Deck 5: How Do Risk and Term Structure Affect Interest Rates

Question 1

If Moody's or Standard and Poor's downgrades its rating on a corporate bond, the demand for the bond ________ and its yield ________.

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

Answer 1

decreases; increases

Question 2

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 terms to maturity of different bonds.
D)the relationship among interest rates on bonds with different maturities.

Answer 2

the relationship among interest rates of different bonds with the same maturity.

Question 3

The risk premium on corporate bonds becomes smaller if

A)the riskiness of corporate bonds increases.
B)the liquidity of corporate bonds increases.
C)the liquidity of corporate bonds decreases.
D)the riskiness of corporate bonds decreases.
E)either B or D of the above occur.

Answer 3

either B or D of the above occur.

Question 4

Moody's and Standard and Poor's are agencies that

A)help investors collect when corporations default on their bonds.
B)advise municipal bond issuers on the tax exempt status of their bonds.
C)produce information about the probability of default on corporate bonds.
D)maintain liquid markets for corporate bonds.

Question 5

If a corporation begins to suffer large losses, then the default risk on its bonds will ________ and the equilibrium interest rate on these bonds will ________.

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

Question 6

When the default risk on corporate bonds decreases, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________.

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

Question 7

Bonds with relatively high risk of default are called

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

Question 8

Bonds with relatively low risk of default are called

A)zero coupon bonds.
B)junk bonds.
C)investment-grade bonds.
D)none of the above.

Question 9

Holding everything else constant, if a corporation begins to suffer large losses, then the default risk on its bonds will ________ and the expected return on those bonds will ________.

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

Question 10

If a corporation's earnings rise, then the default risk on its bonds will ________ and the equilibrium interest rate on these bonds will ________.

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

Question 11

The term structure of interest rates is

A)the relationship among interest rates of different bonds with the same risk and maturity.
B)the structure of how interest rates move over time.
C)the relationship among the terms to maturity of different bonds from different issuers.
D)the relationship among interest rates on bonds with different maturities but similar risk.

Question 12

Which of the following long-term bonds should have the lowest interest rate?

A)Corporate Baa bonds
B)U)S. Treasury bonds
C)Corporate Aaa bonds
D)Municipal bonds

Question 13

The spread between interest rates on low-quality corporate bonds and U.S. government bonds ________ during the Great Depression.

A)was reversed
B)narrowed significantly
C)widened significantly
D)did not change

Question 14

Holding everything else the same, if a corporation's earnings rise, then the default risk on its bonds will ________ and the expected return on those bonds will ________.

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

Question 15

A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby

A)raising the default risk and causing the demand for its bonds to rise.
B)raising the default risk and causing the demand for its bonds to fall.
C)lowering the default risk and causing the demand for its bonds to rise.
D)lowering the default risk and causing the demand for its bonds to fall.

Question 16

(I)An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II)An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left.

A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.

Question 17

As a result of the subprime collapse, the demand for low -quality corporate bonds ________, the demand for high-quality Treasury bonds ________, and the risk spread ________.

A)increased; decreased; was unchanged
B)decreased; increased; increased
C)increased; decreased; decreased
D)decreased; increased; was unchanged

Question 18

(I)If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II)The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium.

A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.

Question 19

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

A)Corporate Baa bonds
B)U)S. Treasury bonds
C)Corporate Aaa bonds
D)Municipal bonds

Question 20

(I)An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the left. (II)An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the right.

A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.

Question 21

An increase in marginal tax rates would likely have the effect of ________ the demand for municipal bonds and ________ the demand for U.S. government bonds.

A)increasing; increasing
B)increasing; decreasing
C)decreasing; increasing
D)decreasing; decreasing

Question 22

Yield curves can be classified as

A)upward-sloping.
B)downward-sloping.
C)flat.
D)all of the above.
E)only A and B of the above.

Question 23

(I)If a corporate bond becomes less liquid, the demand for the bond will fall, causing the interest rate to rise. (II)If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.

A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.

Question 24

When the corporate bond market becomes more liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________.

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

Question 25

The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent over the next ten years. As a result of this tax cut, the demand for municipal bonds should shift to the ________ and the interest rate on municipal bonds should ________.

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

Question 26

The relationship among interest rates on bonds with identical default risk but different maturities is called the

A)time-risk structure of interest rates.
B)liquidity structure of interest rates.
C)yield curve.
D)bond demand curve.

Question 27

If income tax rates were lowered, then

A)the interest rate on municipal bonds would fall.
B)the interest rate on Treasury bonds would rise.
C)the interest rate on municipal bonds would rise.
D)the price of Treasury bonds would fall.

Question 28

If municipal bonds were to lose their tax-free status, then the demand for Treasury bonds would shift ________, and the interest rate on Treasury bonds would ________.

