Question 1

During a "flight to quality"

Accepted Answer

During a "flight to quality," investors move their money into safer assets, such as Treasury bonds, which are considered risk-free. This increased demand for Treasuries lowers their yields, while the yields on riskier bonds, like Baa-rated corporate bonds, increase due to decreased demand. As a result, the spread between Treasury bonds and Baa bonds widens.

Question 2

As default risk decreases, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant.

Accepted Answer

As default risk decreases, investors demand lower returns which causes the expected return on corporate bonds to increase. However, with lower risk, the return becomes less uncertain which means the bond price becomes more stable, resulting in less variability in the return.

Question 3

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 Treasury securities will ________.

Accepted Answer

If the federal government were to guarantee that it will pay creditors if a corporation goes bankrupt in the future, it would decrease the perceived risk of investing in corporate bonds. This would lead to a decrease in the interest rate on corporate bonds. However, it would also increase the demand for Treasury securities as they are perceived as safer investments. This would lead to an increase in the interest rate on Treasury securities.

Question 4

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 ________.

Accepted Answer

Bonds with relatively low risk of default are called investment grade 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 referred to as junk bonds.

Question 5

Which of the following securities has the lowest interest rate?

Accepted Answer

U.S. Treasury bonds typically have the lowest interest rate since they are considered the safest investment and have the backing of the federal government. Junk bonds, corporate Baa bonds, and even investment-grade bonds carry a higher level of risk and therefore offer a higher interest rate to compensate for that risk.

Question 6

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

Accepted Answer

A corporate bond with a rating of Baa signifies a moderate credit risk, making it the riskiest option listed. If an investor has a very low tolerance for risk, they would likely choose investments with higher credit ratings or lower risk profiles, such as a U.S. Treasury bond or a municipal bond, both with very low default risk.

Question 7

When the Treasury 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 ________.

Accepted Answer

When the Treasury bond market becomes less liquid, investors may find corporate bonds more attractive, shifting the demand curve for corporate bonds to the right. Conversely, the demand for Treasury bonds would decrease, shifting their demand curve to the left.

Question 8

Which of the following statements are true?

Accepted Answer

This is true because investors require a higher expected return to compensate for the increased default risk associated with corporate bonds.

Question 9

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.

Accepted Answer

During the Great Depression, there was a high rate of business failures and defaults. As a result, the risk premium for corporate bonds would have been very high, particularly for lower-rated corporate bonds such as Baa rated bonds. Therefore, the best choice is D) corporate Baa bonds.

Question 10

Which of the following statements is true?

Accepted Answer

A liquid asset is defined as an asset that can be readily bought or sold in the market without significantly affecting the asset's price. A liquid asset is one that can be converted into cash quickly and with minimal impact to the asset's value. In contrast, an illiquid asset is an asset that cannot be easily sold or converted into cash without a significant decrease in its value.

Question 11

When the Treasury 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 ________.

Accepted Answer

When the Treasury bond market becomes more liquid, investors are more willing to hold Treasury bonds because they are easier to buy and sell. This increases the demand for Treasury bonds, shifting the demand curve to the right. At the same time, the increased liquidity of the Treasury bond market makes corporate bonds relatively less attractive, reducing the demand for corporate bonds and shifting the demand curve to the left. Therefore, the correct choice is (C) left; right.

Question 12

Bonds with relatively high risk of default are called

Accepted Answer

Bonds with a high risk of default are commonly referred to as junk bonds. These bonds are typically issued by companies with lower credit ratings and come with a higher risk of default, which means investors require a higher return on their investment to compensate for the greater risk.

Question 13

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

Accepted Answer

The collapse of the subprime mortgage market led to a flight to quality, which means investors preferred safer and more secure investments, such as default-free U.S. Treasury bonds. This increased demand for Treasury bonds and decreased demand for riskier investments, such as Baa bonds. As a result, the spread between Baa and Treasury bonds widened.

Question 14

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

Accepted Answer

According to the risk-return tradeoff, as riskiness increases, expected return also increases. Therefore, as the relative riskiness of corporate bonds increases, their expected return will also increase relative to default-free bonds. As a result, the expected return on default-free bonds will decrease relative to corporate bonds, leading to a decrease in the expected return on corporate bonds relative to default-free bonds.

Question 15

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

Accepted Answer

Junk bonds are high-yield bonds with low credit ratings and thus have a higher risk of default compared to other bonds like municipal bonds, investment-grade bonds, and U.S. Treasury bonds.

Question 16

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

Accepted Answer

Risk premiums on corporate bonds tend to decrease during business cycle expansions due to lower perceived risk and increase during recessions due to higher perceived risk.

Question 17

Corporate bonds are not as liquid as government bonds because

Accepted Answer

Corporate bonds are not as liquid as government bonds because there are typically fewer corporate bonds available to be traded for any one corporation. This scarcity makes them more costly to sell, thus decreasing their liquidity. Additionally, corporate bonds are subject to credit risk, as they are not backed by the government. This means that investors need to carefully consider the creditworthiness of the issuer before investing in corporate bonds.

Question 18

The collapse of the subprime mortgage market

Accepted Answer

The collapse of the subprime mortgage market increased perceived riskiness in the corporate bond market, which in turn led to an increase in the Baa-Aaa spread. This means that higher risk bonds became more expensive relative to safer bonds, increasing the spread between the two. The collapse did not directly affect the corporate bond market or the perceived riskiness of Treasury securities.

Question 19

The spread between interest rates on low quality corporate bonds and U.S. government bonds

Accepted Answer

During periods of economic uncertainty, investors tend to seek safe havens, such as U.S. government bonds, which drives up their prices and lowers their interest rates. At the same time, the risk of default for low quality corporate bonds increases, which drives down their prices and increases their interest rates. This leads to a widening of the spread between the two types of bonds. During the Great Depression, the economy suffered a severe contraction, leading to a significant increase in corporate defaults and a widening of the spread between corporate and government bonds.

Question 20

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

Accepted Answer

Corporate bonds usually offer a higher interest rate than government-issued bonds to compensate for the additional risk taken by investors. Baa rated bonds are considered to be a lower rating, indicating a higher credit risk, which is why they offer a higher interest rate compared to Treasury and Aaa corporate bonds. Municipal bonds are issued by local governments and may have lower interest rates as they are considered to have a lower risk.

Quiz 6: The Risk and Term Structure of Interest Rates

During a "flight to quality"

As default risk decreases, the expected return on corporate bonds , and the return becomes uncertain, everything else held constant.

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 Treasury securities will .

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 .