Deck 6: The Risk and Term Structure of Interest Rates

Question 1

Everything else held constant, if the federal government were to guarantee today that it will pay creditors if a corporation goes bankrupt in the future, the interest rate on corporate bonds will ________ and the interest rate on government securities will ________.

A)increase; increase
B)increase; decrease
C)decrease; increase
D)decrease; decrease

Answer 1

C

Question 2

An increase in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Canada bonds, everything else held constant.

A)increase; increase
B)reduce; reduce
C)reduce; increase
D)increase; reduce

Answer 2

C

Question 3

As default risk increases and bond prices adjust, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant.

A)increases; less
B)increases; more
C)decreases; less
D)decreases; more

Answer 3

B

Question 4

The spread between interest rates on low quality corporate bonds and Canada bonds ________.

A)widens significantly during recessions
B)narrows significantly during recessions
C)narrows moderately during recessions
D)does not change during recessions

Question 5

Default risk is the risk that ________.

A)a bond issuer is unable to make interest payments
B)a bond issuer is unable to make a profit
C)a bond issuer is unable to pay the face value at maturity
D)A and C only

Question 6

Which of the following statements is true?

A)A decrease in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds.
B)The interest rate on corporate bonds decreases as default risk increases.
C)A corporate bond's return becomes less uncertain as default risk increases.
D)As their relative riskiness increases, the interest rate on corporate bonds increases relative to the interest rate on default-free bonds.

Question 7

If the possibility of a default increases because corporations begin to suffer losses, then the default risk on corporate bonds will ________, and the bonds' returns will become ________ uncertain, meaning that the expected return on these bonds will decrease, everything else held constant.

A)increase; less
B)increase; more
C)decrease; less
D)decrease; more

Question 8

The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is ________.

A)interest rate risk
B)inflation risk
C)moral hazard
D)default risk

Question 9

As their relative riskiness ________, the equilibrium price of corporate bonds ________ relative to the expected return on default-free bonds, everything else held constant.

A)increases; increases
B)increases; decreases
C)decreases; decreases
D)decreases; does not change

Question 10

An increase in default risk on corporate bonds ________ the demand for these bonds, but ________ the demand for default-free bonds, everything else held constant.

A)increases; lowers
B)lowers; increases
C)does not change; greatly increases
D)moderately lowers; does not change

Question 11

The spread between the interest rates on bonds with default risk and default-free bonds is called the ________.

A)risk premium
B)junk margin
C)bond margin
D)default premium

Question 12

Bonds with no default risk are called ________.

A)flower bonds
B)no-risk bonds
C)default-free bonds
D)zero-risk bonds

Question 13

Which of the following bonds are considered to be default-risk free?

A)Municipal bonds
B)Investment-grade bonds
C)Canadian government bonds
D)Junk bonds

Question 14

An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on government securities, everything else held constant.

A)increase; increase
B)reduce; reduce
C)increase; reduce
D)reduce; increase

Question 15

A bond with default risk will always have a ________ risk premium and an increase in its default risk will ________ the risk premium.

A)positive; raise
B)positive; lower
C)negative; raise
D)negative; lower

Question 16

Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the ________ and the demand curve for Canada bonds to the ________.

A)right; right
B)right; left
C)left; right
D)left; left

Question 17

If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on corporate bonds will ________ and the expected return on these bonds will ________, everything else held constant.

A)decrease; increase
B)decrease; decrease
C)increase; increase
D)increase; decrease

Question 18

The risk structure of interest rates is ________.

A)the structure of how interest rates move over time
B)the relationship among interest rates of different bonds with the same maturity
C)the relationship among the term to maturity of different bonds
D)the relationship among interest rates on bonds with different maturities

Question 19

If a corporation begins to suffer large losses, then the default risk on the corporate bond will ________, everything else held constant.

A)increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall
B)increase and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall
C)decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall
D)decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will rise

Question 20

Canadian government bonds have no default risk because ________.

A)they are backed by the full faith and credit of the federal government
B)the federal government can increase taxes to pay its obligations
C)they are backed with gold reserves
D)they can be exchanged for silver at any time

Question 21

Which of the following statements is true?

