Chap 007

Chapter 07 - The Risk and Term Structure of Interest Rates
Chapter 07 The Risk and Term Structure of Interest Rates

Multiple Choice Questions
1. (p. 148) The bond rating of a security reflects: a. The size of the coupon payment relative to the face value B. The likelihood the lender/borrower will be repaid by the borrower/issuer c. The return a holder is likely to receive d. The size of the coupon rate relative to other interest rates
AACSB: Analytic BLOOMS: Knowledge LOD: 1
2. (p. 148) The two best known bond rating services are: a. The Federal Reserve and Moody's Investment Services b. The Federal Reserve and the U.S. Treasury c. Standard & Poor's and the Wall Street Journal D. Standard & Poor's and Moody's Investment Services
3. (p. 148) Investors usually obtain bond ratings from: A. Private bond-rating agencies b. The annual tax returns of the issuer c. The U.S. government from publicly available information d. Public Information made available by the bond issuers
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4. (p. 148) Which of the following assigns widely followed bond ratings? a. The Federal Reserve b. The U.S. Treasury c. The New York Stock Exchange D. Standard & Poor's
5. (p. 148) Which of the following assigns widely followed bond ratings? a. The Federal Reserve b. The Wall Street Journal C. Moody's Investor Service d. The Nasdaq
6. (p. 149) What is the highest bond rating assigned by Standard and Poor's? a. AA b. EEE C. AAA d. A
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7. (p. 149) The lowest rating for an investment grade bond assigned by Moody's is: A. Baa b. A c. BBB d. Aa
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8. (p. 149) Bonds rated as "highly speculative": a. Are rated so because they guarantee high returns for the buyer B. Are commonly referred to as junk bonds c. Are ranked just below investment grade by Standard & Poor's d. Are rated so because they do not have any default risk
9. (p. 149) Which of the following would be most likely to earn an AAA rating from Standard & Poor's? A. A 30-year bond issued by the U.S. Treasury b. A bond issue by a new vegetarian fast-food chain c. A 10-year bond issued by a state or municipality d. Shares of stock in Coca-Cola
AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2
10. (p. 150) Once a bond rating is assigned, it: a. Never changes over the life of the bond B. Can change as the financial position of the issuer changes c. Can only change if the rating change is approved by the Securities and Exchange Commission d. Can change on the next bond from the issuer but is fixed for the current bond
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11. (p. 150) Commercial paper refers to: a. The financial publications read by the CEO's of public corporations b. Any debt security with a maturity exceeding one year c. Short-term collateralized securities issued only by corporations D. Unsecured short-term debt issued by corporations and governments
AACSB: Analytic BLOOMS: Comprehension LOD: 1
12. (p. 150) Most commercial paper is: a. Issued with maturities exceeding one year b. Issued with maturities between 50 and 75 days C. Used exclusively for short-term financing needs d. Issued by foreign companies doing business in the United States
13. (p. 151) If a bond's rating improves it should cause: a. The bond's price and yield to increase, all other factors constant b. The bond's price and yield to decrease, all other factors constant C. The bond's price to increase and its yield to decrease, all other factors constant d. The bond's price to decrease and its yield to increase, all other factors constant
AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2
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14. (p. 152) If a bond's rating improves, we would expect: A. The demand for this bond to increase, all other factors constant b. The demand for and the yield of this bond to increase, all other factors constant c. The demand for this bond to decrease, and its yield to increase, all other factors constant d. Both the demand for and the price of the bond to decrease, all other factors constant
AACSB: Reflective Thinking BLOOMS: Application LOD: 2
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15. (p. 151) Bonds issued by the U.S. Treasury are referred to as benchmark bonds because: a. They are always purchased for a premium B. They are the closest thing to a risk-free bond c. All bonds from national governments are labeled as benchmark bonds d. All bonds from the U.S. government have the same rate of interest
16. (p. 151) The risk spread is: a. The difference between a bond's purchase price and selling price B. The difference between the bond's yield and the yield on a U.S. Treasury bond of the same maturity c. Less than 0 (zero) for a U.S. Treasury bond d. Assigned by a bond-rating agency
17. (p. 151) The risk spread: A. Is also known as the default-risk premium b. Should have a direct relationship with the bond's price c. Should have an inverse relationship with the bond's yield d. Is always constant
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18. (p. 151) All of the following are true about the risk spread except: a. It should be higher for highly speculative bonds than investment grade bonds b. It should have a direct relationship with the bond's yield c. It should have an inverse relationship with the bond's price D. It should have a direct relationship with the bond's price
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19. (p. 151) The default-risk premium: a. Is negative for a U.S. Treasury bond B. Is also known as the risk spread c. Must always be greater than 0 (zero) d. Is assigned by a bond-rating agency
20. (p. 151) The default-risk premium: A. Should vary directly with the bond's yield and inversely with its price b. Is less than 0 (zero) for a U.S. Treasury bond c. Should be lower for a highly speculative bond than for an investment-grade bond d. Should vary directly with the bond's yield and the bond's price
21. (p. 152) The risk structure of interest rates says: a. The interest rates on a variety of bonds will move independently of each other B. Lower rated bonds will have higher yields c. U.S. Treasury bond yields always change by more than other bonds d. Interest rates only compensate for risk in structured amounts
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22. (p. 151) U.S. Treasury securities are considered to carry no risk spread because: A. They are the closest thing to default-risk free that an investor can obtain b. The prices of U.S. Treasury bonds never change c. The yields on U.S. Treasury bonds never change d. The yields on U.S. Treasury bonds are zero
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23. (p. 152) The risk structure of interest rates refers to: a. The relationship among the interest rates of bonds with different maturities B. The relationship among the interest rates of bonds with the same maturities c. The relationship among the interest rates of bonds from the same issuer but different maturities d. The additional interest required to compensate the buyer for the longer maturity of the bond
