Deck 7: The Structure of Interest Rates

Question 1

Liquidity premiums cause an observed yield curve to be less upward sloping than that predicted by the expectations theory.

Answer 1

False

Question 2

Treasury and corporate security yields may be combined when plotting a yield curve.

Answer 2

False

Question 3

According to the preferred habitat theory,investors may choose a different maturity from their preferred one in response to expected yield premiums.

Answer 3

True

Question 4

The preferred habitat theory holds that the shape of the yield curve is determined by investors' expectations of future interest rates.

Question 5

The term structure of interest rates:

A)describes the relationship between maturity and yield for similar securities.
B)ranks security yields according to the default risk structure.
C)describes how interest rates vary over time.
D)describes the pattern of interest rates over the business cycle.

Question 6

Downward sloping yield curves are viewed briefly near the end of a period of expansion.

Question 7

Between two securities with the same expected yield and a different credit rating,the risk adverse investor would choose the security with the lowest rank rating.

Question 8

Securities with a higher probability of default need to pay higher yields to risk-averse investors

Question 9

A downward sloping yield curve forecasts higher future interest rates.

Question 10

The relationship between yield and term to maturity on securities that differ only in
length of time to maturity is known as the yield curve.

Question 11

If the yield curve is near the top of the business cycle and is downward sloping,financial institutions should try to lengthen the maturity of their liabilities.

Question 12

The less marketable a security,the higher its yield.

Question 13

The default risk premium of a security is the difference between the yield of the security and the yield of a security with a shorter maturity.

Question 14

The expectations theory allows for a discontinuous yield curve.

Question 15

'Flight to quality' implies buying bonds with high credit ratings (low default risk)and selling bonds with low credit ratings.

Question 16

The market segmentation theory does NOT allow for discontinuities in the yield curve.

Question 17

Default risk premiums are usually smaller during periods of high economic growth.

Question 18

It is expected that a security with a higher-grade rating has a larger default risk.

Question 19

'Junk bond' is an alternative name for a speculative-grade bond.

Question 20

Callable bonds have higher market yields than noncallable bonds.

Question 21

The current market interest rate for one year maturity bond is 10%.The forward rate for a one year investment starting in one year from now is 8%.According to the expectations theory of term structure,the current two-year maturity market interest rate is approximately:

A)9%.
B)8%.
C)10%
D)6%.

Question 22

The shape of the yield curve that is the most commonly observed is

A)a flat curve.
B)an ascending curve.
C)a descending curve.
D)a U-shape curve.

Question 23

The yield curve is a plot of:

A)default risks by maturity.
B)yields by default risk.
C)yields by maturity of securities with similar default risk.
D)interest rates over time.

Question 24

Which of the following statements is NOT correct? If the yield curve is near the top of the business cycle and is downward sloping,financial institutions:

A)will typically try to shorten the maturity of their liabilities.
B)will try to lengthen the maturity of their fixed rate loans.
C)want to be able to borrow at lower cost in the future.
D)will try to increase the share of variable rate loans in their portfolio.

Question 25

While incorporating liquidity premiums that increase with the maturity,the yield curve is downward sloping.The yield curve generated by expectations theory alone would be:

A)more steeply downward sloping.
B)more upward sloping.
C)less steeply downward sloping.
D)none of the above.

Question 26

The current market interest rate for one year maturity bond is 10%.The forward rate for a one year investment starting in one year from now is 8%.The forward rate for a one year investment starting in two year from now is 12%.According to the expectations theory of term structure,the shape of the yield curve between 1 year maturity and 3year maturity is:

A)descending.
B)ascending.
C)ascending then descending.
D)descending then ascending.

Question 27

The current market interest rate for two-year maturity bond is 10%.The forward rate for a one year investment starting in one year from now is 8%.According to the expectations theory of term structure,the current one year maturity market interest rate is:

A)smaller than 8%.
B)larger than 10%.
C)equal to 9%.
D)equal to 8%.

Question 28

According to the expectations theory,an upward sloping yield curve indicates that security investors:

A)expect future interest rates to fall.
B)observe that substitute security interest rate falls.
C)expect future interest rates to rise.
D)observe that substitute security interest rate rises.

Question 29

Which of the following statements is NOT correct? In order to represent two bonds as two distinct points on the same yield curve,the two bonds must have the same:

A)marketability.
B)default risk.
C)put/call option.
D)term to maturity.

Question 30

The liquidity premium theory can generate a downwards sloping yield curve if investors expect:

A)a large increase in future interest rates.
B)a small increase in future interest rates.
C)a small increase in future interest rates.
D)a large decrease in future interest rates.

Question 31

If investors expect higher future interest rates,the yield curve generated by the liquidity premium theory is ______ and ____________than the yield curve implied by the expectations theory.

A)ascending; steeper
B)ascending; flatter
C)descending; steeper
D)descending; flatter

Question 32

The liquidity premium theory of the term structure of interest rates:

A)denies the importance of expectations.
B)only supports ascending yield curves.
C)assumes that for a given yield investors prefer several successive short term investments rather than one long term one.
D)assumes that investors only accept to invest in their preferred maturity.

Question 33

The current market interest rate for one year maturity bond is 10%.The forward rate for a one year investment starting in one year from now is 8%.According to the expectations theory of term structure,the current two-year maturity market interest rate is:

A)smaller than 8%.
B)larger than 10%
C)between 8% and 10%.
D)8%.

Question 34

What is the one-year forward rate three years from now if the current three- and four-year rates are 5.50% and 5.80%,respectively?

A)The rate cannot be calculated from the information above.
B)6.2%
C)6.7%
D)4.6%

Question 35

Which of the following theories of the term structure of interest rates best explains discontinuities in the yield curve?

