Question 1

According to the expectations theory, a positively sloped yield curve usually reflects
A)an increase in expected future income.
B)a decrease in expected future income.
C)a decrease in expected future prices.
D)an increase in the money supply.

Accepted Answer

The expectations theory suggests that a positively sloped yield curve reflects an increase in expected future interest rates, which can be associated with an increase in expected future income. This is because higher future income expectations can lead to higher spending, potentially increasing inflation and prompting central banks to raise interest rates.

Question 2

Some researchers believe the expectations theory needs to be modified in order to reflect
A)liquidity premiums.
B)that lenders may have some preference for either long- or short-term securities and hence not be indifferent between the two.
C)the tendency of borrowers to prefer longer term securities so they don't have to issue and reissue short term securities.
D)All of the above are true.

Accepted Answer

The expectations theory suggests that long-term and short-term interest rates are directly related to the expected future short-term interest rates. However, some researchers believe that this theory needs to be modified to reflect other factors such as liquidity premiums, lender preferences, and borrower preferences. Liquidity premiums refer to the extra yield investors may require to hold longer-term securities because of the risk of not being able to sell them quickly in the market. Lenders may have a preference for either long- or short-term securities which can affect the interest rates. Borrowers may prefer longer-term securities so they can avoid issuing and reissuing short-term securities. Therefore, all of the above factors need to be considered for a more accurate explanation of interest rate behavior.

Question 3

Preferred habitats refers to
A)preferring stocks over bonds.
B)minimal allowance for write-offs.
C)preferred maturities for borrowers and lenders that may lead to market segmentation.
D)investment in newly constructed housing.

Accepted Answer

Preferred habitats refer to the preferred maturities for borrowers and lenders that may lead to market segmentation. This concept is often used in financial markets to describe different investor preferences for certain types of securities, such as short-term treasury bills versus long-term bonds. It describes the phenomenon where investors tend to prefer certain investment maturities or types of securities, leading to segmentation in the market. This can have implications for the prices of securities and the efficiency of the market as a whole.

Question 4

The __________ is the extra return required to induce lenders to lend long term rather than short term.
A)risk premium
B)liquidity premium
C)credit risk
D)liquidity risk

Accepted Answer

The liquidity premium is the extra return that lenders demand to lend long term rather than short term. This is because long-term loans are inherently more risky due to the uncertainty of future interest rates and events that could impact the borrower's ability to repay the loan. Short-term loans, on the other hand, are considered less risky because the lender can get their money back relatively quickly if needed. The liquidity premium compensates lenders for this additional risk of long-term loans.

Question 5

A liquidity premium is used to
A)lure lenders to lend short term.
B)lure lenders to lend long term.
C)lure lenders to lend greater amounts.
D)None of the above

Accepted Answer

A liquidity premium is the additional return required by investors for investing in securities or assets that are deemed more illiquid or difficult to sell. Therefore, it would be used to lure lenders to lend long term, as it compensates them for the added risk of investing in less liquid assets.

Question 6

If expected future short-term interest rates are equal to current short-term rates, the liquidity premium will
A)make long-term rates lower than current short-term rates.
B)make long-term rates higher than current short-term rates.
C)make long-term rates equal to current short-term rates.
D)make have no effect.

Accepted Answer

The liquidity premium theory suggests that long-term interest rates not only reflect investors' assumptions about future interest rates but also include a premium for holding longer-term securities (due to their greater risk and lower liquidity compared to short-term securities). Therefore, even if expected future short-term rates are equal to current short-term rates, the liquidity premium will make long-term rates higher than current short-term rates.

Question 7

__________ is the probability of a debtor not paying the principal and/or interest due on an outstanding debt
A)Risk premium
B)Liquidity premium
C)Credit risk
D)Liquidity risk

Accepted Answer

Credit risk refers to the probability of a debtor not being able to pay back the principal and/or interest on an outstanding debt. It is the risk of default or non-payment by the borrower. Lenders typically factor in credit risk when deciding whether to grant a loan or credit, and at what interest rate.