24. (p. 152) A borrower who has to pay an interest rate of 8% rather than 6% due to risk spread will: a. Pay $20 more in interest annually for every $100 borrowed B. Pay 33.3% higher interest in dollar terms c. Pay 2% in net interest d. Pay less interest in total over the life of the loan
25. (p. 156) Which of the following is true? a. Long-term bond yields move together but short-term yields do not b. Short-term bond yields move together but long-term yields do not C. U.S. Treasury Bill yields are lower than the yields on commercial paper d. Long-term bond yields are usually the same as short-term yields
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26. (p. 155) Taxes play an important role in bond returns because: a. All interest from owning bonds is taxed b. All governments (federal, state, municipal) tax bonds similarly C. Some bond interest is exempt from some government taxation, so after tax returns across bonds can vary considerably d. Only U.S. Treasury bonds are tax-exempt, so investors should always seek higher returns from other bonds
27. (p. 154) Municipal bonds are issued by: a. Cities only b. The U.S. Treasury, but the proceeds can only be used by cities c. States and cities, but their interest is taxable only at the federal level D. States and cities and their interest is exempt from U.S. government taxation
28. (p. 155) An investor in a 30% marginal tax bracket, earning $10 in interest annually for a $100 U.S. Treasury bond: a. Earns a 10% after-tax return because interest on U.S. Treasury bonds is tax exempt at the federal level b. Earns a 3% return after-tax C. Would be indifferent between this bond and a municipal bond offering $7 annually per $100 of face value, assuming the same default risk d. Earns a 1% return after-tax
AACSB: Analytic BLOOMS: Analysis LOD: 3
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29. (p. 155) The yield on a tax-exempt bond: A. Equals the taxable bond yield times one minus the tax rate b. Is equal to the yield on a U.S. 30-year bond c. Is called the risk-free yield d. Only applies to foreign bonds because they are exempt from U.S. income taxes
30. (p. 155) Holding risk constant, an investor earning 6% from a tax-exempt bond who is in a 25% tax bracket would be indifferent between that bond and: A. A taxable bond with a 8% yield b. A taxable bond with a 4.5% yield c. A taxable bond with a 6.25% yield d. A taxable bond with a 7.5% yield
AACSB: Analytic BLOOMS: Application LOD: 3
31. (p. 155) Holding risk constant, an investor earning 4% from a tax-exempt bond who is in a 20% tax bracket would be indifferent between that bond and: a. A taxable bond with a 7.5% yield b. A taxable bond with a 8.0% yield C. A taxable bond with a 5% yield d. A taxable bond with a 6% yield
AACSB: Application BLOOMS: Application LOD: 3
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32. (p. 155) Municipal bonds are usually purchased by: a. Retired investors who have no other taxable income b. Investors looking for securities to buy for their IRA accounts c. Investors who live in cities with high municipal tax rates D. Investors who are in high marginal tax brackets
33. (p. 155) Suppose the tax rate is 25% and the taxable bond yield is 8%. What is the taxexempt bond yield? a. 2% b. 2.3% C. 6% d. 6.9%
34. (p. 155) In 2003, ratings agencies downgraded bonds issued by the State of California several times. How will this affect the market for these bonds? a. Yields on these bonds will decrease and the yield on Treasury bonds will increase b. The yield on these bonds will not change, nor will the yield on Treasury bonds c. The yield on these bonds and on Treasury bonds will both decrease D. Yields on these bonds will increase
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35. (p. 155) Tax-exempt bonds: a. Generate higher returns for the bondholder when purchased through a tax-exempt retirement account b. Are not affected by changes in yields on taxable bonds C. Are most beneficial to those who pay higher income tax rates d. Include U.S. Treasury securities because the Internal Revenue Service does not charge income tax on interest earned from these bonds
36. (p. 155) If a local government eliminates the tax exemption on municipal bonds, we'd expect to see: a. An increase in the yield on taxable bonds B. A decrease in the gap in yields on taxable and tax-exempt bonds c. A decrease in the yield on municipal bonds d. Municipal bonds will become more attractive to investors
37. (p. 158) According to the Expectations Theory of the term structure, if interest rates are expected to be 2%, 2%, 4%, and 5% over the next four years, what is the yield on a three-year bond today? A. 2.7% b. 4% c. 4.3% d. 8%
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38. (p. 157) Suppose the economy has an inverted yield curve. According to the Expectations Hypothesis, which of the following interpretations could be used to explain this? A. Interest rates are expected to fall in the future b. Investors prefer bonds with more interest-rate risk c. Investors prefer bonds with less interest-rate risk d. The term spread is positive
AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2
39. (p. 159) Which fact about the term structure is the Expectations Theory unable to explain? a. Why interest rates on bonds with different terms to maturity tend to move together over time b. Why yields on short-term bonds are more volatile than yields on long-term bonds C. Why longer-term yields tend to be higher than shorter-term yields d. Why yields on short-term bonds are more volatile than yields on long-term bonds and why longer-term yields tend to be higher than shorter-term yields
AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Comprehension LOD: 2
40. (p. 159) Which fact about the term structure is the Expectations Theory able to explain? a. Why interest rates on bonds with different terms to maturity tend to move together over time b. Why yields on short-term bonds are more volatile than yields on long-term bonds c. Why longer-term yields tend to be higher than shorter-term yields D. Why interest rates on bonds with different terms to maturity tend to move together over time and why yields on short-term bonds are more volatile than yields on long-term bonds
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41. (p. 163) The risk spread on bonds fluctuates mainly because: a. Taxes tend to increase over time b. Bond rating agencies are often inconsistent C. New information about a borrowers financial condition becomes available d. People change their attitudes towards risk quickly
42. (p. 163) In the fall of 1998 we saw an increase in the risk spread because: a. The risk spread always increases as we approach the end of the year B. The Russian government defaulted on some of its bonds c. There was an extraordinarily large amount of corporate fraud being reported in 1998 d. There was a significant increase in U.S. income tax rates