A)The market segmentation theory
B)The liquidity premium theory
C)The expectations theory
D)The preferred-habitat theory

Question 36

In the market segmentation theory:

A)the investors would consider investing shorter term than their investment horizon if they expect an increase in the interest rates.
B)an additional reward must be offered to investors to invest in a maturity that is not their favourite.
C)the investors only supply funds for securities with a maturity corresponding to their investment horizon.
D)a change in yield in one segment affects other segments at once.

Question 37

The term structure of interest rates refers to the relationship between yields and:

A)maturity.
B)default risk.
C)market interest rates.
D)marketability.

Question 38

If investors expect slightly lower future interest rates,the yield curve generated by the liquidity premium theory is ______and the yield curve implied by the expectations theory is _______.

A)upward sloping; downward sloping
B)upward sloping; upward sloping
C)downward sloping; upward sloping
D)downward sloping; downward sloping

Question 39

Which of the following statements is NOT correct?

A)The greater is the default risk of a bond,the greater is its yield.
B)The better credit rating a bond gets,the higher is its yield.
C)The higher is the probability of non-payment on a bond,the higher is its yield.
D)Government bonds have lower yields than corporate bonds of similar characteristics.

Question 40

According to the expectations theory a downward sloping yield curve indicates that future short-term rates are expected to _______.

A)fall
B)rise
C)remain unchanged
D)fluctuate

Question 41

A call option is a desirable feature of a bond for __________ and the put option is a desirable feature of a bond for ____________.

A)investors; issuers
B)issuers; investors
C)investors; investors
D)issuers; issuers

Question 42

Describe four important factors bond-rating agencies consider when assigning a bond rating.

Question 43

Speculative-grade bonds are:

A)bonds that ratings agencies rate in the top four rating categories.
B)bonds that ratings agencies rate below 'BBB' (S&P)or below 'Baa' (Moody's).
C)bonds that ratings agencies rate above 'BBB' (S&P)or 'Baa' (Moody's).
D)bonds that legally require ratings by ratings agencies like S&P and Moody's.

Question 44

Which of the following statements is NOT correct?

A)BBB rating is better than B rating.
B)B rating is better than CCC rating.
C)C rating is better than CCC rating.
D)AA rating is better than BBB rating.

Question 45

Define the concept "marketability".Why is marketability considered essential in determining offering rates?

Question 46

An investor is more likely to exercise a put option on a bond when:

A)interest rates are expected to increase.
B)interest rates are expected to decrease.
C)the security's price is expected to increase.
D)the security's rating is upgraded by Moody's.

Question 47

Which of the following statements is NOT correct?

A)The credit rating is the measure of default risk estimated by a credit rating agency.
B)Standard & Poor's is a credit rating agency.
C)The rating assigned at the time of the issue is valid up to the maturity date of the security.
D)The higher rating grade the security is assigned the lower is the assessed default risk.

Question 48

Define default risk.Why it is important to consider such risk?

Question 49

Which security below should we use as a benchmark to measure the default risk of a 3-year bond issued by a bank?

A)3-year Commonwealth government bond
B)1-year bond issued by a bank
C)3-year Corporate bond
D)There are not enough data to conclude.

Question 50

BBB rated bond is:

A)a junk bond.
B)speculative grade bond.
C)investment grade bond.
D)callable bond.

Question 51

Bond A and bond B are similar except for one characteristic: bond A is not callable whereas bond B is callable.Investors will want a higher yield on bond _____ and will pay ______ for the bond.

A)A; less
B)A; more
C)B; less
D)B; more

Question 52

The greater the marketability of a security:

A)the lower is the yield of the security.
B)the lower is the price of the security.
C)the more difficult it is to sell the security.
D)the higher the probability the face value at maturity will be repaid fully.

Question 53

Discuss the flight-to-quality argument on default risk premium and business cycle.

Question 54

A bond investor is more likely to exercise a put option in a bond contract if:

A)market interest rates increase.
B)market interest rates decrease.
C)the default risk of a bond decreases.
D)good news about the bond issuer financial position has been released.

Question 55

A security's default risk can be measured as:

A)the difference between the rate paid on the security and the rate paid on a default-free security,with all factors other than default risk being held constant.
B)the difference between the rate paid on the security and the rate paid on a bond,with all factors other than default risk being held constant.
C)the difference between the prime lending rate and the rate paid on a default-free security,with all factors other than default risk being held constant.
D)none of the above.

Question 56

The default risk premiums are expected to increase:

A)with the upgrading of credit ratings.
B)in recessions.
C)with the decrease in the probability of default.
D)with the increase in marketability of the security.

Question 57

Which of the following statements about callable bonds is NOT correct?

A)Callable bonds have higher yields than comparable non-callable bonds.
B)The call price is usually at par or slightly above the bond's par value.
C)The shorter is the term to maturity,the greater is the call interest premium.
D)Investors are notified when bonds are called.

Question 58

Call interest premium is:

A)the difference in interest rates between callable and comparable non-callable bonds.
B)the difference in interest rates between puttable and comparable non-puttable bonds.
C)the difference in interest rates between puttable and comparable non-callable bonds.
D)the difference in interest rates between callable and comparable non-puttable bonds.

Question 59

Which of the following statements is NOT correct?

A)The more-likely is default on a security,the higher is its yield.
B)The better is the credit rating of a security,the lower is its yield.
C)The higher is the probability of repayment on a bond,the higher is its price.
D)The higher is the default risk of a bond,the higher is its price.

Question 60

Which of the following is NOT a factor influencing the marketability of a security?

A)costs of trade.
B)costs of physical transfer.
C)costs of search.
D)costs of borrowing.