A)rightward; fall
B)rightward; rise
C)leftward; fall
D)leftward; rise

Question 29

A decrease in marginal tax rates would likely have the effect of ________ the demand for municipal bonds and ________ the demand for U.S. government bonds.

A)increasing; increasing
B)increasing; decreasing
C)decreasing; increasing
D)decreasing; decreasing

Question 30

Typically, yield curves are

A)gently upward-sloping.
B)gently downward-sloping.
C)flat.
D)bowl shaped.
E)mound shaped.

Question 31

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.
E)medium-term interest rates are below both short-term and long-term interest rates.

Question 32

Corporate bonds are not as liquid as government bonds because

A)fewer 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)all of the above.
E)only A and B of the above.

Question 33

When a municipal bond is given tax-free status, the demand for municipal bonds shifts ________, causing the interest rate on the bond to ________.

A)leftward; rise
B)leftward; fall
C)rightward; rise
D)rightward; fall

Question 34

Which of the following statements are true?

A)Because coupon payments on municipal 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 increase the demand for municipal bonds, lowering their interest rates.
C)Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption.
D)All of the above are true statements.
E)Only A and B are true statements.

Question 35

(I)If a corporate bond becomes less liquid, the interest rate on the bond will fall. (II)If a corporate bond becomes less liquid, the interest rate on Treasury bonds will fall.

A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.

Question 36

When a municipal bond is given tax-free status, the demand for Treasury bonds shifts ________, and the interest rate on Treasury bonds ________.

A)leftward; rises
B)leftward; falls
C)rightward; rises
D)rightward; falls

Question 37

If income tax rates rise, then

A)the prices of municipal bonds will fall.
B)the prices of Treasury bonds will rise.
C)the interest rate on Treasury bonds will rise.
D)the interest rate on municipal bonds will rise.

Question 38

(I)The risk premium widens as the default risk on corporate bonds increases. (II)The risk premium widens as corporate bonds become less liquid.

A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.

Question 39

When the corporate bond market becomes less liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________.

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

Question 40

Which of the following statements are true?

A)Because coupon payments on municipal 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 increase the demand for Treasury bonds, lowering their interest rates.
C)Interest rates on municipal bonds will be higher than on comparable bonds without the tax exemption.
D)Only A and B are true statements.

Question 41

If the yield curve has a mild upward slope, the liquidity premium theory indicates that the market is predicting

A)a rise in short-term interest rates in the near future and a decline further out in the future.
B)constant short-term interest rates in the near future and further out in the future.
C)a decline in short-term interest rates in the near future and a rise further out in the future.
D)a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

Question 42

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 rise 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)all of the above.
E)only A and B of the above.

Question 43

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

A)1 percent.
B)2 percent.
C)4 percent.
D)none of the above.

Question 44

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 cannot be downward-sloping.
D)all of the above.
E)only A and B of the above.

Question 45

According to the liquidity premium theory of the term structure, a downward-sloping yield curve indicates that short-term interest rates are expected to

A)rise in the future.
B)remain unchanged in the future.
C)decline moderately in the future.
D)decline sharply in the future.

Question 46

In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major shortcoming of the

A)market segmentation theory.
B)expectations theory.
C)liquidity premium theory.
D)separable markets theory.

Question 47

According to the expectations theory of the term structure,

A)the interest rate on long-term bonds will exceed the average of expected future short-term interest rates.
B)interest rates on bonds of different maturities move together over time.
C)buyers of bonds prefer short-term to long-term bonds.
D)all of the above.
E)only A and B of the above.

Question 48

The liquidity premium theory of the term structure

A)indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond.
B)assumes that bonds of different maturities are perfect substitutes.
C)suggests that markets for bonds of different maturities are completely separate because people have different preferences.
D)does none of the above.

Question 49

According to the liquidity premium 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 plus a liquidity premium.
B)buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of different maturities move together over time.
C)even with a positive liquidity premium, if future short-term interest rates are expected to fall significantly, then the yield curve will be downward-sloping.
D)all of the above.
E)only A and B of the above.

Question 50

If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, then the pure 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 51

Which theory of the term structure proposes that bonds of different maturities are not substitutes for one another?

A)market segmentation theory
B)expectations theory
C)liquidity premium theory
D)separable markets theory

Question 52

The liquidity premium theory of the term structure

A)assumes investors tend to prefer short-term bonds because they have less interest-rate risk.
B)assumes that interest rates on the long-term bond respond to demand and supply conditions for that bond.
C)assumes that an average of expected short-term rates is an important component of interest rates on long-term bonds.
D)assumes all of the above.
E)assumes none of the above.

Question 53

According to the expectations theory of the term structure,

A)yield curves should be equally likely to slope downward as to slope upward.
B)when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future.
C)when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future.
D)all of the above.
E)only A and B of the above.