43. (p. 163) A company that continues to have strong profit performance during an economic downturn when many other companies are suffering losses or failing should: a. See an increase in the yield of their bonds and the price of the bond increases B. See their bond rating maintained or actually increase c. See the demand for their bonds decrease and their yields decrease d. See the demand and price for their bonds decrease
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44. (p. 155) Bonds with the same tax status and ratings: a. Always have the same yield B. Can have different yields due to different maturities c. Should sell for the same price d. Will still have different yields depending on their face values
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45. (p. 157) The U.S. Treasury yield curve: A. Shows the relationship among bonds with the same risk characteristics but different maturities b. Assumes maturities are constant, and reflects the difference in risk c. Always has a positive slope d. Always has a negative slope
46. (p. 162) During a recession you would expect the difference between the commercial paper rate and the yield on U.S. T-bills of the same maturity to: a. Be the same since their maturities are the same B. Increase reflecting the possibility of higher default risk for commercial paper c. Decrease d. Fluctuate on a daily basis
47. (p. 156) Which of the following statements pertaining to the yield curve is not true? a. Yield curves usually slope upwards B. The yield curve shows the difference in default risk between securities c. The yield curve shows the relationship among bonds with the same risk characteristics but different maturities d. The yield curve can be flat or downward sloping depending on market conditions
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48. (p. 155) If the federal government replaced the current income tax with a national sales tax, the price of: a. Corporate bonds would rise b. Municipal bonds would rise c. Corporate bonds would fall while the price of municipal bonds would rise D. Municipal bonds would fall while the price of corporate bonds would rise
49. (p. 155) Interest on most bonds issued by states is usually exempt from: a. State income tax but not federal b. From federal income tax but not state C. Both state and federal income taxes d. From city income taxes
50. (p. 156) The term structure of interest rates: a. Always results in an upward sloping yield curve B. Represents the variation in yields for securities differing in maturities c. Usually results in a flat yield curve d. Usually results in a downward sloping yield curve
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51. (p. 156) Which of the following statements in not true of the yield curve for U.S. Treasury securities? a. The yield curve usually slopes upward B. The yield curve usually has a positive slope at first then becomes inverted c. The yield curve shows the relationship among securities of different maturities d. The yield curve can shift over time
52. (p. 156) The yield curve for U.S. Treasury securities allows us to draw the following conclusions, except that: a. Long-term yields tend to higher than short term yields b. Interest rates of different maturities tend to move together C. Long-term rates tend to equal short-term rates d. Yields on short-term securities are more volatile than yields on long-term bonds
53. (p. 164) When the yield curve is upward sloping, people are expecting: a. An economic slowdown b. The U.S. Treasury may default on its obligations c. The Federal Reserve is going to ease monetary policy D. Long-term yields to be higher than short-term yields
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54. (p. 164) When the yield curve is downward sloping: A. People are expecting an economic slowdown b. Short-term yields are lower than long term yields c. People are expecting higher inflation in the future d. People could be expecting a tightening in monetary policy
55. (p. 156) Any theory of the term structure of interest rates needs to explain each of the following, except: a. The upward slope of the yield curve b. Why the yields of different maturities tend to move together C. Why short-term yields are usually higher than long-term yields d. Why long-term yields are usually higher than short-term yields
56. (p. 157) The Expectations Hypothesis assumes: a. A high level of uncertainty regarding the future of long-term yields B. Investors know the yields on bonds today and form expectations of the yields on short-term bonds in future time periods c. Securities of different maturities are not perfect substitutes for each other d. The risk premium increases with longer maturities
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57. (p. 157) The Expectations Hypothesis suggests: a. The yield curve should usually be downward sloping b. The yield curve should usually be upward sloping c. The slope of the yield curve reflects the risk premium associated with longer-term bonds D. The slope of the yield curve depends on the expectations for future short-term rates
58. (p. 157) The yield on a 30-year U.S. Treasury security is 6.5%; the yield on a 2-year U.S. Treasury bond is 4.0%. This data: a. Indicate the yield curve is downward sloping b. Indicate the yield curve is flat since the risk premium needs to be added for longer maturities C. Indicate the yield curve is upward sloping d. Indicate that people expect inflation to decrease in the future
59. (p. 157) Assume the Expectation Hypothesis regarding the term structure of interest rates is correct. Then, if the current one-year interest rate is 4% and the two-year interest rate is 6%, then investors are expecting: a. The future one-year rate to be 4% B. The future one-year rate to be 8% c. The future one-year rate to be 6% d. The future one-year rate to be 5%
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60. (p. 157) Assume the Expectations Hypothesis regarding the term structure of interest rates is correct. Then, if the current two-year interest rate is 5% and the current one-year rate is 6%, then investors expect: A. The future one-year rate to be 4% b. The future one-year rate to be 5% c. The future one-year rate to be 6% d. The future one-year rate to be 1%
61. (p. 157) Assume the Expectations Hypothesis regarding the term structure of interest rates is correct. If the current one-year interest rate is 3% and the expected one-year interest rate is 5%, then the current two-year interest rate should be: a. 3% b. 5% C. 4% d. 8%
62. (p. 157) Assume an investor has a choice of 3 consecutive one-year bonds or one 3-year bond. Assuming the Expectations Hypothesis of the term structure of interest rates is correct: a. The average interest rate of the three consecutive one-year bonds should be less than the 3year bond to reflect the risk premium B. The interest rate of the 3-year bond should equal the average interest rate of the 3 one-year bonds c. The three consecutive one-year bonds must have the same interest rate d. The current one-year interest rate must equal the current 3-year interest rate
