Deck 5: The Risk Structure and Term Structure of Interest Rates

Question 1

The default risk premium is measured

A)by an index published monthly by the Securities and Exchange Commission.
B)by an index published monthly by The Wall Street Journal.
C)as the difference between the yield on a non-Treasury security and the yield on a U.S. Treasury security of the same maturity.
D)as the difference between the nominal yield on the security and the real after-tax yield on the security.

Answer 1

as the difference between the yield on a non-Treasury security and the yield on a U.S. Treasury security of the same maturity.

Question 2

When a company whose ability to repay its obligations in full is uncertain,

A)it will have to issue debt with longer maturities than would a company with a lower probability of default.
B)its bonds will sell for higher prices than would the bonds of a company with a lower probability of default.
C)it must offer investors higher yields to compensate them for the risk they take in buying their bonds or making loans.
D)it must do so through financial markets rather than through financial intermediaries.

Answer 2

it must offer investors higher yields to compensate them for the risk they take in buying their bonds or making loans.

Question 3

Which of the following bond ratings by Moody's Investors Service would NOT be considered to be below investment grade?

A)Baa
B)Ba
C)B
D)All of these ratings are considered below investment grade.

Answer 3

Baa

Question 4

U)S. Treasury securities

A)are considered risk free because their prices never change.
B)have been defaulted on several time in U.S. history.
C)are considered default-risk-free instruments.
D)have a large default risk premium.

Question 5

Default risk

A)is the probability that a borrower will not pay in full the promised coupon or principal.
B)exists only for the bonds of small corporations.
C)is also known as market risk.
D)is zero for bonds issued by cities and states.

Question 6

The default risk premium is

A)relevant only for securities issued by very small companies.
B)the additional yield a saver requires for holding a bond with some default risk.
C)zero for corporate bonds, but quite substantial for corporate stock.
D)constant across the business cycle.

Question 7

Which of the following is considered a default-risk-free instrument?

A)a three-month commercial paper issued by GE
B)a share of stock issued by Google
C)a three-month Treasury bill
D)a ten-year bond issued by Intel

Question 8

Investors often pay professional analysts to gather and monitor information on the creditworthiness of borrowers because

A)federal law requires it.
B)most investors are risk neutral.
C)the cost of acquiring information about a borrower's creditworthiness can be high.
D)doing so increases the net-of-tax yield on most investments.

Question 9

The default risk premium fluctuates mainly

A)because bond rating agencies tend to be inconsistent in their ratings of bonds.
B)because risk-neutral investors will often become risk-averse as time passes.
C)because taxes tend to rise over the long run.
D)as new information about a borrower's creditworthiness becomes available.

Question 10

Which of the following assigns widely-followed bond ratings?

A)Standard & Poor's Corporation
B)Securities and Exchange Commission
C)Federal Reserve
D)IBM

Question 11

Default risk arises from the fact that

A)borrowers differ in their ability to repay in full the principal and interest required by a loan agreement.
B)the bond price drops when interest rates rise.
C)it is inherently riskier to wait for a capital gain than to receive an immediate interest payment.
D)interest rates are far more likely to go up than to go down.

Question 12

Which of the following is the lowest rating given to an investment-grade bond by Moody's?

A)Aa
B)A
C)Baa
D)B

Question 13

Currently, a three-year Treasury note pays 4.75%. Assuming that your tax rate is 20%, what is the minimum interest rate that you would you need to earn on a tax-free municipal bond in order to buy it instead?

A)0)95%
B)3)8%
C)5)7%
D)15.25%

Question 14

If lenders anticipate no changes in liquidity, information costs, and tax differences, the yield on a risky security should be

A)greater than that on a safe security and the price of a risky security should also be greater than that of a safe security.
B)less than that on a safe security and the price of a risky security should also be less than that of a safe security.
C)greater than that on a safe security and the price of a risky security should be lower than that of a safe security.
D)less than that on a safe security and the price of a risky security should be greater than that on a safe security.

Question 15

Bond ratings

A)are published annually by the federal government and are based largely on information contained in corporate tax returns.
B)are published annually by the federal government and are based on publicly available information.
C)are published monthly by the federal government and are based on publicly available information.
D)are published by private bond-rating agencies.