Question 8

The __________ is the extra return or interest with which a lender is compensated for accepting more risk.
A)risk premium
B)liquidity premium
C)credit risk
D)liquidity risk

Accepted Answer

The risk premium is the extra return or interest demanded by lenders to compensate for the additional risk they are taking on. The other options (liquidity premium, credit risk, and liquidity risk) are all related to risk but are not specifically tied to the compensation demanded by lenders.

Question 9

Which of these is a major corporate credit-rating agency that evaluates a borrower's probability of default and assigns the borrower to a particular risk class?
A)Dow Jones Industrial Average (DJIA)
B)Moody's Investors Services
C)FDIC
D)Dow Jones Investor Service (DJIS)

Accepted Answer

Moody's Investors Services is a major corporate credit-rating agency that evaluates a borrower's probability of default and assigns the borrower to a particular risk class. The Dow Jones Industrial Average (DJIA) and Dow Jones Investor Service (DJIS) are indices that track stock market performance, while the FDIC is a government agency that provides insurance for depositors in case a bank fails.

Question 10

Changes in interest rates may be caused by which of the following?
A)Changes in liquidity premiums
B)Changes in preferred habitats
C)Changes in the supply of funds driven by changes in expectations
D)All of the above may cause interest rates to change.

Accepted Answer

Changes in interest rates can be influenced by various factors such as changes in liquidity premiums, preferred habitats, and the supply of funds driven by changes in expectations. Therefore, all the options stated in A, B, and C may cause interest rates to change.

Question 11

The current long-term interest rate is a function of all of the following except
A)the current short-term rate.
B)the short-term rates expected in the future.
C)last year's long-term rate.
D)the liquidity premium.

Accepted Answer

Last year's long-term rate is not a determinant of the current long-term interest rate. The other three factors listed (the current short-term rate, expected future short-term rates, and liquidity premium) all have an impact on the current long-term interest rate.

Question 12

The current long-term interest rate is a function of which of the following?
A)the current short-term rate.
B)the short-term rates expected in the future.
C)the liquidity premium.
D)All of the above are correct.

Accepted Answer

The long-term interest rate is influenced by multiple factors including the current short-term rate, expected future short-term rates, and the liquidity premium. Therefore, all the given options A, B, and C are correct.

Question 13

Which of the following is a measure of the credit worthiness of the issuer of a security?
A)the liquidity premium
B)the discount from par
C)the money illusion
D)the credit risk

Accepted Answer

Credit risk refers to the likelihood of the issuer of a security defaulting on their payments, which is a measure of their credit worthiness. The liquidity premium refers to the extra return investors would demand for holding a less liquid security, while the discount from par reflects the market's assessment of the security's current value compared to its face value. The money illusion refers to the tendency for people to focus on nominal rather than real values, which is not directly related to credit worthiness.

Question 14

Which security has the least credit risk?
A)Common stock
B)Treasury securities
C)Preferred stock
D)Equities

Accepted Answer

Treasury securities are backed by the full faith and credit of the United States government, making them the least risky investment option. Common stock and preferred stock are both examples of equities, which are riskier investments.

Question 15

The rate paid on the last dollar of income the tax payer earns is called
A)the after-tax yield
B)the average tax rate
C)the marginal tax rate
D)the marginal after-tax yield

Accepted Answer

The marginal tax rate is the rate paid on the last dollar of income earned.

Question 16

If Maureen lives in a country where no taxes are levied on the first $20,000 of income and a 10% tax is levied on all income above $20,000, what is her marginal tax rate if she has an average tax rate of 5%?
A)5%
B)10%
C)15%
D)25%

Accepted Answer

Maureen's average tax rate is calculated as the total tax paid divided by her total income. Let X be her total income. Then:
Total Tax Paid = 0.05X
Tax on income above 20,000 = 0.10(X-20,000)
Total tax paid = 0.05X + 0.10(X-20,000)
Setting the average tax rate equal to 5%, we get:
0.05X = 0.05(Total Income) = 0.05(20,000) + 0.10(X-20,000)
Simplifying the expression above, we get:
0.05X = 500 + 0.10X - 2000
0.05X = 1500
X = 30,000
Thus, Maureen's total income is $30,000. Her marginal tax rate refers to the tax rate she pays on the last dollar of income earned. Since she pays a 10% tax rate on income above $20,000, her marginal tax rate is equal to 10%. Therefore, the correct choice is B.