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63. (p. 157) According to the Expectations Hypothesis: a. When short-term interest rates are expected to rise in the future, the long-term interest rates are equal to current short-term interest rates b. When short-term rates are expected to remain constant in the future, the long-term interest rates are higher than current short-term interest rates C. Short-term bonds are perfect substitutes for long-term bonds d. Expectations of future short-term rates equal estimates of current short-term rates
64. (p. 157) According to the Expectations Hypothesis, if investors believed that, for a given holding period, the average of the expected future short-term yields was greater than the longterm yield for the holding period, they would act so as to: a. Drive down the price of the short-term bond and drive up the price of the long-term bond B. Drive up the price of the short-term bond and drive down the price of the long-term bond c. Drive up the prices of both the short- and long-term bonds d. Drive down the prices of both the short- and long-term bonds
65. (p. 157) The Expectations Hypothesis cannot explain: a. Why yields on securities of different maturities move together b. Why short-term yields are more volatile than long term yields C. Why yield curves usually slope upward d. Why yield curves usually slope downward
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66. (p. 157) Under the Expectations Hypothesis, a downward-sloping yield curve suggests: A. Investors expect future short-term interest rates to fall b. Investors expect future short-term interest rates to rise c. This is a trick question, the yield curve always slopes upward d. Investors expect future short-term interest rates to remain constant
AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Evaluation LOD: 1
67. (p. 157) The Expectations Hypothesis assumes each of the following, except: a. Long-term bond rates are equal to the average of current and expected future short-term interest rates B. Bonds of different maturities are not perfect substitutes c. Bonds of different maturities have the same risk characteristics d. Bonds of different maturities are perfect substitutes
68. (p. 161) Suppose that interest rates are expected to remain unchanged over the next few years. However, there is a risk premium for longer-term bonds. According to the liquidity premium theory, the yield curve should be: a. Upward sloping and very steep B. Upward sloping and relatively flat c. Inverted d. Vertical
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69. (p. 161) Suppose the economy has an inverted yield curve. According to the Liquidity Premium Theory, which of the following interpretations could be used to explain this? a. Interest rates are expected to rise in the future B. Investors expect an economic slowdown c. Investors are indifferent between bonds with different time horizons d. The term spread has increased
70. (p. 162) The economy enters a period of robust economic growth that is expected to last for several years. How would this be reflected in the risk and term structures of interest rates? a. An inverted yield curve b. A decrease in the term spread C. A decrease in the interest rate spread d. An increase in yields on tax-exempt bonds
71. (p. 162) If a one-year bond currently yields 4% and is expected to yield 6% next year, the Liquidity Premium Theory suggests the yield today on a two-year bond will be: a. More than 4% but less than 5% b. 5% c. 4% D. More than 5%
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72. (p. 162) The addition of the Liquidity Premium Theory to the Expectations Hypothesis allows us to explain why: A. Yield curves usually slope upward b. Interest rates on bonds of different maturities move together c. Long-term interest rates are less volatile than short term interest rates d. Yield curves are flat
73. (p. 165) The reason for the increase in inflation risk over time is due to the fact that: a. The inflation rate always increase over time b. We always have inflation C. It is more difficult to forecast inflation over longer periods of time d. Investors are more focused on nominal returns than real returns
AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Evaluation LOD: 1
74. (p. 163) The risk premium that investors associate with a bond increases with all of the following except: a. Maturity b. Inflation risk increases c. Interest-rate risk D. An improved bond rating
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75. (p. 162) Under the Liquidity Premium Theory a flat yield curve implies: a. There is no risk premium for longer-term maturities b. Short-term interest rates are expected to remain constant C. Short-term interest rates are expected to decrease d. Long-term interest rates are higher than short-term interest rates
76. (p. 162) Under the Liquidity Premium Theory, if investors expect short-term interest rates to remain constant, the yield curve should: A. Have a positive slope b. Have a negative slope c. Be flat d. Have an increasing slope
77. (p. 164) Under the expectations hypothesis, if expectations are for lower inflation in the future than what it currently is, the yield curve's slope: a. Will become more upward sloping b. Will become flat C. Will be negative d. Will be vertical
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78. (p. 164) As GDP rises the: a. Risk spread and term spread decrease b. Risk spread and term spread increase c. Risk spread increases and the term spread decreases D. Risk spread decreases and the term spread increases
79. (p. 165) Under the liquidity premium theory, if investors become less certain about future monetary policy, the yield curve should: A. Become more upward sloping b. Become flatter c. Become inverted d. Be vertical
80. (p. 163) When the growth rate of the economy slows we would expect: a. The risk to increase for U.S. Treasury securities b. The risk spread to increase more between U.S. Treasury Securities and Aaa securities than between Aaa and Baa securities C. The risk spread to increase more between Aaa and Baa securities than U.S. Treasuries and Aaa securities d. Investors to purchase more junk bonds in search of a higher yield
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81. (p. 163) A flight to quality refers to a move by investors: a. Away from bonds towards stocks b. Towards securities of other countries and away from U.S. Treasuries c. Towards precious metals and away from U.S. Treasury bonds D. Away from low-quality bonds towards high-quality bonds
82. (p. 163) We would expect the risk spread between Baa bonds and U.S. Treasury securities of the same maturities to: A. Widen during periods of economic recession b. Remain relatively constant over the business cycle c. Decrease during economic slowdowns d. Increase during economic growth periods