A)Because coupon payments on tax-exempt bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets.
B)An decrease in tax rates will increase the demand for U.S Treasury bonds, lowering their interest rates.
C)Interest rates on tax-exempt bonds will be higher than comparable bonds without the tax exemption.
D)An decrease in tax rates will increase the supply of U.S Treasury bonds, lowering their interest rates.

Question 22

When Canada bonds become more liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Canada bonds shifts to the ________.

A)right; right
B)right; left
C)left; right
D)left; left

Question 23

Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant.

A)increase; increase
B)increase; decrease
C)decrease; increase
D)decrease; decrease

Question 24

Corporate bonds are not as liquid as Canada bonds because ________.

A)fewer corporate bonds for any one corporation are traded, making them more costly to sell
B)the corporate bond rating must be calculated each time they are traded
C)corporate bonds are not callable
D)corporate bonds cannot be resold

Question 25

During a "flight to quality" ________.

A)the spread between Canada bonds and Baa bonds increases
B)the spread between Canada bonds and Baa bonds decreases
C)the spread between Canada bonds and Baa bonds is not affected
D)the change in the spread between Canada bonds and Baa bonds cannot be predicted

Question 26

The collapse of the subprime mortgage market ________.

A)did not affect the corporate bond market
B)increased the perceived riskiness of Treasury securities
C)reduced the Baa-Aaa spread
D)increased the Baa-Aaa spread

Question 27

Which of the following securities has the lowest interest rate?

A)Junk bonds
B)Canada bonds
C)Investment-grade bonds
D)Corporate Baa bonds

Question 28

If you have a very low tolerance for risk, which of the following bonds would you be least likely to hold in your portfolio?

A)A federal government bond
B)A provincial bond
C)A corporate bond with a rating of Aaa
D)A corporate bond with a rating of Baa

Question 29

Bonds with relatively low risk of default are called ________.

A)zero coupon bonds
B)junk bonds
C)investment grade bonds
D)fallen angels

Question 30

The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ Canada bonds.

A)less liquid than
B)less speculative than
C)tax-exempt unlike
D)lower-yielding than

Question 31

Which of the following long-term bonds has the highest interest rate?

A)Corporate Baa bonds
B)Canada bonds
C)Corporate Aaa bonds
D)Provincial bonds

Question 32

Which of the following statements is true?

A)Because coupon payments on tax-exempt bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets.
B)An increase in tax rates will decrease the demand for tax-exempt bonds, lowering their interest rates.
C)Interest rates on tax-exempt bonds will be higher than comparable bonds without the tax exemption.
D)Because coupon payments on tax-exempt are exempt from federal income tax, the expected after-tax return on them will be lower for individuals in higher income tax brackets.

Question 33

Which of the following bonds would have the highest default risk?

A)Provincial bonds
B)Investment-grade bonds
C)Canada bonds
D)Junk bonds

Question 34

A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds to the ________ and the demand curve for Canada bonds shifts to the ________.

A)right; right
B)right; left
C)left; left
D)left; right

Question 35

The collapse of the subprime mortgage market increased the spread between Baa and default-free Canada bonds. This is due to ________.

A)a reduction in risk
B)a reduction in maturity
C)a flight to quality
D)a flight to liquidity

Question 36

Bonds with relatively low risk of default are called ________ securities and have a rating of Baa (or BBB)and above; bonds with ratings below Baa (or BBB)have a higher default risk and are called ________.

A)investment grade; lower grade
B)investment grade; junk bonds
C)high quality; lower grade
D)high quality; junk bonds

Question 37

Bonds with relatively high risk of default are called ________.

A)Brady bonds
B)junk bonds
C)zero coupon bonds
D)investment grade bonds

Question 38

Which of the following statements is true?

A)A liquid asset is one that can be quickly and cheaply converted into cash.
B)The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds.
C)The differences in bond interest rates reflect differences in default risk only.
D)The corporate bond market is the most liquid bond market.

Question 39

An increase in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the interest rate on those corporate bonds, everything else held constant.

A)increase; increase
B)reduce; reduce
C)increase; reduce
D)reduce; increase

Question 40

During the Great Depression years 1930-1933 there was a very high rate of business failures and defaults, we would expect the risk premium for ________ bonds to be very high.