Question 17

Assume a corporate marginal tax rate of 38%. What yield on a municipal bond would leave a corporation indifferent between a 9% corporate bond and a municipal bond?
A)4.8%
B)5.58%
C)6.03%
D)7.2%

Accepted Answer

To find the equivalent yield on a municipal bond that would make a corporation indifferent between it and a 9% corporate bond, we can use the following formula:

(1 - Marginal tax rate) = Yield on municipal bond ÷ Yield on corporate bond

Substituting the given values, we get:

(1 - 0.38) = Yield on municipal bond ÷ 0.09

0.62 = Yield on municipal bond ÷ 0.09

Yield on municipal bond = 0.62 x 0.09 = 0.0558 or 5.58%

Therefore, the answer is B.

Question 18

If security purchasers found the after-tax yield on municipal bonds higher than that of corporate bonds, leading to an increase in municipal bond purchases and an increase in corporate bond sales, this would cause the
A)yields on municipals to increase.
B)prices on corporate bonds to increase.
C)yields on corporate bonds to decrease.
D)yields on municipals to decrease.

Accepted Answer

An increase in demand for municipal bonds and a decrease in demand for corporate bonds would cause the yield on municipal bonds to decrease (due to increased competition among buyers driving down the yield), while the yield on corporate bonds would increase (due to decreased demand driving up the yield).

Question 19

The main advantage of municipal securities is that
A)their credit risk is usually very low.
B)the interest income earned is exempt from federal income tax and taxes in the issuing state.
C)they are the most liquid type of securities.
D)Both a and b are correct.

Accepted Answer

Municipal securities have the advantage of low credit risk, as they are issued by local governments with taxing authority. Additionally, their interest income is exempt from federal income tax and taxes in the issuing state, making them particularly attractive to investors in higher tax brackets.

Question 20

Typically, the yields on municipal securities are
A)well above the yields on other securities with similar credit ratings and similar terms to maturity.
B)well below the yields on other securities with similar credit ratings and similar terms to maturity.
C)taxed at both the state and federal level.
D)about the same as the yields on other securities with similar credit ratings and similar terms to maturity.

Accepted Answer

Municipal securities usually have lower yields compared to other securities with similar credit ratings and terms to maturity, because they are exempt from federal income taxes and sometimes state and local taxes as well. This tax advantage makes them attractive to investors, leading to lower yields.

Quiz 6: The Structure of Interest Rates

According to the expectations theory, a positively sloped yield curve usually reflects

Some researchers believe the expectations theory needs to be modified in order to reflect

Preferred habitats refers to

The __________ is the extra return required to induce lenders to lend long term rather than short term.

A liquidity premium is used to

If expected future short-term interest rates are equal to current short-term rates, the liquidity premium will

__________ is the probability of a debtor not paying the principal and/or interest due on an outstanding debt

The __________ is the extra return or interest with which a lender is compensated for accepting more risk.

Which of these is a major corporate credit-rating agency that evaluates a borrower's probability of default and assigns the borrower to a particular risk class?

Changes in interest rates may be caused by which of the following?

The current long-term interest rate is a function of all of the following except

The current long-term interest rate is a function of which of the following?

Which of the following is a measure of the credit worthiness of the issuer of a security?

Which security has the least credit risk?

The rate paid on the last dollar of income the tax payer earns is called

If Maureen lives in a country where no taxes are levied on the first $20,000 of income and a 10% tax is levied on all income above $20,000, what is her marginal tax rate if she has an average tax rate of 5%?

Assume a corporate marginal tax rate of 38%. What yield on a municipal bond would leave a corporation indifferent between a 9% corporate bond and a municipal bond?

If security purchasers found the after-tax yield on municipal bonds higher than that of corporate bonds, leading to an increase in municipal bond purchases and an increase in corporate bond sales, this would cause the

The main advantage of municipal securities is that

Typically, the yields on municipal securities are