Question 1

Some financial institutions such as commercial banks are required by law to invest only in
A)junk bonds.
B)corporate stock.
C)Treasury securities.
D)investment-grade bonds.

Accepted Answer

D

Question 2

Securities that offer ____ liquidity will offer a ____ yield to be preferred.
A)lower; higher
B)lower; lower
C)higher; higher
D)B and C

Accepted Answer

This is because securities that offer higher liquidity are more easily tradeable and can be converted to cash quickly, which lowers the risk for investors. As a result, these securities do not need to offer as high of a yield to attract investors compared to less liquid securities, which come with higher risk and require a higher yield to compensate for that risk.

Question 3

The yield offered on a debt security is ____ related to the prevailing risk-free rate and ____ related to the security's risk premium.
A)negatively; negatively
B)positively; positively
C)negatively; positively
D)positively; negatively

Accepted Answer

The yield on a debt security is positively related to both the prevailing risk-free rate and the security's risk premium. This is because as the risk-free rate increases, the overall yield required by investors also increases. Similarly, as the risk associated with a security (its risk premium) increases, investors demand a higher yield to compensate for the higher risk.

Question 4

In general, securities with ____ characteristics will offer ____ yields.
A)favorable; higher
B)favorable; lower
C)unfavorable; lower
D)none of the above

Accepted Answer

The answer of In general, securities with ____ characteristics will...

Question 5

Credit ratings are most commonly used to indicate which financial institutions have available funds that they can lend to borrowers.

Accepted Answer

Credit ratings are used to indicate the creditworthiness of borrowers, not the availability of funds at financial institutions.

Question 6

Holding other factors such as risk constant, the relationship between the maturity and annualized yield of securities is called the
A)term structure of interest rates.
B)default structure of interest rates.
C)liquidity structure of interest rates.
D)tax structure of interest rates.
E)none of the above

Accepted Answer

The relationship between the maturity and annualized yield of securities is known as the term structure of interest rates. This can be seen in the shape of the yield curve, which shows how interest rates vary for securities with different maturities. The other options (B, C, and D) do not accurately describe this relationship.

Question 7

Within the category of capital market securities, municipal bonds have the ____ before-tax yield, and their after-tax yield is typically ____ of Treasury bonds from the perspective of investors in high tax brackets.
A)highest; below that
B)lowest; above that
C)highest; above that
D)lowest; below that

Accepted Answer

Municipal bonds generally offer the lowest before-tax yield because the interest income is exempt from federal income taxes and, in some cases, state and local taxes as well. For investors in high tax brackets, this tax exemption can make the after-tax yield of municipal bonds higher than that of Treasury bonds, which are subject to federal income tax.

Question 8

If a security can easily be converted to cash without a loss in value, it
A)is liquid.
B)has a high after-tax yield.
C)has high default risk.
D)is illiquid.

Accepted Answer

A security that can easily be converted to cash without a loss in value is considered to be liquid. This means that the asset can be sold quickly without affecting its market value. High after-tax yield, high default risk, and illiquidity are not characteristics of a security that is easily convertible to cash without a loss in value.

Question 9

Assume investors are indifferent among security maturities.Today, the annualized 2-year interest rate is 12 percent, and the 1-year interest rate is 9 percent.What is the forward rate according to the pure expectations theory?
A)15.08 percent
B)3.00 percent
C)12.00 percent
D)12.62 percent
E)11.41 percent

Accepted Answer

The answer of Assume investors are indifferent among security maturities.Today,...

Question 10

Assume that annualized yields of short-term and long-term securities are equal.If investors suddenly believe interest rates will increase, their actions may cause the yield curve to
A)become inverted.
B)become flat.
C)become upward sloping.
D)be unaffected.

Accepted Answer

If investors believe interest rates will increase, they may sell off their long-term securities, causing their prices to drop and their yields to increase. This will cause the yield curve to become upward sloping, meaning that yields on longer-term securities will be higher than yields on short-term securities.

Question 11

The theory for the term structure of interest rates that says the shape of the yield curve is determined solely by expectations of future interest rates is called the
A)segmented markets theory.
B)liquidity premium theory.
C)pure expectations theory.
D)theory of rational expectations.

Accepted Answer

The pure expectations theory posits that the shape of the yield curve is determined solely by expectations of future interest rates. It assumes that there is only one possible investment horizon and that investors are only concerned about the expected return on their investment. This theory also assumes that there are no market frictions, such as transaction costs or taxes, that could affect the shape of the yield curve.

Question 12

The term structure of interest rates defines the relationship
A)between risk and return.
B)between risk and maturity.
C)between maturity and yield.
D)between default risk ratings and maturity.

Accepted Answer

The term structure of interest rates shows the relationship between maturity and yield, as it illustrates the different yields on bonds with different maturities. It does not directly relate to risk or default risk ratings.