Question 16

The risk premium of corporate bonds typically increases

A)when the average price of corporate bonds increase.
B)during a recession.
C)when the interest rates on corporate bonds decreases.
D)when the risk premium on treasury bonds increases.

Question 17

Which of the following statements about junk (high-risk)bonds is true?

A)They never outperform treasury bonds since they're too risky.
B)The price of junk bonds increase as their perceived risk increases.
C)They tend to perform best during recessions.
D)One can profit by owning them if market perceptions of their risk decline.

Question 18

The risk structure of interest rates refers to

A)the amount of additional interest necessary to compensate savers for the greater risk of default on some bonds.
B)the relationship among the interest rates on similar bonds with different maturities.
C)the relationship among the interest rates on bonds with the same maturity.
D)the amount of additional yield necessary to compensate savers for the lesser liquidity of some bonds.

Question 19

Currently, a three-month Treasury bill has a yield of 5% while the yield on a ten-year Treasury bond is 4.7%. What is the risk premium of the typical A-rated ten-year corporate bond with a yield of 5.5%?

A)0)5%
B)0)8%
C)5)5%
D)1)17%

Question 20

Which of the following is the highest bond rating assigned by Moody's Investors Service?

A)Aaa
B)A
C)B
D)Baa

Question 21

Many savers are willing to accept a lower interest rate on municipal bonds than on comparable instruments because

A)the after-tax yield on municipal bonds is greater.
B)municipal bonds invariably have lower default risk.
C)municipal bonds are more liquid than most other instruments.
D)the yield on municipal bonds is considered inflation proof.

Question 22

In late 2008, the average risk premium rose because

A)investors feared a revival of inflation.
B)large tax increases in the United States reduced corporate profits and led to fears of increased defaults.
C)of the financial crisis.
D)of fraud in the market for municipal bonds.

Question 23

Following the downgrade of U.S. debt by Standard & Poor's in August, 2011:

A)other rating agencies also downgraded U.S. debt
B)interest rates spiked as investor's perception of risk increased
C)investors didn't seem to be any more concerned about default risk than before the downgrade
D)the U.S. implemented a plan to significantly reduce its budget deficit later that year

Question 24

Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on thirty-year U.S. Treasury bonds is 10%. You would be indifferent between buying a thirty-year Treasury bond and buying a thirty-year municipal bond issued within your state (ignoring differences in liquidity, risk, and costs of information)if the municipal bond has a yield of

A)6)5%.
B)7)0%.
C)9)5%.
D)10.0%.

Question 25

Differences in the taxation of returns

A)only affect the yields of illiquid credit market instruments.
B)have a negligible effect on the yields of credit market instruments.
C)only affect the yields of high-information cost credit market instruments.
D)create differences in yields among credit market instruments.

Question 26

Which of the following statements is true?

A)The more liquid the bond, the lower the yield.
B)Tax-free bonds normally have a higher interest rate than other types of bonds.
C)The price of a bond increases as it becomes more risky.
D)The yield curve illustrates the relative default risks of alternative types of bonds.

Question 27

Municipal bonds are issued

A)only by local governments.
B)only by state governments.
C)by both state and local governments.
D)by the federal government, and by state and local governments.

Question 28

Financial instruments with high information costs

A)will usually be more liquid than similar instruments with low information costs.
B)will have lower yields than U.S. Treasury securities.
C)may not be offered for sale in some states.
D)will have lower prices than similar instruments with low information costs.

Question 29

Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on a thirty-year corporate bond is 10%. You would be indifferent between buying this corporate bond and buying a thirty-year municipal bond issued within your state (ignoring differences in liquidity, risk, and costs of information)if the municipal bond has a yield of

A)6)5%.
B)7)0%.
C)9)5%.
D)10.0%.

Question 30

During the financial crisis of 2007-2009,

A)mortgage-backed securities became more liquid.
B)information costs of mortgage-backed securities rose.
C)information costs of mortgage-backed securities declined.
D)the tax treatment of mortgage-backed securities was changed.