83. (p. 163) We would expect the relationship between the risk spread on Baa bonds and U.S. Treasury securities of similar maturities to: a. Vary directly with economic growth b. Show no variation over the business cycle C. Vary inversely with economic growth d. Breakdown with economic growth
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84. (p. 163) A flight to quality should result in: a. The price of U.S. Treasury Securities rising and the price of corporate bonds rising b. The yield on U.S. Treasury Securities falling and the price of corporate bonds rising c. The yield on corporate bonds falling and the price of U.S. Treasury Securities rising D. The yield on U.S. Treasury securities falling and the price of corporate bonds falling
85. (p. 163) When the Russian government defaulted on its bonds in August 1998: a. Risk spreads decreased significantly B. Yields on U.S. Treasury securities fell while yields on corporate bonds rose c. Yields on U.S. Treasury securities rose while prices of corporate bonds rose d. Risk spreads decreased significantly
86. (p. 164) An inverted yield curve is a valuable forecasting tool because: a. The yield curve usually is inverted so it reflects a growing economy B. The yield curve seldom is inverted and can signal an economic slowdown c. Investors are expecting higher short-term rates in the future, and this usually signals an economic slowdown d. Inverted yield curves signal better economic times are expected
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87. (p. 164) The slope of the yield curve seems to predict the performance of the economy: a. Usually with a 3-month lag B. Usually with a one-year lag c. Usually within a few weeks d. Usually with a two-year lag
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88. (p. 165) A proposed increase in the federal income tax rate should: A. Have no impact on the slope of the yield curve since the tax laws impact all maturities the same b. Cause the slope of the yield curve to become negative c. Increase the slope of the yield curve since it increases the risk premium of longer maturities d. Flatten the yield curve
89. (p. 155) How would you expect the mayors of most U.S. cities to respond to a proposed significant reduction in U.S. income taxes? a. Favorably, since this will significantly increase the demand for municipal bonds B. Unfavorably, the demand for municipal bonds will fall and their yields will increase c. Favorably, the price of municipal bonds should increase and their yields fall d. No reaction, this should have no impact on municipal bonds at all
90. (p. 166) The terrorist attack on the World Trade Center on September 11, 2001: A. Triggered a flight to quality in the bond market b. Caused the demand for U.S. Treasury securities to fall and the demand for corporate bonds to rise c. Caused the price of U.S. Treasury securities to fall and the yields on corporate bonds to fall d. Did not have any significant impact since the risk on all bonds increased
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91. (p. 163) If the Federal Reserve announces an easing of monetary policy and this move was not expected: a. It should have no impact on the slope of the yield curve B. We should expect the yield curve to possibly become inverted c. The slope of the yield curve would become larger d. We should expect the yield curve to steepen
92. (p. 163) Increasing tensions in many parts of the world should: a. Cause the demand for all government securities including U.S. Treasury securities to decrease b. Cause the risk spread between U.S. Treasury bonds and other bonds to decrease C. Cause the price of U.S. Treasury bonds to increase and the yield on other bonds to increase d. Cause the price of U.S. Treasury bonds to increase and the yield on other bonds to decrease
93. (p. 163) Increased borrowing by the U.S. Treasury to finance growing budget deficits will: a. Result in U.S. Treasury yields being higher than high-grade corporate bonds b. Result in the price of U.S. Treasury bonds rising C. Cause the yield on U.S. Treasury bonds to increase, but still be lower than corporate bonds d. Result in lower yields on corporate bonds
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94. (p. 162) The presence of a term spread that is usually positive indicates that: a. The yield curve always slopes upward B. Bonds of similar risk but with different maturities are not perfect substitutes c. We should expect the yield curve to usually be flat d. We should expect the yield curve to usually slope downward
95. (p. 163) The interest-rate risk that is associated with bond investing: a. Is exists even if an investor plans on holding the bond to maturity B. Arises because of a mismatch between the investor's investment horizon and the maturity of the bond c. Is not reflected in the risk premium d. Can be eliminated by holding only short-term bonds
96. (p. 163) Imagine a scandal that finds the officers of bond rating agencies have been taking bribes to inflate the rating of specific bonds. This should: a. Have no impact on the bond market since bond markets are highly efficient b. Decrease the demand for all bonds C. Increase the demand for U.S. Treasury securities and decrease the demand for corporate bonds d. Decrease the risk spread
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97. (p. 165) A yield curve that slopes upward says each of the following, except: A. Short-term rates are expected to decrease b. People may be expecting short-term rates will be higher in the future c. Short-term rates could be expected to remain constant d. Long-term interest rates are higher than current short-term rates
98. (p. 157) Under the Expectations Hypothesis, bonds of different maturities are assumed to be perfect substitutes because: a. The risk premium is assumed to be negative B. Market forces would always have long-term interest rates equal the average of the current and expected short-term rate c. Expectations of future interest rates are uncertain and therefore cannot be included in the analysis d. Bond markets are very liquid
99. (p. 155) A proposed increase in the federal income tax rates may actually be viewed favorably by many mayors of cities because: a. It will allow them to also raise their tax rates b. It will cause the demand for municipal bonds to increase and their yields to increase c. People will pay less attention to local taxes D. It will cause the price of municipal bonds to increase and their yields to decrease
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100. (p. 163) As technology allows information regarding the financial health of corporations to become easier to obtain, we should expect: A. The risk spread to decrease b. The role of bond rating agencies to become more important c. A decrease in the number of participants in the bond market d. The risk spread to increase
Short Answer Question
101. (p. 148) What is the main purpose (function) of bond rating services?
