Question 1

Municipal bonds are issued by:

Accepted Answer

Municipal bonds are issued by states and cities, and their interest is exempt from U.S. government taxation.

Question 2

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):

Accepted Answer

To find the equivalent taxable yield that would make the investor indifferent, you use the formula: Tax-Exempt Yield / (1 - Tax Rate). Plugging in the numbers: 6% / (1 - 0.25) = 6% / 0.75 = 8%.

Question 3

Which fact about the term structure is the expectations theory unable to explain?

Accepted Answer

The expectations theory suggests that long-term interest rates are a reflection of current and expected future short-term interest rates. However, it does not adequately explain why longer-term yields are typically higher than shorter-term yields, a phenomenon often attributed to the term premium, which compensates investors for the increased risk of holding longer-term bonds.

Question 4

The risk structure of interest rates refers to the:

Accepted Answer

The risk structure of interest rates refers to the relationship among the interest rates of bonds from different issuers with the same maturities, highlighting how credit risk affects interest rates.

Question 5

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?

Accepted Answer

The Expectations Theory suggests that the yield on a three-year bond today would be the average of the expected interest rates over the next three years. Therefore, (2% + 2% + 4%) / 3 = 2.67%, which is closest to 2.7%.

Question 6

The risk structure of interest rates says:

Accepted Answer

The risk structure of interest rates states that lower rated bonds ("riskier" bonds) will have higher yields to compensate for the additional risk. This is because investors require a higher return to compensate for the increased likelihood of default or other factors that make the investment riskier.

Question 7

Suppose the economy has an inverted yield curve. According to the expectations hypothesis, which of the following interpretations could be used to explain this?

Accepted Answer

The expectations hypothesis states that long-term interest rates are equal to the average of expected future short-term interest rates. If the yield curve is inverted, this means that short-term interest rates are expected to fall in the future. The inverted curve indicates that investors are demanding higher rates for short-term bonds than for long-term bonds because of an expected decrease in interest rates.

Question 8

An investor in a 30% marginal tax bracket, earning $10 in interest annually for a $100 U.S. Treasury bond:

Accepted Answer

The investor earns $7 after-tax from the Treasury bond ($10 - 30% of $10), which is the same as the municipal bond's tax-exempt interest, making them indifferent between the two.

Question 9

U.S. Treasury securities are considered to carry no risk spread because:

Accepted Answer

U.S. Treasury securities are issued by the federal government and are considered to be the closest thing to default-risk free that an investor can obtain. This means that there is virtually no risk of default, and as such, the securities carry no risk spread. The other options are incorrect as the prices and yields of U.S. Treasury securities do change, and the yields can be low or high depending on various factors.

Question 10

The yield on a tax-exempt bond:

Accepted Answer

The yield on a tax-exempt bond equals the taxable bond yield times one minus the tax rate because tax-exempt bonds provide income that is exempt from federal or state income taxes, making their effective yield higher than a comparable taxable bond.

Question 11

If a local government eliminates the tax exemption on municipal bonds, we'd expect to see:

Accepted Answer

Eliminating the tax exemption on municipal bonds would make them less attractive compared to taxable bonds, as one of their main advantages (being tax-exempt) disappears. This would likely lead to a decrease in the gap in yields between taxable and tax-exempt bonds, as municipal bonds would need to offer higher yields to attract investors, moving their yields closer to those of taxable bonds.

Question 12

Which of the following is true?

Accepted Answer

U.S. Treasury Bills, being government-backed securities, typically offer lower yields compared to commercial paper, which is unsecured and issued by corporations. This reflects the lower risk associated with government securities.

Question 13

In 2003, ratings agencies downgraded bonds issued by the State of California several times. How will this affect the market for these bonds?

Accepted Answer

When ratings agencies downgrade bonds, they are indicating that there is a higher risk associated with investing in those bonds. This higher risk means that investors will demand a higher yield in order to be compensated for taking on that risk. Therefore, yields on the State of California bonds will increase. The yield on Treasury bonds is unlikely to be directly impacted by the downgrade of California bonds, so it is not necessary to consider it as part of the answer.

Question 14

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):

Accepted Answer

The answer of Holding liquidity and default risk constant, an...

Question 15

Tax-exempt bonds:

Accepted Answer

Tax-exempt bonds are most beneficial to those who pay higher income tax rates because they allow investors to earn tax-free income. This means that the higher your tax bracket, the more valuable the tax-exempt status of the bond becomes.

Question 16

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

Accepted Answer

The interest rate increases from 6% to 8%, which is a 2% increase. This 2% increase is 33.3% of the original 6% rate (2/6 = 0.333 or 33.3%).

Question 17

Taxes play an important role in bond returns because:

Accepted Answer

Taxes can have a significant impact on bond returns as some bond interest may be exempt from certain types of government taxation, leading to variation in after-tax returns across various bonds.

Question 18

Municipal bonds are usually purchased by:

Accepted Answer

Municipal bonds are tax-exempt at the federal level and often at the state and local levels, making them attractive to investors in high marginal tax brackets. This is because the tax-exempt status of municipal bonds effectively increases their yield compared to taxable bonds. Retired investors with no taxable income may not benefit from this tax exemption, investors looking for securities for their IRA accounts may not prioritize municipal bonds, and investors who live in cities with high municipal tax rates may choose to diversify their portfolio with bonds from other municipalities.

Question 19

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

Accepted Answer

The borrower's ethnicity cannot be used to qualify mortgages as prime or subprime as it is considered discriminatory and is illegal under fair lending laws such as the Equal Credit Opportunity Act (ECOA) and Fair Housing Act (FHA). The other options, such as the borrower's income, credit score, and loan to value ratio, are commonly used to determine the creditworthiness of a borrower and to classify mortgages as either prime or subprime.

Question 20

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

Accepted Answer

The equivalent tax-exempt bond yield can be calculated using the formula: Tax-exempt yield = Taxable yield * (1 - Tax rate). Here, it is 8% * (1 - 0.25) = 6%.

Quiz 7: The Risk and Term Structure of Interest Rates