Question 54

If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, then the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of

A)one year.
B)two years.
C)three years.
D)four years.
E)five years.

Question 55

According to the market segmentation theory of the term structure,

A)the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity.
B)bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time.
C)investors' strong preference for short-term relative to long-term bonds explains why yield curves typically slope downward.
D)only A and B of the above.

Question 56

According to the liquidity premium theory of the term structure, when the yield curve has its usual slope, the market expects

A)short-term interest rates to rise sharply.
B)short-term interest rates to drop sharply.
C)short-term interest rates to stay near their current levels.
D)none of the above.

Question 57

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 rise in the future.
B)when the yield curve is downward-sloping, short-term interest rates are expected to decline in the future.
C)buyers of bonds prefer short-term to long-term bonds.
D)all of the above.
E)only A and B of the above.

Question 58

If the yield curve slope is flat, the liquidity premium theory indicates that the market is predicting

A)a mild rise in short-term interest rates in the near future and a mild decline further out in the future.
B)constant short-term interest rates in the near future and further out in the future.
C)a mild decline in short-term interest rates in the near future and a continuing mild decline further out in the future.
D)constant short-term interest rates in the near future and a mild decline further out in the future.

Question 59

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 60

According to the market segmentation theory of the term structure,

A)the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity.
B)bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time.
C)investors' strong preference for short-term relative to long-term bonds explains why yield curves typically slope upward.
D)all of the above.
E)none of the above.

Question 61

The term structure of interest rates describes how interest rates move over time.

Question 62

The interest rates on bonds of different maturities tend to move together over time.

Question 63

The risk structure of interest rates describes the relationship between the interest rates of different bonds with the same maturities.

Question 64

The ________ theory is the most widely accepted theory of the term structure of interest rates because it explains the major empirical facts about the term structure so well.

A)liquidity premium
B)market segmentation
C)expectations
D)none of the above

Question 65

The risk premium on corporate bonds becomes smaller as the liquidity of the bonds falls.

Question 66

________ bonds are exempt from federal income taxes.

A)Corporate Aaa
B)U)S. Treasury
C)Corporate Baa
D)Municipal

Question 67

Following the subprime collapse, the spread (difference)between the interest rates on Baa bonds and Treasury bonds widened.

Question 68

A moderately upward-sloping yield curve indicates that short-term interest rates are expected to

A)neither rise nor fall in the near future.
B)remain relatively unchanged, but that long-term rates are expected to fall.
C)neither rise nor fall, but that long-term rates are expected to rise moderately.
D)rise moderately in the near future.

Question 69

A steep upward-sloping yield curve indicates that short-term interest rates are expected to

A)neither rise nor fall in the near future.
B)remain relatively unchanged, but that long-term rates are expected to fall.
C)neither rise nor fall, but that long-term rates are expected to rise moderately.
D)rise moderately in the near future.

Question 70

A bond rating of Aa or AA would mean that the quality of the bond is

A)the highest.
B)high.
C)medium grade.
D)speculative.

Question 71

________ bonds are the most liquid of all long-term bonds.

A)Callable
B)Municipal
C)Corporate Aaa
D)U)S. Treasury

Question 72

An increase in income tax rates will cause the interest rates on tax-exempt municipal bonds to fall relative to the interest rate on taxable corporate securities.

Question 73

Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that views long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond is the

A)pure expectations theory.
B)preferred habitat theory.
C)liquidity premium theory.
D)segmented markets theory.

Question 74

The risk structure of interest rates is explained by

A)default risk.
B)liquidity.
C)tax considerations.
D)all of the above.

Question 75

________ cannot explain the empirical fact that interest rates on bonds of different maturities tend to move together.

A)The market segmentation theory
B)The expectations theory
C)The liquidity premium theory
D)Both A and B of the above
E)Both A and C of the above

Question 76

The expectations theory is able to explain why yield curves are usually upward-sloping.

Question 77

________ are investment advisory firms that rate the quality of corporate and municipal bonds in terms of probability of default.

A)Financial institutions
B)Credit-rating agencies
C)Securities companies
D)none of the above

Question 78

If a bond has a favorable tax treatment, its required interest rate (all else equal)

A)will be higher.
B)will not be affected.
C)will be lower.
D)all of the above could happen.

Question 79

Since yield curves are usually upward sloping, the ________ indicates that, on average, people tend to prefer holding short-term bonds to long-term bonds.

A)market segmentation theory
B)expectations theory
C)liquidity premium theory
D)both A and B of the above
E)both A and C of the above

Question 80

Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that assumes that bonds of different maturities are not substitutes for one another is the

A)expectations theory.
B)segmented markets theory.
C)liquidity premium theory.
D)preferred habitat theory.