11 Everything else held constant, if the expected return on Verizon stock rises

Question

11 Everything else held constant, if the expected return on Verizon stock rises from 7 to 8 percent and the yield to

      maturity on 20-year U.S. Treasury bonds rises from 2.55 to 3.45 percent, then the expected return of holding

      Verizon stock ________ relative to U.S. Treasury bonds and the demand for U.S. Treasury bonds ________.

A) rises; rises                                        B) rises; falls                        C) falls; rises                         D) falls; falls

12. The supply of loanable funds curve would be shifted to the left by

A) a relative decrease in expected returns on other assets.         

B) a decrease in the U.S. government deficit.

C) an increase in expected inflation.

D) an increase in the liquidity of bonds relative to other assets.

13. Which of the following could be expected to cause the equilibrium interest rate to rise?

A) a decrease in government deficits.                                              B) a decrease in the corporate tax on profits.

C) a decrease in subsidies for corporate investment.                    D) a decrease in expected inflation.

14. If asset one is a AAA rated U.S. Treasury bond yielding 3.5% and asset two is a BBB rated corporate bond with the       

      same time to maturity as asset one and is yielding of 6.5%, individual investors would

A) prefer asset one.

B) prefer asset two.

C) be indifferent between the two assets.

D) require more information before choosing asset one or asset two.

15. Interest rates typically follow a __________ pattern relative to economic activity and the default premium

      typically follows a ___________ pattern relative to economic activity.

A) procyclical; procyclical                                                                B) procyclical; countercyclical

C) countercyclical; procyclical                                                         D) countercyclical; countercyclical

16. If there is an excess demand for money

A) individuals sell bonds, causing the interest rate to rise.          B) individuals sell bonds, causing the interest rate to fall.

C) individuals buy bonds, causing interest rates to fall.               D) individuals buy bonds, causing interest rates to rise.

17. According to the preferred habitat theory of the term structure, a slightly upward sloping yield curve indicates that short-

       term interest rates are expected to

A) rise slightly in the future.                                                             B) remain unchanged in the future.

C) decline moderately in the future.                                                 D) decline sharply in the future.

18. If the expected path of 1-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent,

      and 5 percent, the preferred habitat theory predicts that the bond with the highest interest rate today is the one

      with a maturity of

A) one year.          B) two years.        C) four years.       D) five years.    E) unable to be determined with the information given.

19. Which of the following 20-year bonds normally has the lowest yield to maturity?

A) Corporate Baa bonds          B) U.S. Treasury bonds               C) Corporate Aaa bonds            D) Municipal bonds

20. Which theory of term structure predicts that long-term yields will exceed short-term yields on average?

A) Pure expectations          B) Segmented markets           C) Liquidity premium           D) None of the previous.

Explanation / Answer

11. Everything else held constant when the expected return on Verizon stock rises from 7 to 8 percent and the yield to maturity on 20-year U.S. Treasury bonds rises from 2.55 to 3.45 percent, it is clear that the expected return on Verizon stock rises (because rise in expected return is greater) relative to US treasury bond. Therefore the demand for US Treasury bond falls. The correct option is therefore

Option B) rises; falls

12. When the expected inflation rate rises, the supply of loanable funds curve shifts to the left and the demand curve to the right, which drives up the nominal interest rate in such a way that the expected inflation rate remains the same. Therefore the correct option is:

Option C) an increase in expected inflation

13. When there is a fall in the corporate tax on profits, the revenue of the government falls which shifts the supply of loanable funds curve to the left. Similarly, the demand curve shifts to the right because people want to borrow more to invest more and earn higher profit because taxes have been reduced. Thus there is an increase in the equilibrium interest rate. Therefore the correct option is:

Option B) a decrease in the corporate tax on profits

14. AAA rated bonds are of the highest quality with lowest degree of investment risk. BBB rated bonds are of medium quality which has a high probability of becoming unreliable over the long term. Therefore it appears as is AAA bonds are preferable, but it also depends on the following facts:

Therefore the correct option is:

Option D) require more information before choosing asset one or asset two.

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