PRINCIPLES OF FINANCE

Section 1. 15 questions (True or False – 15 points)

1. Households generally supply more funds to the markets as their income and wealth increase. (1 point)

__True

__False

2. When the quantity of a financial security supplied or demanded changes at every given interest rate in

response to a change in a factor, this causes a shift in the supply or demand curve. (1 point)

__True

__False

3. An improvement in economic conditions would likely shift the supply curve down and to the right and shift

the demand curve for funds up and to the right. (1 point)

__True

__False

4. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him

or her to forego current consumption. (1 point)

__True

__False

5. Simple interest calculations assume that interest earned is never reinvested. (1 point)

__True

__False

6. Earning a 5 percent interest rate with annual compounding is better than earning a 4.95 percent interest

rate with semiannual compounding. (1 point)

__True

__False

7. For any positive interest rate the present value of a given annuity will be less than the sum of the cash

flows, and the future value of the same annuity will be greater than the sum of the cash flows. (1 point)

__True

__False

8. An increase in the marginal tax rates for all U.S. taxpayers would probably result in reduced supply of

funds by households. (1 point)

__True

__False

9. The risk that a security cannot be sold at a predictable price with low transaction costs at short notice

is called liquidity risk. (1 point)

__True

__False

10. We expect liquidity premiums to move inversely with interest rate volatility. (1 point)

__True

__False

11. Everything else equal, the interest rate required on a callable bond will be less than the interest rate

on a convertible bond. (1 point)

__True

__False

12. The term structure of interest rates is the relationship between interest rates on bonds similar in

terms except for maturity. (1 point)

__True

__False

13. The unbiased expectations hypothesis of the term structure posits that long-term interest rates are

unrelated to expected future short-term rates. (1 point)

__True

__False

14. The traditional liquidity premium theory states that long-term interest rates are greater than the

average of expected future interest rates. (1 point)

__True

__False

15. According to the market segmentation theory, short-term investors will not normally switch to

intermediate- or long-term investments. (1 point)

__True

__False

Section 2. 5 questions (Word Problems – 25 points) (You may use a scientific calculator, but SHOW YOUR WORK

and round your answers to 2 decimal places. (e.g., 32.16))

16. A particular security’s equilibrium rate of return is 9 percent. For all securities, the inflation risk

premium is 3.05 percent and the real risk-free rate is 2.9 percent. The security’s liquidity risk premium is

0.55 percent and maturity risk premium is 0.75 percent. The security has no special covenants. Calculate the

security’s default risk premium. (5 points)

17. You are considering an investment in 20-year bonds issued by Moore Corporation. The bonds have no

special covenants. The Wall Street Journal reports that one-year T-bills are currently earning 0.50 percent.

Your broker has determined the following information about economic activity and Moore Corporation bonds:

Real risk-free rate

=

0.45%

Default risk premium

=

1.05%

Liquidity risk premium

=

0.80%

Maturity risk premium

=

0.75%

a.

What is the inflation premium? (2 points)

b.

What is the fair interest rate (ij) on Moore Corporation 30-year bonds? (3 points)

18. Based on economists’ forecasts and analysis, one-year T-bill rates and liquidity premiums for the next

four years are expected to be as follows:

1R1

=

5.65%

E(2r1)

=

6.75%

L2

=

0.05%

E(3r1)

=

6.85%

L3

=

0.10%

E(4r1)

=

7.15%

L4

=

0.12%

Calculate the four annual rates. (5 points)

19. The current one-year T-bill rate is .40 percent and the expected one-year rate 12 months from now is

1.28 percent. According to the Unbiased Expectations Theory (UET), what should be the current rate for a

two-year Treasury security? (5 points)

20. On March 11, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year zero-

coupon Treasury security rates were as follows:1R1 = 4.75%, 1R2 = 4.95%, 1R3 = 5.25%, 1R4 = 5.65%

Using the Unbiased Expectations Theory, calculate the one-year forward rates on zero-coupon Treasury bonds

for years two, three, and four as of March 11, 20XX. (5 points)

2f1 =

3f1 =

4f1 =

Section 3. 10 questions (Time Value of Money Calculations – 36 points) (Round your answers to 2 decimal

places. (e.g., 32.16))

21. Calculate the present value of $4,000 received six years from today if your investments pay: (5 points)

Present Value

a.

6 percent compounded annually

$

b.

8 percent compounded annually

c.

10 percent compounded annually

d.

10 percent compounded semiannually

e.

10 percent compounded quarterly

22. Calculate the future value in six years of $9,000 received today if your investments pay: (5 points)

Future Value

a.

6 percent compounded annually

$

b.