A)federal government
B)corporate Aaa
C)provincial
D)corporate Baa

Question 41

Explain the factors that determine the risk structure of interest rates. Explain how a change of each factor changes interest rates.

Question 42

If income tax rates were lowered, then ________.

A)the prices of tax-exempt bonds would fall
B)the interest rate on tax-exempt bonds would fall
C)the interest rate on U.S. Treasury bonds would rise
D)the prices of tax-exempt bonds would rise

Question 43

Explain using a diagram how the "flight to quality" after the Subprime collapse lead to a rising spread between lower-quality (BBB-rated)and highest-quality (AAA-rated)bonds.

Question 44

The interest rate on tax-exempt bonds rises relative to the interest rate on U.S. Treasury securities when ________.

A)income tax rates are raised
B)tax-exempt bonds become more widely traded
C)corporate bonds become riskier
D)income tax rates are lowered

Question 45

If income tax rates were lowered, then ________.

A)the interest rate on tax-exempt bonds would fall
B)the interest rate on U.S. Treasury bonds would rise
C)the interest rate on tax-exempt bonds would rise
D)the price of Canada bonds would fall

Question 46

A plot of the interest rates on default-free Canada bonds with different terms to maturity is called ________.

A)a risk-structure curve
B)a default-free curve
C)a yield curve
D)an interest-rate curve

Question 47

When yield curves are steeply upward sloping, ________.

A)long-term interest rates are above short-term interest rates
B)short-term interest rates are above long-term interest rates
C)short-term interest rates are about the same as long-term interest rates
D)medium-term interest rates are above both short-term and long-term interest rates

Question 48

Based on default risk, which bonds are called: a. "investment grade", b. "junk bonds" or "speculative-grade", and c. "fallen angels"?

Question 49

Three factors explain the risk structure of interest rates: ________.

A)liquidity, default risk, and the income tax treatment of a security
B)maturity, default risk, and the income tax treatment of a security
C)maturity, liquidity, and the income tax treatment of a security
D)maturity, default risk, and the liquidity of a security

Question 50

Tax-exempt bond interest rates increase relative to corporate bond interest rates when ________.

A)income taxes are increased
B)corporate bonds become riskier
C)U)S. Treasury securities become more widely traded
D)there is a major default in the tax-exempt bond market

Question 51

If the U.S. government where to raise the income tax rates, would this have any impact on a state's cost of borrowing funds? Explain.

Question 52

The interest rate on tax-exempt bonds falls relative to the interest rate on U.S. Treasury securities when ________.

A)there is a major default in the tax-exempt bond market
B)income tax rates are raised
C)tax-exempt bonds become less widely traded
D)corporate bonds become riskier

Question 53

Typically, yield curves are ________.

A)gently upward sloping
B)mound shaped
C)flat
D)bowl shaped

Question 54

Demonstrate graphically and explain how a reduction in default risk affects the demand or supply of corporate and Canada bonds.

Question 55

Differences in ________ explain why interest rates on Treasury securities are not all the same.

A)risk
B)liquidity
C)time to maturity
D)tax characteristics

Question 56

When yield curves are flat, ________.

A)long-term interest rates are above short-term interest rates
B)short-term interest rates are above long-term interest rates
C)short-term interest rates are about the same as long-term interest rates
D)medium-term interest rates are above both short-term and long-term interest rates

Question 57

If income tax rates were lowered, then ________.

A)the interest rate on tax-exempt bonds would rise
B)the interest rate on U.S. Treasury bonds would rise
C)the interest rate on tax-exempt bonds would fall
D)the interest rate on tax-exempt bonds would stay the same

Question 58

When yield curves are downward sloping, ________.

A)long-term interest rates are above short-term interest rates
B)short-term interest rates are above long-term interest rates
C)short-term interest rates are about the same as long-term interest rates
D)medium-term interest rates are above both short-term and long-term interest rates

Question 59

The spread between the interest rates on Baa corporate bonds and Canada bonds was very large during the Great Depression years 1930-1933. Explain this difference using the bond supply and demand analysis.

Question 60

The term structure of interest rates is ________.

A)the relationship among interest rates of different bonds with the same maturity
B)the structure of how interest rates move over time
C)the relationship among the term to maturity of different bonds
D)the relationship among interest rates on bonds with different maturities

Question 61

In actual practice, short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the ________.