These companies monitor the status of individual bond issuers and assess the likelihood that a lender/bondholder will be repaid by a borrower/issuer.
102. (p. 148) Briefly describe the two different types of junk bonds (high-yield bonds).
There are two types of junk bonds; there are the fallen angels, which were at one time investment grade bonds, but their issuer fell on hard times. The second type results because little is known about the issuer. These bonds originate as junk bonds.
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103. (p. 151) If an investor wants to compare commercial paper to a corresponding risk-free investment, which security would he/she use and why?
He or she should use the U.S. Treasury bill. The reason is U.S. Treasuries are the closest thing to risk free and the reason for the Treasury bill is that T-Bills, like commercial paper have very short maturities, usually less than 360 days.
104. (p. 151) An investor sees the current twelve-month rate at 4% and expects the following future twelve-month rate for each of the subsequent years; 4.5%, 5.5% and 6.0%. If this investor views a four-year maturity at 5.65% as equal to four consecutive one-year securities, what is his/her risk premium?
0.65%
105. (p. 164) Why do economists pay particular attention to inverted yield curves?
Inverted yield curves can be highly useful for forecasting economic slowdowns. Usually the yield curve turning inverted predicts an economic slowdown, usually with a one-year lag.
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106. (p. 162) If the yield curve is flat, using liquidity premium theory, what do you know about the expected future short-term interest rate?
If the yield curve is flat, the expected future short-term interest rate(s) must be lower than the current short-term rate because liquidity premium theory assigns a positive risk premium to longer maturities, which is why the yield curve usually slopes upward.
107. (p. 152) What does the risk structure of interest rates predict about the yield on bonds of the same maturities?
The risk structure of interest rates predicts that the interest rates on a variety of bonds will move together and that lower rated bonds will have higher yields.
108. (p. 154) Explain why many mayors of cities facing the need to borrow for infrastructure improvements, may not look favorably on a large federal income tax rate reduction?
The interest earned on municipal bonds is exempt from federal income taxes. A reduction in the federal income tax rate decreases the attractiveness of these bonds. As a result of the decrease in demand, their prices will fall and their yields will need to increase to attract investors.
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109. (p. 155) What is the effective after-tax yield to an investor from a bond paying $70 per $1,000 annually, if the investor is in a 25% marginal tax bracket? Explain.
5.25%. The $70 is taxed at 25%; leaving the bondholder with $52.50; which when divided by the $1,000 provides an effective yield of 5.25%
110. (p. 155) Consider the following four investors. Rank each according to who has the most to gain from investing in 30-year tax-exempt municipal bonds. Each investor has $1000 in a savings account that he/she plans to use to buy bonds. Explain briefly why you ranked the investors this way. (a) A 20-year old college student who earns low income through working over summers and breaks. The student plans to graduate next year. (b) The CEO of a large company who is currently in the highest tax bracket. (c) A middle-income household saving up to move into a larger home. (d) A 60-year old nurse who plans to retire at age 62. He uses a tax-exempt pension fund for all of his savings.
(b), (c), (a), (d) The CEO has the most to gain because she is in the highest marginal tax break. Therefore, she would receive the largest benefit from investing in tax-exempt bonds. Similarly, the middleincome family will benefit, but their savings will not be as significant as those of the CEO. The 20-year old college student earns low income, so her tax savings are relatively low. Finally, the nurse will receive no benefit from purchasing a tax-exempt bond because he uses a tax-exempt pension to purchase his assets. Therefore, he saves nothing from buying a taxexempt bond in lieu of a taxable bond.
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111. (p. 162) Using the information provided and the Expectations Hypothesis, compute the yields for a two-year, three-year, and four-year bonds.
Now, suppose there is a risk premium attached to each bond. These risk premia are given in the table below:
Using the information above and the Liquidity Premium Theory, compute the yields for a two-year, three-year, and four-year bonds. How does this yield curve compare to the one you computed using the Expectations Hypothesis?
Using the Expectations Hypothesis, the interest rates are as follows: 1-year: 2.5% (given) 2-year: 3% 3-year: 3.33% 4-year: 3.625% Using the Liquidity Premium Theory, the interest rates are as follows: 1-year: 2.5% (given) 2-year: 3.5% 3-year: 4.33% 4-year: 5.625% Using the Liquidity Premium Theory, the yield curve has a steeper positive slope. This is caused by the presence of a risk premium attached to the longer-term bonds.