8 percent compounded annually

c.

10 percent compounded annually

d.

10 percent compounded semiannually

e.

10 percent compounded quarterly

23. Calculate the present value of the following annuity streams: (4 points)

a.

$6,000 received each year for 5 years on the last day of each year if your investments pay 6 percent

compounded annually.

Present value

$

b.

$6,000 received each quarter for 5 years on the last day of each quarter if your investments pay 6 percent

compounded quarterly.

Present value

$

c.

$6,000 received each year for 5 years on the first day of each year if your investments pay 6 percent

compounded annually.

Present value

$

d.

$6,000 received each quarter for 5 years on the first day of each quarter if your investments pay 6 percent

compounded quarterly.

Present value

$

24. Calculate the future value of the following annuity streams: (4 points)

a.

$4,000 received each year for 4 years on the last day of each year if your investments pay 5 percent

compounded annually.

Future value

$

b.

$4,000 received each quarter for 4 years on the last day of each quarter if your investments pay 5 percent

compounded quarterly.

Future value

$

c.

$4,000 received each year for 4 years on the first day of each year if your investments pay 5 percent

compounded annually.

Future value

$

d.

$4,000 received each quarter for 4 years on the first day of each quarter if your investments pay 5 percent

compounded quarterly.

Future value

$

25. Compute the future values of the following annuities first assuming that payments are made on the last

day of the period and then assuming payments are made on the first day of the period: (8 points)

Payment

Years

Interest Rate (Annual)

Future Value

(Payment made on

last day of period)

Future Value

(Payment made on

first day of period)

$ 323

15

11%

$

$

6,555

10

11

76,484

7

13

169,332

11

4

26. If you deposit $600 in a bank account that earns 6 percent per year, how much total interest will you

have earned after the fourth year? (2 points)

27. How much money would you have to deposit today in order to have $4,000 in three years if the discount

rate is 6 percent per year? (2 points)

28. If an ounce of gold, valued at $640, increases at a rate of 6.9 percent per year, how long will it take

to be valued at $1,000? (2 points)

29. What are the monthly payments (principal and interest) on a 15-year home mortgage for an $220,000 loan

when interest rates are fixed at 8 percent? (2 points)

30. If a friend promises to pay you $1,500 five years from now for a $1,000 loan today, what is the rate of

interest on the loan? (2 points)

Section 1. 15 questions (True or False – 15 points)

1. Households generally supply more funds to the markets as their income and wealth increase. (1 point)

__True

__False

2. When the quantity of a financial security supplied or demanded changes at every given interest rate in

response to a change in a factor, this causes a shift in the supply or demand curve. (1 point)

__True

__False

3. An improvement in economic conditions would likely shift the supply curve down and to the right and shift

the demand curve for funds up and to the right. (1 point)

__True

__False

4. The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him

or her to forego current consumption. (1 point)

__True

__False

5. Simple interest calculations assume that interest earned is never reinvested. (1 point)

__True

__False

6. Earning a 5 percent interest rate with annual compounding is better than earning a 4.95 percent interest

rate with semiannual compounding. (1 point)

__True

__False

7. For any positive interest rate the present value of a given annuity will be less than the sum of the cash

flows, and the future value of the same annuity will be greater than the sum of the cash flows. (1 point)

__True

__False

8. An increase in the marginal tax rates for all U.S. taxpayers would probably result in reduced supply of

funds by households. (1 point)

__True

__False

9. The risk that a security cannot be sold at a predictable price with low transaction costs at short notice

is called liquidity risk. (1 point)

__True

__False

10. We expect liquidity premiums to move inversely with interest rate volatility. (1 point)

__True

__False

11. Everything else equal, the interest rate required on a callable bond will be less than the interest rate

on a convertible bond. (1 point)

__True

__False

12. The term structure of interest rates is the relationship between interest rates on bonds similar in

terms except for maturity. (1 point)

__True

__False

13. The unbiased expectations hypothesis of the term structure posits that long-term interest rates are

unrelated to expected future short-term rates. (1 point)

__True

__False

14. The traditional liquidity premium theory states that long-term interest rates are greater than the

average of expected future interest rates. (1 point)

__True

__False

15. According to the market segmentation theory, short-term investors will not normally switch to

intermediate- or long-term investments. (1 point)

__True

__False

Section 2. 5 questions (Word Problems – 25 points) (You may use a scientific calculator, but SHOW YOUR WORK

and round your answers to 2 decimal places. (e.g., 32.16))

16. A particular security’s equilibrium rate of return is 9 percent. For all securities, the inflation risk

premium is 3.05 percent and the real risk-free rate is 2.9 percent. The security’s liquidity risk premium is

0.55 percent and maturity risk premium is 0.75 percent. The security has no special covenants. Calculate the

security’s default risk premium. (5 points)

17. You are considering an investment in 20-year bonds issued by Moore Corporation. The bonds have no

special covenants. The Wall Street Journal reports that one-year T-bills are currently earning 0.50 percent.