Question 31

During the financial crisis of 2007-09, the prices of U.S. Treasury securities

A)rose and the price of corporate bonds declined.
B)fell relative to the prices of corporate bonds.
C)remained in the same relative position to the prices of corporate bonds.
D)were frozen by order of the federal government.

Question 32

The existence of rating agencies has

A)lowered returns on corporate bonds.
B)raised returns on corporate bonds.
C)left returns on corporate bonds largely unaffected.
D)raised returns on both corporate bonds and Treasury securities.

Question 33

Interest and capital gains are taxed differently in the United States in that

A)interest is exempt from state and local taxes.
B)interest is taxed as ordinary income, but capital gains are taxed only when realized.
C)interest is taxed as ordinary income, but capital gains are taxed as accrued.
D)capital gains when realized are exempt from state and local taxes.

Question 34

A flight to quality refers to a shift by savers from

A)bonds and into stocks.
B)stocks and into gold or other precious metals.
C)bonds and into real assets, such as real estate.
D)low-quality bonds and into high-quality bonds.

Question 35

The greatest appeal of U.S. Treasury securities is that

A)they have high yields.
B)they have no default risk.
C)the U.S. Treasury will repurchase them at any time.
D)their market prices fluctuate very little.

Question 36

If the federal government replaced the current income tax with a value-added tax

A)the prices of Treasury and municipal bonds would rise.
B)the prices of Treasury and municipal bonds would fall.
C)the prices of Treasury bonds would rise, while the prices of municipal bonds would fall.
D)the prices of Treasury bonds would fall, while the prices of municipal bonds would rise.

Question 37

A company that retains a high bond rating during a recession in which many other companies see their bond ratings cut will experience

A)an increased flow of funds into the market for its securities.
B)an increased demand for its securities, resulting in a higher expected return.
C)a decreased demand for its securities, resulting in a lower expected return.
D)a decreased flow of funds into the market for its securities.

Question 38

For state residents, interest on most bonds issued by their state government is

A)exempt from state and federal income taxes.
B)exempt from state, but not from federal, income taxes.
C)exempt from federal, but not from state, income taxes.
D)subject to both state and federal income taxes.

Question 39

Suppose that savers become less willing to purchase medium-quality corporate bonds. The result will be that the prices of medium-quality corporate bonds will

A)fall relative to the price of U.S. Treasury securities, but rise relative to the price of high-quality corporate bonds.
B)rise relative to the price of U.S. Treasury securities, but fall relative to the price of high-quality corporate bonds.
C)rise relative to the prices of U.S. Treasury securities and high-quality corporate bonds.
D)fall relative to the prices of U.S. Treasury securities and high-quality corporate bonds.

Question 40

Suppose that savers become much more willing to purchase a certain type of municipal bond. The result will be that the bond's price will

A)fall relative to the price of U.S. Treasury securities but rise relative to the price of corporate bonds.
B)rise relative to the price of U.S. Treasury securities but fall relative to the price of corporate bonds.
C)rise relative to the prices of U.S. Treasury securities and corporate bonds.
D)fall relative to the prices of U.S. Treasury securities and corporate bonds.

Question 41

Some claim that ratings agencies have a conflict of interest since:

A)they rate the quality of their own bonds
B)since agencies charge firms for their services rather than investors, they have an incentive to give high ratings to gain business
C)government began to include bond ratings as part of regulations of mutual funds, banks, and financial firms
D)they issued many of the mortgages that were later securitized into bonds

Question 42

Which of the following is a single statistic that summarizes a rating agency's view of the issuer's likely ability to make the required payments on its bonds?

A)grade
B)bond rating
C)speculation
D)yield

Question 43

Which of the following statements about junk bonds is false?

A)Given the likelihood of default, it is never profitable to purchase junk bonds.
B)They pay higher interest rates than investment grade bonds due to higher perceived risk.
C)Prior to the 1970s, corporations were unable to issue junk bonds.
D)A popular measure of junk bond yields reached a record low in 2012.

Question 44

A bond that is generally agreed to have higher default risk will experience all of the following EXCEPT:

A)declining demand
B)declining supply
C)higher yield
D)lower price

Question 45

Bonds receiving one of the top four ratings are considered:

A)junk
B)speculative
C)AAA
D)investment grade

Question 46

Discuss what happened to the market prices on corporate securities relative to government securities during the Great Recession.