Question 13

If all other characteristics are similar, ____ would have to offer ____.
A)taxable securities; a higher after-tax yield than tax-exempt securities
B)taxable securities; a higher before-tax yield than tax-exempt securities
C)tax-exempt securities; a higher after-tax yield than taxable securities
D)tax-exempt securities; a higher before-tax yield than taxable securities

Accepted Answer

Taxable securities must offer a higher before-tax yield than tax-exempt securities to compensate for the taxes investors must pay on the earnings from taxable securities, making them attractive compared to tax-exempt securities.

Question 14

An investor's tax rate is 30 percent.What must the before-tax yield on a security be to have an after-tax yield of 11 percent?
A)7.7 percent
B)15.71 percent
C)130 percent
D)11.00 percent
E)none of the above

Accepted Answer

Let x be the before-tax yield. After-tax yield = before-tax yield * (1 - tax rate)
11% = x * (1 - 0.3)
11% = x * 0.7
x = 15.71%

Question 15

Default risk is likely to be highest for
A)short-term Treasury securities.
B)AAA corporate securities.
C)long-term Treasury securities.
D)BBB corporate securities.

Accepted Answer

BBB corporate securities have lower credit ratings compared to AAA corporate securities, indicating a higher likelihood of default.

Question 16

A firm in the 35 percent tax bracket is aware of a tax-exempt security that is paying a yield of 7 percent.To match this yield, taxable securities must offer a before-tax yield of
A)7.0 percent.
B)10.8 percent.
C)20.0 percent.
D)none of the above

Accepted Answer

The formula for calculating the before-tax yield that would match a tax-exempt yield is:

Before-tax yield = Tax-exempt yield / (1 - Tax bracket)

In this case, the tax bracket is 35 percent:

Before-tax yield = 7% / (1 - 0.35) = 10.77%

Therefore, taxable securities must offer a before-tax yield of 10.77% to match the 7% yield of the tax-exempt security. Option B is the correct choice.

Question 17

If issuers of securities (borrowers) and investors suddenly expect interest rates to decrease, their actions to benefit from their expectations should cause
A)long-term yields to rise.
B)short-term yields to decrease.
C)prices of long-term securities to decrease.
D)A and B
E)none of the above

Accepted Answer

The answer of If issuers of securities (borrowers) and investors...

Question 18

If shorter term securities have higher annualized yields than longer term securities, the yield curve
A)is horizontal.
B)is upward sloping.
C)is downward sloping.
D)cannot be determined unless we know additional information (such as the level of market interest rates).

Accepted Answer

If shorter term securities have higher annualized yields than longer term securities, it indicates that investors have expectations of declining interest rates in the future. This results in a downward sloping yield curve.

Question 19

Assume an investor's tax rate is 25 percent.The before-tax yield on a security is 12 percent.What is the after-tax yield?
A)16.00 percent
B)9.25 percent
C)9.00 percent
D)3.00 percent
E)none of the above

Accepted Answer

The answer of Assume an investor's tax rate is 25...

Question 20

Interest income from municipal bonds is exempt from state taxes but is subject to federal taxes.

Accepted Answer

The answer of Interest income from municipal bonds is exempt...

Quiz 3: Structure of Interest Rates

Some financial institutions such as commercial banks are required by law to invest only in

Securities that offer liquidity will offer a yield to be preferred.

The yield offered on a debt security is related to the prevailing risk-free rate and related to the security's risk premium.

In general, securities with characteristics will offer yields.

Credit ratings are most commonly used to indicate which financial institutions have available funds that they can lend to borrowers.

Holding other factors such as risk constant, the relationship between the maturity and annualized yield of securities is called the

Within the category of capital market securities, municipal bonds have the before-tax yield, and their after-tax yield is typically of Treasury bonds from the perspective of investors in high tax brackets.

If a security can easily be converted to cash without a loss in value, it

Assume investors are indifferent among security maturities.Today, the annualized 2-year interest rate is 12 percent, and the 1-year interest rate is 9 percent.What is the forward rate according to the pure expectations theory?

Assume that annualized yields of short-term and long-term securities are equal.If investors suddenly believe interest rates will increase, their actions may cause the yield curve to

The theory for the term structure of interest rates that says the shape of the yield curve is determined solely by expectations of future interest rates is called the

The term structure of interest rates defines the relationship

If all other characteristics are similar, would have to offer .

An investor's tax rate is 30 percent.What must the before-tax yield on a security be to have an after-tax yield of 11 percent?

Default risk is likely to be highest for

A firm in the 35 percent tax bracket is aware of a tax-exempt security that is paying a yield of 7 percent.To match this yield, taxable securities must offer a before-tax yield of

If issuers of securities (borrowers) and investors suddenly expect interest rates to decrease, their actions to benefit from their expectations should cause

If shorter term securities have higher annualized yields than longer term securities, the yield curve

Assume an investor's tax rate is 25 percent.The before-tax yield on a security is 12 percent.What is the after-tax yield?

Interest income from municipal bonds is exempt from state taxes but is subject to federal taxes.