Question 1

An inverted yield curve ________.
A) slopes up
B) is flat
C) slopes down
D) has a U shape

Accepted Answer

An inverted yield curve slopes down, meaning that longer-term interest rates are lower than shorter-term interest rates. This is often seen as a predictor of an economic recession.

Question 2

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

Accepted Answer

Economists' attempts to explain the term structure of interest rates illustrate how they modify theories to improve them when they are inconsistent with the empirical evidence. This process of refining and adjusting theories based on new data is an essential aspect of the scientific method in economics.

Question 3

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 remain relatively stable 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) yield curves should be equally likely to slope downward as slope upward

Accepted Answer

The expectations theory of the term structure suggests that the shape of the yield curve reflects investors' expectations about future interest rates. If investors expect future short-term rates to rise, the yield curve will slope upward; if they expect rates to fall, it will slope downward. The theory does not inherently favor upward or downward sloping curves, implying that both are equally likely depending on future interest rate expectations.

Question 4

According to the expectations theory of the term structure ________.
A) the interest rate on long-term bonds will exceed the average of short-term interest rates that people expect to occur over the life of the long-term bonds, because of their preference for short-term securities
B) interest rates on bonds of different maturities move together over time
C) buyers of bonds prefer short-term to long-term bonds
D) buyers require an additional incentive to hold long-term bonds

Accepted Answer

The expectations theory of the term structure suggests that interest rates on bonds of different maturities move together over time, driven by market expectations of future short-term interest rates. Thus, Option A is incorrect because buyers do not necessarily prefer short-term securities; rather, the market expectations determine the interest rates. Option C is also incorrect as some buyers may prefer long-term bonds, depending on their investment goals and risk tolerance. Option D is also incorrect because the theory does not suggest that buyers require an extra incentive to hold long-term bonds.

Question 5

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 will not be observed to be downward sloping
D) the interest rate for each maturity bond is determined by supply and demand for that maturity bond

Accepted Answer

According to the liquidity premium theory of the term structure, 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. This theory suggests that the term premium is positive, meaning that the yield curve will typically be upward sloping. This theory does not suggest that buyers of bonds may have a preference for bonds of different maturities or that interest rates for different maturities are based on supply and demand for that maturity bond.

Question 6

If the expected path of 1-year interest rates over the next five years is 2 percent,4 percent,1 percent,4 percent,and 3 percent,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) four years

Accepted Answer

The answer of If the expected path of 1-year interest...

Question 7

Over the next three years,the expected path of 1-year interest rates is 4,1,and 1 percent.The expectations theory of the term structure predicts that the current interest rate on 3-year bond is ________.
A) 1 percent
B) 2 percent
C) 3 percent
D) 4 percent

Accepted Answer

The expectations theory of the term structure suggests that the yield on a longer-term bond will equal the geometric average of short-term interest rates expected to prevail over the life of the long-term bond. Here, the average of the expected 1-year interest rates over the next three years (4%, 1%, 1%) is calculated as the geometric mean: [(1.04 * 1.01 * 1.01)^(1/3)] - 1 ≈ 2%. Therefore, the current interest rate on a 3-year bond, according to the expectations theory, would be approximately 2%.

Question 8

According to this theory of the term structure,bonds of different maturities are not substitutes for one another.
A) Segmented markets theory
B) Expectations theory
C) Liquidity premium theory
D) Separable markets theory

Accepted Answer

Segmented markets theory suggests that bonds of different maturities have their own separate markets and are not perfect substitutes for each other. This is in contrast to the Expectations theory, which assumes that bonds of all maturities are perfect substitutes, and the Liquidity premium theory, which suggests that longer maturity bonds have higher yields due to the greater risk associated with holding them. The Separable markets theory is not a commonly recognized theory of the term structure.

Question 9

If bonds with different maturities are perfect substitutes,then the ________ on these bonds must be equal.
A) expected return
B) surprise return
C) surplus return
D) excess return

Accepted Answer

If bonds with different maturities are perfect substitutes, then investors would only care about the expected return on these bonds, which would have to be equal in order to make them perfect substitutes. Choices B, C, and D are not relevant in this context.

Question 10

The expectations theory and the segmented markets theory do not explain the facts very well,but they provide the groundwork for the most widely accepted theory of the term structure of interest rates,________.
A) the Keynesian theory
B) separable markets theory
C) liquidity premium theory
D) the asset market approach

Accepted Answer

The liquidity premium theory builds upon the expectations theory and segmented markets theory to explain the term structure of interest rates more accurately. It states that longer-term bonds have higher yields because investors require compensation, or a liquidity premium, for the greater risk and uncertainty associated with holding them over a longer period. This theory is widely accepted among economists and investors.

Question 11

In actual practice,short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the ________.
A) segmented markets theory
B) expectations theory
C) liquidity premium theory
D) separable markets theory

Accepted Answer

The segmented markets theory suggests that short-term and long-term interest rates are determined independently of each other, based on supply and demand within each segment. The observation that short-term and long-term rates usually move together contradicts this theory, highlighting its major shortcoming.

Question 12

A key assumption in the segmented markets theory is that bonds of different maturities ________.
A) are not substitutes at all
B) are perfect substitutes
C) are substitutes only if the investor is given a premium incentive
D) are substitutes but not perfect substitutes

Accepted Answer

The segmented markets theory assumes that bonds of different maturities are not substitutes at all, suggesting that investors have specific maturity preferences and do not switch between maturities regardless of changes in yield.

