Deck 7: The Risk and Term Structure of Interest Rates

Question 1

What is the highest bond rating assigned by Standard and Poor's?

A)AA
B)EEE
C)AAA
D)A

Answer 1

C

Question 2

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.

Answer 2

A

Question 3

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 highly liquid and virtually free of default risk.
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.

Answer 3

B

Question 4

All of the following are true about the risk spread except it should:

A)be higher for highly speculative bonds than investment grade bonds.
B)have a direct relationship with the bond's yield.
C)have an inverse relationship with the bond's price.
D)have a direct relationship with the bond's price.

Question 5

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.

Question 6

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.

Question 7

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.

Question 8

The bond rating of a security reflects the:

A)size of the coupon payment relative to the face value.
B)likelihood the lender/borrower will be repaid by the borrower/issuer.
C)return a holder is likely to receive.
D)size of the coupon rate relative to other interest rates.

Question 9

Which of the following would be most likely to earn an AAA rating from Standard & Poor's?

A)A 10-year bond issued by Canada
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

Question 10

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.

Question 11

Bonds rated as "highly speculative" are:

A)rated so because they guarantee high returns for the buyer.
B)commonly referred to as junk bonds.
C)ranked just above investment grade by Standard & Poor's.
D)rated so because they do not have any default risk.

Question 12

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

Question 13

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

Question 14

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.

Question 15

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.

Question 16

The lowest rating for an investment grade bond assigned by Moody's is:
A)

A)Baa.
B)
C)BBB.
D)Aa.

Question 17

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.

Question 18

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.

Question 19

If a bond's rating improves it should cause the bond's price:

A)and yield to increase, all other factors constant.
B)and yield to decrease, all other factors constant.
C)to increase and its yield to decrease, all other factors constant.
D)to decrease and its yield to increase, all other factors constant.

Question 20

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.

Question 21

The risk structure of interest rates refers to the:

A)relationship among the interest rates of bonds with different maturities.
B)relationship among the interest rates of bonds from different issuers with the same maturities.
C)relationship among the interest rates of bonds from the same issuer but different maturities.
D)additional interest required to compensate the buyer for the longer maturity of the bond.

Question 22

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 always low.

Question 23

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.

Question 24

Suppose the tax rate is 25% and the taxable bond yield is 8%.What is the equivalent tax-exempt bond yield?

A)2%
B)2.3%
C)6%
D)6.9%

Question 25

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 less default risk.
C)Investors prefer bonds with less interest-rate risk.
D)The term spread is positive.

Question 26

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 and liquidity characteristics.
D)earns a 1% return after-tax.

Question 27

Holding liquidity and default 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 taxable bone with a(n):

A)7.5% yield.
B)8.0% yield.
C)5% yield.
D)6% yield.

Question 28

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.

Question 29

Holding liquidity and default 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 taxable bond with a(n):

A)8% yield.
B)4.5% yield.
C)6.25% yield.
D)7.5% yield.

Question 30

A borrower who has to pay an interest rate of 8% rather than 6% due to risk spread will pay:

A)$20 more in interest annually for every $100 borrowed.
B)33.3% higher interest in dollar terms.
C)2% in net interest.
D)less interest in total over the life of the loan.

Question 31

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.

Question 32

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, which yield is the closest to the yield on a three-year bond today?

A)2.7%
B)4%
C)4.3%
D)8%

Question 33

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.

Question 34

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.

Question 35

Which of the following is not typically used for qualifying mortgages as prime or subprime?

A)The borrower's income
B)The borrower's credit score
C)The borrower's ethnicity
D)The loan to value ratio

Question 36

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.

Question 37

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 during recessions.

Question 38

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.

Question 39

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 long-term bond yields are influenced by expected future short-term bond yields.

Question 40

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.

Question 41

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.

Question 42

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.

Question 43

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 the future one-year rate to be:

A)4%.
B)8%.
C)6%.
D)5%.

