chapter 5

Question 1

Nominal (quoted) risk-free rate (rRF)

Answer 1

the rate of interest on a security that is free of all risk; rRF is proxied by the T-bill rate or the T-bond rate and includes an inflation premium

Question 2

Production opportunities

Answer 2

the return available within an economy from investment in productive (cash-generating) assets

Question 3

Time preferences for consumption

Answer 3

the preference of consumers for current consumption as opposed to saving for future consumption

Question 4

Risk

Answer 4

in a financial market context, the chance that a financial asset will not earn the return promised

Question 5

Inflation

Answer 5

the tendency of prices to increase over time

Question 6

r

Answer 6

quoted nominal rate of interest on security

Question 7

rRF

Answer 7

quoted risk-free rate of return

Question 8

RP

Answer 8

risk premium. Portion of return that exceeds the risk-free rate of return (rRF) and represents payment for risk of investment ( RP = DRP + LP + MRP)

Question 9

DRP

Answer 9

default risk premium = reflects the chance that the borrower will not pay the debt/interest on time

Question 10

LP

Answer 10

liquidity premium= reflects that some investments are easier to put into cash on short notice @ reasonable price

Question 11

MRP

Answer 11

maturity risk premium = longer-term binds experience greater price reactions to interest rate changes than do short-term bonds

Question 12

Real risk-free rate of interest, r*

Answer 12

the rate of interest that would exist on default-free U.S. treasury securities if no inflation were expected

Question 13

Inflation premium

Answer 13

a premium for expected inflation that investors add to the real risk-free rate of return

Question 14

Default risk premium- (DRP)

Answer 14

the difference between the interest rate on a U.S. treasury bond and a corporate bond of equal maturity and marketability; compensation for the risk that a corporation will not meet its debt obligation

Question 15

Liquidity premium

Answer 15

a premium added to the rate on a security if the security cannot be converted to cash on short notice at a price that is close to its original cost

Question 16

Interest rate price risk

Answer 16

• the risk of capital losses to which investors are exposed because of changing interest rates

Question 17

Maturity risk premium (MRP)

Answer 17

a premium that reflects interest rate price risk; bonds w/ longer maturities have greater interest rate risk, thus greater MRPs

Question 18

reinvestment rate risk

Answer 18

the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested

Question 19

term structure of interest rates

Answer 19

the relationship between yields and maturities of securities

Question 20

yield curve

Answer 20

a graph showing the relationship between yields and maturities of securites

Question 21

“normal” yield curve

Answer 21

an upward sloping yield curve

Question 22

inverted (abnormal) yield curve

Answer 22

a downward sloping yeild curve

Question 23

liquidity prefernce theory

Answer 23

the theory that, all else being equal, lenders prefer to make short-term loans rather than long term (so lend shorter term at lower rate than long term)

Question 24

expectation theory

Answer 24

the theory that the shape of the yield curve depends on investors’ expectations about future inflation rates

Question 25

market segmentation theory

Answer 25

the theory that every borrower and lender has a preferred maturity and that the slope of the yield curve depends on the supply of and the demand for funds in the long term market relative to the short term market

Question 26

open market operations

Answer 26

operations in which the federal reserve buys or sells treasury securities to expand or contract the U.S. money supply