Question 13

According to the segmented markets theory of the term structure ________.
A) bonds of one maturity are close substitutes for bonds of other maturities, therefore, interest rates on bonds of different maturities move together over time
B) the interest rate for each maturity bond is determined by supply and demand for that maturity bond
C) investors' strong preferences for short-term relative to long-term bonds explains why yield curves typically slope downward
D) because of the positive term premium, the yield curve will not be observed to be downward-sloping

Accepted Answer

The segmented markets theory of the term structure suggests that the interest rate for each maturity bond is determined by supply and demand for that maturity bond. Therefore, interest rates on bonds of different maturities can move independently from each other. This theory is a departure from the traditional view that all bonds are perfect substitutes and thus, interest rates move together across maturities. The segmented markets theory explains why yield curves may not necessarily slope downward, as it depends on the current supply and demand conditions for each maturity bond.

Question 14

According to the segmented markets 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
B) buyers of bonds do not prefer bonds of one maturity over another
C) interest rates on bonds of different maturities do not move together over time
D) buyers require an additional incentive to hold long-term bonds

Accepted Answer

The segmented markets theory suggests that the markets for different maturity bonds are distinct and separate, leading to the idea that interest rates on bonds of different maturities do not necessarily move together over time. This theory emphasizes that investors have specific maturity preferences and that these preferences can cause the yields on bonds of different maturities to behave independently.

Question 15

If the expected path of one-year interest rates over the next five years is 4 percent,5 percent,7 percent,8 percent,and 6 percent,then the expectations theory predicts that today's interest rate on the five-year bond is ________.
A) 4 percent
B) 5 percent
C) 6 percent
D) 7 percent

Accepted Answer

The expectations theory states that the long-term interest rates are the geometric average of expected future short-term rates. In this case, the average of the expected one-year interest rates is:

(1.04 x 1.05 x 1.07 x 1.08 x 1.06)^(1/5) -1 = 1.077 - 1 = 0.077 or 7.7%.

Therefore, today's interest rate on the five-year bond is expected to be 7 percent, which is closest to (C) 6 percent.

Question 16

The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond,and investors have no preference for short-term bonds relative to long-term bonds.
A) segmented markets theory
B) expectations theory
C) liquidity premium theory
D) separable markets theory

Accepted Answer

The expectations theory of the term structure of interest rates holds that long-term rates are an average of expected future short-term rates, indicating that there is no difference between owning a short-term and a long-term bond. This theory is known as an unbiased predictor of future short-term rates. Segmented markets theory suggests that different investors have different investment horizons, so there are independent markets for short-term and long-term bonds. The liquidity premium theory argues that long-term bonds have a liquidity premium because they are less liquid than short-term bonds. Separable markets theory, sometimes referred to as dual markets theory, states that short-term and long-term rates are determined by separate supply and demand factors.

Question 17

According to the expectations theory of the term structure,the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond.
A) average
B) sum
C) difference
D) multiple

Accepted Answer

According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the average of the short-term interest rates that people expect to occur over the life of the long-term bond. This theory is based on the idea that investors are indifferent between investing in short-term or long-term bonds, as long as they receive the same average return over the life of the investment. Therefore, the interest rate on a long-term bond must compensate for the expected fluctuations in short-term interest rates over time, resulting in an average yield that is equal to the expected yield on a portfolio of short-term bonds.

Question 18

If the expected path of 1-year interest rates over the next four years is 5 percent,4 percent,2 percent,and 1 percent,then the expectations theory predicts that today's interest rate on the four-year bond is ________.
A) 1 percent
B) 2 percent
C) 3 percent
D) 4 percent

Accepted Answer

The expectations theory suggests that the long-term interest rate for a bond is the geometric average of short-term interest rates expected over the same time period. So, the four-year bond rate will be the average of the four one-year interest rate expectations: [(1+2+4+5)/4] = 3 percent. Therefore, the correct answer is C) 3 percent.

Question 19

If the expected path of 1-year interest rates over the next five years is 1 percent,2 percent,3 percent,4 percent,and 5 percent,the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of ________.
A) two years
B) three years
C) four years
D) five years

Accepted Answer

According to the expectations theory, the long-term interest rates are an average of the expected future short-term interest rates. As the expected path of interest rates is increasing over time, the bond with the longest maturity, i.e. 5 years, will have the highest interest rate. Therefore, the answer is D) five years.

Question 20

The segmented markets theory can explain ________.
A) why yield curves usually tend to slope upward
B) why interest rates on bonds of different maturities tend to move together
C) why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high
D) why yield curves have been used to forecast business cycles

Accepted Answer

The segmented markets theory suggests that the market for each maturity of bond is completely separate and distinct. This theory can explain why yield curves usually tend to slope upward, as it posits that the demand and supply for bonds of different maturities are independent, leading to higher interest rates for longer maturities due to increased risk.

Quiz 6: The Risk and Term Structure of Interest Rates

An inverted yield curve ________.

Economists' attempts to explain the term structure of interest rates ________.

According to the expectations theory of the term structure ________.

According to the expectations theory of the term structure ________.

According to the liquidity premium theory of the term structure ________.

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

Over the next three years,the expected path of 1-year interest rates is 4,1,and 1 percent.The expectations theory of the term structure predicts that the current interest rate on 3-year bond is ________.

According to this theory of the term structure,bonds of different maturities are not substitutes for one another.

If bonds with different maturities are perfect substitutes,then the ________ on these bonds must be equal.

The expectations theory and the segmented markets theory do not explain the facts very well,but they provide the groundwork for the most widely accepted theory of the term structure of interest rates,________.

In actual practice,short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the ________.

A key assumption in the segmented markets theory is that bonds of different maturities ________.

According to the segmented markets theory of the term structure ________.

According to the segmented markets theory of the term structure ________.

If the expected path of one-year interest rates over the next five years is 4 percent,5 percent,7 percent,8 percent,and 6 percent,then the expectations theory predicts that today's interest rate on the five-year bond is ________.

According to the expectations theory of the term structure,the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond.

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

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

The segmented markets theory can explain ________.