Your broker has determined the following information about economic activity and Moore Corporation bonds:

Real risk-free rate

=

0.45%

Default risk premium

=

1.05%

Liquidity risk premium

=

0.80%

Maturity risk premium

=

0.75%

a.

What is the inflation premium? (2 points)

b.

What is the fair interest rate (ij) on Moore Corporation 30-year bonds? (3 points)

18. Based on economists’ forecasts and analysis, one-year T-bill rates and liquidity premiums for the next

four years are expected to be as follows:

1R1

=

5.65%

E(2r1)

=

6.75%

L2

=

0.05%

E(3r1)

=

6.85%

L3

=

0.10%

E(4r1)

=

7.15%

L4

=

0.12%

Calculate the four annual rates. (5 points)

19. The current one-year T-bill rate is .40 percent and the expected one-year rate 12 months from now is

1.28 percent. According to the Unbiased Expectations Theory (UET), what should be the current rate for a

two-year Treasury security? (5 points)

20. On March 11, 20XX, the existing or current (spot) one-year, two-year, three-year, and four-year zero-

coupon Treasury security rates were as follows:1R1 = 4.75%, 1R2 = 4.95%, 1R3 = 5.25%, 1R4 = 5.65%

Using the Unbiased Expectations Theory, calculate the one-year forward rates on zero-coupon Treasury bonds

for years two, three, and four as of March 11, 20XX. (5 points)

2f1 =

3f1 =

4f1 =

Section 3. 10 questions (Time Value of Money Calculations – 36 points) (Round your answers to 2 decimal

places. (e.g., 32.16))

21. Calculate the present value of $4,000 received six years from today if your investments pay: (5 points)

Present Value

a.

6 percent compounded annually

$

b.

8 percent compounded annually

c.

10 percent compounded annually

d.

10 percent compounded semiannually

e.

10 percent compounded quarterly

22. Calculate the future value in six years of $9,000 received today if your investments pay: (5 points)

Future Value

a.

6 percent compounded annually

$

b.

8 percent compounded annually

c.

10 percent compounded annually

d.

10 percent compounded semiannually

e.

10 percent compounded quarterly

23. Calculate the present value of the following annuity streams: (4 points)

a.

$6,000 received each year for 5 years on the last day of each year if your investments pay 6 percent

compounded annually.

Present value

$

b.

$6,000 received each quarter for 5 years on the last day of each quarter if your investments pay 6 percent

compounded quarterly.

Present value

$

c.

$6,000 received each year for 5 years on the first day of each year if your investments pay 6 percent

compounded annually.

Present value

$

d.

$6,000 received each quarter for 5 years on the first day of each quarter if your investments pay 6 percent

compounded quarterly.

Present value

$

24. Calculate the future value of the following annuity streams: (4 points)

a.

$4,000 received each year for 4 years on the last day of each year if your investments pay 5 percent

compounded annually.

Future value

$

b.

$4,000 received each quarter for 4 years on the last day of each quarter if your investments pay 5 percent

compounded quarterly.

Future value

$

c.

$4,000 received each year for 4 years on the first day of each year if your investments pay 5 percent

compounded annually.

Future value

$

d.

$4,000 received each quarter for 4 years on the first day of each quarter if your investments pay 5 percent

compounded quarterly.

Future value

$

25. Compute the future values of the following annuities first assuming that payments are made on the last

day of the period and then assuming payments are made on the first day of the period: (8 points)

Payment

Years

Interest Rate (Annual)

Future Value

(Payment made on

last day of period)

Future Value

(Payment made on

first day of period)

$ 323

15

11%

$

$

6,555

10

11

76,484

7

13

169,332

11

4

26. If you deposit $600 in a bank account that earns 6 percent per year, how much total interest will you

have earned after the fourth year? (2 points)

27. How much money would you have to deposit today in order to have $4,000 in three years if the discount

rate is 6 percent per year? (2 points)

28. If an ounce of gold, valued at $640, increases at a rate of 6.9 percent per year, how long will it take

to be valued at $1,000? (2 points)

29. What are the monthly payments (principal and interest) on a 15-year home mortgage for an $220,000 loan

when interest rates are fixed at 8 percent? (2 points)

30. If a friend promises to pay you $1,500 five years from now for a $1,000 loan today, what is the rate of

interest on the loan? (2 points)

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