A)segmented markets theory
B)expectations theory
C)liquidity premium theory
D)separable markets theory

Question 62

If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that today's interest rate on the five-year bond is ________.

A)4 percent
B)5 percent
C)6 percent
D)7 percent

Question 63

Over the next three years, the expected path of 1-year interest rates is 4, 1, and 1 percent. The expectations theory of the term structure predicts that the current interest rate on 3-year bond is ________.

A)1 percent
B)2 percent
C)3 percent
D)4 percent

Question 64

According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond.

A)average
B)sum
C)difference
D)multiple

Question 65

A key assumption in the segmented markets theory is that bonds of different maturities ________.

A)are not substitutes at all
B)are perfect substitutes
C)are substitutes only if the investor is given a premium incentive
D)are substitutes but not perfect substitutes

Question 66

If the expected path of 1-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the expectations theory predicts that today's interest rate on the four-year bond is ________.

A)1 percent
B)2 percent
C)3 percent
D)4 percent

Question 67

According to the liquidity premium theory of the term structure ________.

A)because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time
B)the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium
C)because of the positive term premium, the yield curve will not be observed to be downward sloping
D)the interest rate for each maturity bond is determined by supply and demand for that maturity bond

Question 68

If bonds with different maturities are perfect substitutes, then the ________ on these bonds must be equal.

A)expected return
B)surprise return
C)surplus return
D)excess return

Question 69

The segmented markets theory can explain ________.

A)why yield curves usually tend to slope upward
B)why interest rates on bonds of different maturities tend to move together
C)why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high
D)why yield curves have been used to forecast business cycles

Question 70

The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond, and investors have no preference for short-term bonds relative to long-term bonds.

A)segmented markets theory
B)expectations theory
C)liquidity premium theory
D)separable markets theory

Question 71

According to the segmented markets theory of the term structure ________.

A)bonds of one maturity are close substitutes for bonds of other maturities, therefore, interest rates on bonds of different maturities move together over time
B)the interest rate for each maturity bond is determined by supply and demand for that maturity bond
C)investors' strong preferences for short-term relative to long-term bonds explains why yield curves typically slope downward
D)because of the positive term premium, the yield curve will not be observed to be downward-sloping

Question 72

According to this theory of the term structure, bonds of different maturities are not substitutes for one another.

A)Segmented markets theory
B)Expectations theory
C)Liquidity premium theory
D)Separable markets theory

Question 73

According to the expectations theory of the term structure ________.

A)the interest rate on long-term bonds will exceed the average of short-term interest rates that people expect to occur over the life of the long-term bonds, because of their preference for short-term securities
B)interest rates on bonds of different maturities move together over time
C)buyers of bonds prefer short-term to long-term bonds
D)buyers require an additional incentive to hold long-term bonds

Question 74

According to the segmented markets theory of the term structure ________.

A)the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds
B)buyers of bonds do not prefer bonds of one maturity over another
C)interest rates on bonds of different maturities do not move together over time
D)buyers require an additional incentive to hold long-term bonds

Question 75

An inverted yield curve ________.

A)slopes up
B)is flat
C)slopes down
D)has a U shape

Question 76

If the expected path of 1-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of ________.

A)one year
B)two years
C)three years
D)four years

Question 77

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 expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of ________.

A)two years
B)three years
C)four years
D)five years

Question 78

Economists' attempts to explain the term structure of interest rates ________.

A)illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence
B)illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate movements
C)prove that the real world is a special case that tends to get short shrift in theoretical models
D)have proved entirely unsatisfactory to date

Question 79

According to the expectations theory of the term structure ________.

A)when the yield curve is steeply upward sloping, short-term interest rates are expected to remain relatively stable in the future
B)when the yield curve is downward sloping, short-term interest rates are expected to remain relatively stable in the future
C)investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward
D)yield curves should be equally likely to slope downward as slope upward

Question 80

The expectations theory and the segmented markets theory do not explain the facts very well, but they provide the groundwork for the most widely accepted theory of the term structure of interest rates, ________.

A)the Keynesian theory
B)separable markets theory
C)liquidity premium theory
D)the asset market approach