Question 47

Why did some economists and policymakers think ratings agencies had a conflict of interest leading up to the Financial Crisis of 2007-2009?

Question 48

If the three-month Treasury bill has an interest rate of 0.2%, the ten-tear Treasury bond has an interest rate of 2.75%, and a ten-year bond issued by Time Warner has an interest rate of 6%, what is the risk premium on Time Warner's bond?

Question 49

Which of the following is NOT a reason that credit ratings agencies became more relevant beginning in the late 1970s?

A)the number of bond defaults rose due to periods of recession and inflation
B)rating agencies began to charge investors for their services
C)governments began to include bond ratings in their regulation of banks, mutual funds, and other financial firms
D)rating agencies began to rate bonds issued by foreign governments and firms

Question 50

In 2009, global investors began to regain confidence in the financial system and reversed the flight to safety that had taken place during the depths of the financial crisis. Make use of a graph of the market for corporate bonds to show the impact on corporate bonds prices and yields.

Question 51

Suppose the private bond rating agencies ceased to exist. What would be the impact on the bond market?

Question 52

All of the following are names for bonds receiving low ratings EXCEPT:

A)junk
B)garbage
C)high yield
D)speculative

Question 53

Which of the following accurately describes the tax treatment of municipal bonds?

A)All income from municipal bonds is tax free.
B)Interest is tax free, but unrealized capital gains are taxable.
C)Interest is tax free, but realized capital gains are taxable.
D)Interest is taxable, but capital gains are tax free.

Question 54

In late 2012, President Obama proposed raising the top income tax rate. All of the following are likely impacts of higher income tax rates on bonds EXCEPT:

A)higher interest rates on Treasury bonds
B)lower interest rates on Municipal bonds
C)increased demand for Municipal bonds
D)lower prices for Municipal bonds

Question 55

The term structure is usually defined with yields on which securities?

A)corporate bonds
B)commercial paper
C)U)S. Treasury securities
D)municipal bonds

Question 56

The term structure of interest rates

A)represents the relationship among the interest rates on bonds that are otherwise similar but that have different maturities.
B)reflects differing tax treatment received by different instruments.
C)always results in an upward-sloping yield curve.
D)usually results in a downward-sloping yield curve.

Question 57

If the six-month Treasury bill has an interest rate of 0.5%, the ten-year Treasury bond has an interest rate of 1.6%, and a ten-year bond issued by Dell has an interest rate of 4%, what is the risk premium on Dell's bond?

Question 58

How do ratings agencies earn income?

Question 59

Steve Forbes has run for president twice on a program of a "flat tax." Under a flat tax, there would be only one tax bracket for the federal income tax and most tax deductions and tax exemptions would be eliminated. Suppose that Forbes wins the 2016 presidential election. What would be the likely impact on the market for municipal bonds?

Question 60

Which bond would someone in a 35% tax bracket choose to buy: a municipal bond with an interest rate of 7% or a corporate bond with an interest rate of 10%?

Question 61

Unlike the segmented markets theory, the expectations theory attributes the slope of the yield curve to

A)tax considerations.
B)the fact that short-term bonds are not perfect substitutes for long-term bonds.
C)the market's view of future short-term interest rates.
D)the variance in the inflation rates over the business cycle.

Question 62

When the yield curve is downward-sloping,

A)short-term yields are higher than long-term yields.
B)long-term yields are higher than short-term yields.
C)the bond market is anticipating the U.S. Treasury may default on its obligations.
D)the inflation rate is expected to rise.

Question 63

The expectations theory suggests that

A)the yield curve should usually be upward-sloping.
B)the yield curve should usually be downward-sloping.
C)the slope of the yield curve depends on the expected future path of short-term rates.
D)the slope of the yield curve reflects the risk premium incorporated into the yields on long-term bonds.

Question 64

According to the liquidity premium theory, a steep yield curve may be an indicator of

A)expectations of a significant increase in inflation.
B)an upcoming recession.
C)an economic slowdown.
D)lower future short-term interest rates.

Question 65

What is the most important contrast between the segmented markets theory and the expectations theory?