Question 44

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.

Question 45

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 borrower's financial condition becomes available.
D)people do not change their attitudes towards risk quickly.

Question 46

A company that continues to have strong profit performance during an economic downturn when many other companies are suffering losses or failing should see:

A)an increase in the yield of their bonds and the price of the bond increases.
B)their bond rating maintained or actually increase.
C)the demand for their bonds decrease and their yields decrease.
D)the demand and price for their bonds decrease.

Question 47

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.

Question 48

Any theory of the term structure of interest rates needs to explain each of the following, except why:

A)short-term yields are more volatile than long-term yields.
B)the yields of different maturities tend to move together.
C)short-term yields are usually higher than long-term yields.
D)long-term yields are usually higher than short-term yields.

Question 49

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 rarely.

Question 50

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 long-term bonds usually are less liquid than short-term bonds with the same default risk.

Question 51

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.

Question 52

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.

Question 53

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.

Question 54

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.
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.

Question 55

The Expectations Hypothesis suggests the:

A)yield curve should usually be downward sloping.
B)yield curve should usually be upward sloping.
C)slope of the yield curve reflects the risk premium associated with longer-term bonds.
D)slope of the yield curve depends on the expectations for future short-term rates.

Question 56

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.

Question 57

When the yield curve slope is more upward sloping than usual, 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)a future rise in short-term interest rates.

Question 58

Which of the following statements is not true of the yield curve for U.S.Treasury securities?

A)The yield curve usually slopes upward.
B)The yield curve usually is inverted.
C)The yield curve shows the relationship among securities of different maturities.
D)The yield curve can shift over time.

Question 59

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 indicate:

A)the yield curve is downward sloping.
B)the yield curve is flat since the risk premium needs to be added for longer maturities.
C)the yield curve is upward sloping.
D)that people expect inflation to decrease in the future.

Question 60

If the federal government replaced the current income tax with a national sales tax, the price of:

A)corporate bonds and municipal bonds would rise.
B)municipal bonds would rise and corporate bonds would not change.
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.

Question 61

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%.

Question 62

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 structure 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

Question 63

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.

Question 64

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.

Question 65

Under the expectations hypothesis, if expectations are for lower inflation in the future than what it currently is, the yield curve's slope will:

A)become more upward sloping.
B)become flat.
C)be negative.
D)be vertical.

Question 66

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.

Question 67

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.

Question 68

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.

Question 69

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 the:

A)average interest rate of the three consecutive one-year bonds should be less than the 3-year bond to reflect the risk premium.
B)interest rate of the 3-year bond should equal the average interest rate of the 3 one-year bonds.
C)three consecutive one-year bonds must have the same interest rate.
D)current one-year interest rate must equal the current 3-year interest rate.

Question 70

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.

Question 71

The reason for the increase in inflation risk over time is due to the fact that:

A)the inflation rate always increases 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.

Question 72

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 long-term yield for the holding period, they would act so as to drive:

A)down the price of the short-term bond and drive up the price of the long-term bond.
B)up the price of the short-term bond and drive down the price of the long-term bond.
C)up the prices of both the short- and long-term bonds.
D)down the prices of both the short- and long-term bonds.

Question 73

The Expectations Hypothesis cannot explain why:

A)yields on securities of different maturities move together.
B)short-term yields are more volatile than long term yields.
C)yield curves usually slope upward.
D)long-term bonds usually are less liquid than short-term bonds with the same default risk.

Question 74

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.

Question 75

Assume the Expectations Hypothesis regarding the term structure of interest rates is correct.If the current one-year interest rate is 3% and the one-year-ahead expected one-year interest rate is 5%, then the current two-year interest rate should be:

A)3%.
B)5%.
C)4%.
D)8%.

Question 76

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.

Question 77

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.

Question 78

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 the future one-year rate to be:

A)4%.
B)5%.
C)6%.
D)1%.

Question 79

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.

Question 80

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.