M1?

Demand deposits (checking account deposits).

Interest rate is 5%. What is the present value of $1,102.50 received two years from today?

1102.50 / (1.05)² = 1000.

One-year T-bill, face $10,000, price $9,700. YTM is closest to:

3.09%.
Calculation: (10,000 − 9,700) / 9,700 ≈ 3.09%.

Coupon bond: face $1,000, coupon 8%, sells for $920. Its YTM must be:
Back: C. Greater than 8%.

Price below par → YTM > coupon rate.

Market interest rates fall, and your bond’s YTM drops from 6% to 4%. What happens to the bond’s price?

It rises, because bond prices and YTM are inversely related.

Bond: face $1,000, coupon 6%, sells for $800. Current yield is:

7.5%.
Calculation: $60 / $800 = 7.5%.

Buy 10-year bond at face $1,000, coupon 8%. One year later collect $80 coupon and sell for $950. Rate of return?

B. 3.0%.
Calculation: (80 + (950 − 1000)) / 1000 = 3%.

Nominal 1-year T-bill is 3%; expected inflation is 5%. Fisher equation: real rate is ____, which tends to ____ borrowing.

C. −2%; encourage.
Calculation: 3% − 5% = −2%.