A)The expectation theory states that investors view similar assets that differ only with respect to maturity as perfect substitutes.
B)The segmented markets theory states that investors view similar assets that differ only with respect to maturity as perfect substitutes.
C)The expectations theory does a better job of explaining why yield curves typically are upward-sloping.
D)The segmented markets theory does a better job of explaining why yields on instruments of different maturities tend to move together.

Question 66

A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a two-year bond according to the liquidity premium theory?

A)4)5%
B)4)75%
C)4)95%
D)4)975%

Question 67

The yield on a thirty-year Treasury bond is 8% at the same time as the yield on two-year Treasury note is 5%. This occurrence

A)indicates that the yield curve is downward sloping.
B)is well explained by the segmented markets theory.
C)is largely explained by the favorable tax treatment of Treasury notes.
D)indicates that the bond market is anticipating that inflation will fall.

Question 68

A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a three-year bond according to the liquidity premium theory?

A)4)5%
B)4)68%
C)4)85%
D)5)05%

Question 69

If the expected path of interest rates on one-year bonds over the next five years is 2%, 4%, 3%, 2%, and 1%, 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)five years.

Question 70

According to the liquidity premium theory, what does a flat yield curve indicate?

A)Short-term interest rates are expected to remain stable.
B)Short-term interest rates are expected to rise.
C)Short-term interest rates are expected to fall.
D)Long-term interest rates are expected to fall.

Question 71

The key assumption of the liquidity premium theory is that investors

A)view bonds of different maturities as perfect substitutes.
B)view bonds of different maturities as completely unsubstitutable.
C)always choose the bond with the highest expected return, regardless of maturity.
D)care about both expected returns and time to maturity.

Question 72

The segmented markets theory

A)has difficulty explaining why yield curves usually slope up.
B)has difficulty explaining why yield curves usually slope down.
C)has difficulty explaining why yields on instruments of different maturities tend to move together.
D)provides a good explanation of why yields on instruments of different maturities tend to move together.

Question 73

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

A)Typically, it slopes upward.
B)It depicts the relationship among yields on securities of different maturities.
C)Typically, it shifts up or down rather than twists.
D)Typically, it slopes downward.

Question 74

Which interest rate is typically the lowest?

A)3-month Treasury bills
B)2-year Treasury notes
C)10-year Treasury bonds
D)30-year Treasury bonds

Question 75

According to the liquidity premium theory, the yield curve normally has a positive slope because

A)short-term interest rates are expected to rise.
B)term premiums rise as the time to maturity increases.
C)risk premiums rise over time.
D)long-term bonds are more liquid than short-term bonds.

Question 76

The implication of the expectations theory that expected returns for a holding period must be the same for bonds of different maturities depends on the assumption that

A)yield curves usually slope upward.
B)yield curves usually slope downward.
C)instruments with different maturities are perfect substitutes.
D)savers are usually risk averse.

Question 77

Which of the following is true of the segmented markets theory?

A)It assumes that borrowers have particular periods for which they want to borrow.
B)It assumes that lenders always lend for short periods.
C)It provides a good explanation for why yield curves usually slope upward.
D)It assumes that instruments with different maturities are perfect substitutes.

Question 78

The expectations theory

A)has difficulty explaining why U.S. Treasury securities have lower yields than corporate bonds.
B)has difficulty explaining why yields on bonds of different maturities move together.
C)has difficulty explaining why yield curves usually slope upward.
D)accounts well for the fact that yield curves usually slope upward.

Question 79

Under the expectations theory if market participants expect that future short-term rates will be higher than current short-term rates, the yield curve will

A)slope upward.
B)slope downward.
C)be flat.
D)slope upward, slope downward, or be flat, depending on risk, liquidity, cost of information, and tax considerations.

Question 80

The segmented markets theory

A)explains upward-sloping yield curves as resulting from the demand for long-term bonds being high relative to the demand for short-term bonds.
B)explains upward-sloping yield curves as resulting from the demand for long-term bonds being low relative to the demand for short-term bonds.
C)explains upward-sloping yield curves as resulting from the favorable tax treatment of long-term bonds.
D)is unable to account for upward-sloping yield curves.