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112. (p. 155) What is the equivalent tax-exempt bond yield for a taxable bond with an 8% yield and a bondholder in a 35% marginal tax rate? Explain.
5.20%. The tax-exempt bond yield = (Taxable bond yield) x (1 - tax rate). Substituting; The tax exempt bond yield = (8%) x (1-0.35) = 5.20%
113. (p. 158) Assuming the Expectations Hypothesis is correct, and given the following information: The current four-year interest rate is 5.0% The current one-year interest rate is 4.0% The expected one-year rate for one year from now is 5.0% The expected one-year rate for two years from now is 5.5% What is the expected one-year rate for three years from now? Explain.
The general statement of the Expectations Hypothesis is that the interest rate on a bond with n years to maturity is the average of n expected future one year interest rates, which is:
In this case n = 4 and we know int = 5.0%, using a little algebra allows us to solve for ie1t + 3. In this case 4 x 5 = 20 and subtract the sum of the first three short-term rates, which is 14.5; this leaves us 5.5% as the expected one year rate or three years from now.
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114. (p. 156) Any theory of the yield curve must be able to explain what three general conditions?
#1) The interest rates of different maturities will move together; #2) Yields on short-term bonds will be more volatile than yields on long-term bonds; and #3) Long-term yields are usually higher than short-term yields, (the yield curve usually slopes upward).
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115. (p. 162) The usually upward sloping yield curve indicates that long-term bonds have higher yields than short-term bonds. Why is this?
Bondholders face both inflation- and interest-rate risk. The longer the term of the bond, the greater both types of risk. This implies that the risk premium increases with maturity.
116. (p. 159) Why can't the Expectations Hypothesis stand alone as an adequate theory to explain yield curves?
The Expectations Hypothesis does a good job of explaining why interest rates of different maturities move together and for explaining why short-term rates are more volatile than longterm rates. What it cannot do is explain why yield curves usually are upward sloping. To use only expectations hypothesis implies that investors usually expect short-term interest rates to rise, which certainly is not the case.
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117. (p. 162) Consider the yield curve below. Using the Expectations Hypothesis, what conclusion can we draw from the data? Now, using the Liquidity Premium Theory, cite two possible conclusions we can draw from the data.
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According to Expectations Theory, an upward sloping yield curve implies that interest rates are expected to increase in the future. The Liquidity Premium Theory has two possible interpretations of the yield curve: (1) interest rates are expected to increase, or (2) there is a positive risk premium associated with longer-term bonds.
118. (p. 163) What impact should an economic slowdown have on the risk structure of interest rates?
An economic slowdown should increase the risk premium on privately issued bonds since some firms may find it increasingly difficult to meet their financial obligations. It is important to note, however, that a slowdown or recession does not affect the risk of holding government bonds, which is why the risk premium increases for private bonds.
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119. (p. 163) During economic slowdowns why would you expect the risk premium to increase the most between U.S. Treasury bonds and junk bonds?
While it is true that during economic slowdowns most private bond issuers may feel increased difficulty, it is highly likely that firms that were already in a precarious position regarding their finances (junk bonds) would feel the most difficulty, thus significantly increasing the risk premium on those issues the most.
120. (p. 163) When we compare the graphs of GDP growth over time to the corresponding risk spread on Baa bonds compared to 10-year U.S. Treasury bonds, what relationship can be inferred?
There seems to be an inverse relationship between GDP growth and the size of the risk spread. As GDP growth slows, the risk spread increases and vice versa.
121. (p. 163) Describe the concept of flight to quality in terms of the Russian government default of August 1998.
The concept of flight to quality implies that during any economic downturn or turmoil in financial markets, investors (savers) will seek out high quality bonds and shun low quality bonds. This can have very significant impacts on the prices and yields of high and low quality bonds, adding to the volatility of financial markets. This was certainly what was observed when the Russia government defaulted.
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122. (p. 162) Why do yield curves usually slope upward?
The upward sloping yield curve is the most common since it includes the risk premium for longer maturities, and the risk premium increases with maturities. So even if investors expected short term rates to remain constant, we would still observe an upward sloping yield curve.
123. (p. 164) Explain why an inverted yield curve is a valuable forecasting tool?
An inverted yield curve is a valuable forecasting tool because it predicts a general economic slowdown. Even if short-term rates were expected to remain constant, the yield curve would slope upward. So an inverted yield curve signals an expected decrease in short-term interest rates.
124. (p. 165) If an economy is experiencing rapid economic growth, explain what you would expect to happen to the yield curve and why?
If an economy is experiencing rapid economic growth we may see the slope of the yield curve increase for two reasons; one as the economy expands lenders will raise interest rates as they allocate the relatively scarce loanable funds to a growing demand. In addition, as the Federal Reserve becomes concerned about inflation they may tighten monetary policy which will raise short-term interest rates.
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125. (p. 163) Why might we expect to see a high correlation between increases in the risk structure of interest rates and the yield curve becoming inverted?
Both situations, the risk structure of interest rates increasing and the inverted yield curve, usually occur when there are troubled economic times. As a result, we would expect to see the risk spread increase in anticipation of economic slowdowns as we would view the inverted yield curve as an omen of an economic slowdown.
126. (p. 157) Does the Expectations Hypothesis allow for people to have a preference for longerterm investments? Explain
Not really, a key assumption of the Expectations Hypothesis is that bonds of different maturities are perfect substitutes, which basically implies that investors are indifferent between different maturities and that the yield of consecutive short-term investments will equal the yield of a long-term investment over the same investment horizon.
127. (p. 154) Explain why most retired individuals are not likely to be heavily invested in municipal bonds.
Most retired individuals are not working and as a result, they may find themselves in a relatively low marginal tax bracket. As a result, the tax-exempt status of municipal bond interest is less beneficial and hence, less attractive to them.
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128. (p. 167) At the beginning of 2006 the yield curve was usually flat, and sometimes downward sloping (inverted). This raised concerns that a recession might be on the way. But the slope of the yield curve is only part of the story. What else is important?
A recession is associated both with an inverted yield curve and with an increase in the risk spread. As illustrated in the text, in 2006 Baa bond yields were less than two percentage points above U.S. Treasury yields, well below levels associated with recessions.
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Essay Questions
129. (p. 151) Please use the graphs to show what happens to the risk (yield) differential in each situation and why.
Assume the corporate and Treasury bonds have the same maturity; if the corporate bonds are default-risk free what could you tell about the price and yields of each? Explain. If the corporate bonds are now viewed as having the possibility of default, what happens in each market? If the corporate bonds are granted tax-exempt status, what happens in each market? If the corporate bonds have a longer maturity than the Treasury bonds what would happen?
If corporate bonds are expected to be default-risk free, the risk premium would be 0 (zero) so the price and yield should be the same across both bonds. The demand for corporate bonds will decrease, and the demand for Treasury bonds will rise; this will result in the price of Treasury bonds increasing while their yields fall, where in the corporate bond market, the price decreases and the yields increase. The demand for these bonds will increase, their price will rise and the yield will fall. In the Treasury bond market, the demand will decrease, so the price will fall and the yield will increase. The demand for the corporate bonds will decrease since longer maturity bonds carry more risk. This will cause their price to fall and the yield to rise. In the Treasury bond market, the demand will increase, thus the price of the bond will rise and the yield will decrease.
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130. (p. 163) In 2002 and 2003, the financial markets were hit by many corporate accounting scandals. Discuss these scandals and the impact they would have not only in terms of a flight to quality, but also in terms of the faith that people place in bond rating agencies.
The corporate accounting scandals certainly will fuel a flight to quality, which should cause the risk premium to increase as the demand for Treasury bonds increases and the demand for corporate bonds decreases. The faith that people place in bond rating agencies is more difficult to assess. A key factor is the information being provided before the scandals broke, were the potential problems identified by the bond rating services? If yes, then people may have more faith in them in the future. If the bond rating services were oblivious to these scandals, then people may question their true value in the future.
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131. (p. 162) Under the Expectations Hypothesis of the term structure of interest rates, explain the impact of a U.S. Treasury decision to phase out the 30-year bond and to only focus on 3month, 1-year, 5-year and 10-year bonds?
This decision should not have any impact in terms of the Expectations Hypothesis. A key assumption of the Expectations Hypothesis is savers look at all maturities as perfect substitutes because they have certainty regarding the future of interest rates. Thus, the phasing out of the 30-year bond would have no impact on the decisions made by savers.
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132. (p. 163) We have heard the predictions regarding the large number of people that will be retiring over the next 25-50 years and the strain this is going to place on the federal budget. Assuming that federal borrowing will have to increase, what is the likely impact going to be on the risk and term structure (if any) of interest rates and why?
Increased borrowing by the U.S. Treasury may certainly cause interest rates to increase, however the U.S. Treasury will still be the benchmark bond or the risk-free bond. Other bonds will still have their yield calculated by taking the risk-free rate (now perhaps higher) and adding the appropriate risk premium to this rate. As a result, greater borrowing by the U.S. Treasury would likely result in an increase in all yields. Regarding the term structure, this may depend on the selection of instruments used by the Treasury. For example, if the Treasury decides to finance the deficit by issuing only long-term (30 year) bonds, the price of these bonds will adjust to market forces. In order to attract buyers their price may fall and their yields increase causing the slope of the yield curve to increase. A similar argument could be offered if the Treasury decided to finance the deficit with mainly short-term instruments, in this case the subsequent market forces may cause the slope of the yield curve to decrease.
133. (p. 163) The paper-bill spread refers to the interest rate spread between commercial paper and Treasury bills with the same maturity. Is this a risk spread or a term spread? How do you expect the paper-bill spread is related to GDP growth? What is the intuition for this result? What does this imply about the yield curve?
This is a risk spread because it compares the commercial paper yield to a benchmark bond, a U.S. Treasury bill. Since the terms are the same, this is not a term spread. Risk spreads generally increase when GDP growth decreases. This happens because the default risk premium associated with commercial paper increases when economic conditions worsen. This doesn't imply anything about the yield curve per se, because the two bonds have the same terms to maturity.
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134. (p. 166) Suppose that the Federal Reserve is concerned about rising inflation, so they increase short-term interest rates. How will this affect long-term rates and the yield curve? What does the slope of the yield curve reveal about the effectiveness of the Fed's policy? Explain in the context of the Liquidity Premium Theory.
The increase in the short-term rate may cause the yield curve to be inverted. In addition to raising short-term rates, the policy will reduce expected inflation, reducing the risk premium associated with longer-term bonds. As the risk premium declines, the yield on long-term bonds decreases. The more inverted the yield curve becomes, the greater the reduction in expected inflation (relative to the increase in short-term rates).
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Chapter 07 - The Risk and Term Structure of Interest Rates

Chapter 07 The Risk and Term Structure of Interest Rates

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