Deck 5: The Structure of Interest Rates

Question 1

Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 4 percent today, a two- year bond paying 5 percent today, a three-year bond paying 5.3 percent today, or a four-year bond paying 5.8 percent today.The investor would buy

A)a one-year bond today.
B)a two-year bond today.
C)a three-year bond today.
D)a four-year bond today.

Answer 1

D

Question 2

The process of turning assets such as mortgages into bonds sold to investors is

A)default.
B)standard deviation.
C)standardization.
D)securitization.

Answer 2

D

Question 3

Which of the following is true of short­term interest rates?​

A)Short-term interest rates decline when long-term interest rates increase.
B)​Short­term interest rates are more volatile than long­term interest rates.
C)​Short­term interest rates are higher than long­term interest rates.
D)​Short­term interest rates are less volatile than long­term interest rates.

Answer 3

B

Question 4

The U.S.Treasury security that was issued most recently, in the primary market, is known as the

A)off-the-run security.
B)on-the-run security.
C)in-the-money security.
D)out-of-the-money security.

Question 5

The interest that an investor will earn, on maturity, if she purchases a two year bond by paying 6.6 percent today is

A)1.1025.
B)1.1363.
C)1.0036.
D)1.0003.

Question 6

Which of the following was an outcome of the announcement made by the U.S.government in October 2001 that it will stop selling 30-year bonds?

A)There was a sharp fall in the price of the securities and an increase in the yield to maturity.
B)There was a sharp rise in the price of the securities and a decline in the yield to maturity.
C)There was a sharp rise in the price of the securities and an increase in the yield to maturity.
D)There was a sharp fall in the price of the securities and a decline in the yield to maturity.

Question 7

Which of the following is a security in which a saver buys the security for a given time to maturity, earning interest at the specified rate?

A)Commercial paper
B)Debenture
C)Government bond
D)Certificates of deposit

Question 8

Which of the following is true of a certificate of deposit?

A)It is sold by large corporations to raise short-term funds.
B)​A fall in its demand will lead to an increase in the price of the security and a fall in its yield to maturity.
C)Higher the term to maturity of a certificate of deposit, higher the yield to maturity.
D)​It is not a liquid security and cannot be transferred from one party to another.

Question 9

Which of the following bonds has a comparatively higher yield to maturity?​

A)​A one­year bond with a 6.7 percent interest today
B)​A three­year bond with a 5 percent interest today
C)​A two­year bond with a 4 percent interest today
D)​A four­year bond with a 4.5 percent interest today

Question 10

Which of the following securities has the highest yield to maturity?

A)An on-the-run Treasury bond with ten years to maturity
B)An on-the-run Treasury bond with twenty years to maturity
C)An off­the­run Treasury bond with twenty­four years to maturity​
D)An off-the-run Treasury bond with twelve years to maturity

Question 11

​Which of the following is a possible outcome of a fall in the demand for a security?

A)​It will lead to an increase in the price and the yield to maturity of the security.
B)​It will lead to an increase in the price of the security and a fall in its yield to maturity.
C)​It will lead to a fall in the price of the security and a fall in its yield to maturity.
D)​It will lead to a fall in the price of the security and an increase in its yield to maturity.

Question 12

A basis point equals

A)one hundredth of a percentage point.
B)one tenth of a percentage point.
C)one half of a percentage point.
D)ten percentage points.

Question 13

An on-the-run ten-year Treasury security is

A)a ten-year government bond that is in greatest demand by investors who want to hold it until it matures.
B)a ten-year government bond that can be used to pay estate taxes, also known as a flower bond.
C)a non-taxable ten-year government bond.
D)a ten-year government bond that was the most recently issued.

Question 14

A corporate bond with a financial rating of _____ is likely to have the lowest yield to maturity.?

A)Ccc
B)Baa
C)Aaa
D)BBB

Question 15

What does a yield curve show?

A)The yield to maturity on the vertical axis and the time to maturity on the horizontal axis
B)The time to maturity on the vertical axis and the yield to maturity on the horizontal axis
C)The yield to maturity on the vertical axis and the maturity date on the horizontal axis
D)The maturity date on the vertical axis and the yield to maturity on the horizontal axis

Question 16

The relationship between interest rates with differing times to maturity is known as the ___________of interest rates.

A)term structure
B)term curve
C)yield curve
D)yield structure

Question 17

When the federal tax rate on interest income is 20 percent, an investor will purchase______in order to maximize returns.

A)a local government bond with an interest rate of 7 percent
B)a corporate bond with an interest rate of 8 percent
C)a corporate bond with an interest rate of 8.5 percent
D)a local government bond with an interest rate of 6.5 percent

Question 18

​Which of the following securities is likely to have the highest yield to maturity?

A)​A corporate bond with a Baa rating
B)​A corporate bond with AAA rating
C)​A government bond exempted from federal income tax
D)​A certificate of deposit with a three months to maturity

Question 19

A debt security sold by large corporations to raise short­term funds is known as a(n)​

A)​commercial paper.
B)​treasury bill.
C)​debenture.
D)​bond.

Question 20

The analysis of the term structure of interest rates assumes that​

A)​there is uncertainty about future interest rates.
B)​there is no risk involved in the purchase and sale of long­term securities.
C)​short­term and long­term securities offer the same rate of interest.
D)​there are no transaction costs.

Question 21

$\text { 32. Which of the following statements is true? }$

A)A short-term bond and a long-term bond provides the same premium.
B)Investors in short-term bonds earn higher premiums than investors in long-term bonds.
C)A change in the interest rates of bonds affect the prices of long-term bonds more than the prices of short- term bonds.
D)A change in the interest rates of bonds affect the prices of short-term bonds more than the prices of long- term bonds.

Question 22

An inverted yield curve indicates that

A)an economic expansion has just begun.
B)an economic expansion has been going on for several years.
C)a recession is about to begin.
D)a recession is nearly over.

Question 23

Consider the following hypothetical situation.The interest rate on a two-year bond today is 7.5 percent and the interest rates on two one-year bonds are 3 percent and 4 percent respectively.The term premium earned by the investors is

A)5 percent.
B)4 percent.
C)4.25 percent.
D)6 percent.

Question 24

What does a flat yield curve imply, according to the expectations theory of the term structure of interest rates?

A)The price level will not change in the future.
B)Future long-term rates are expected to rise.
C)Future long-term rates are expected to fall.
D)Future short-term rates are not expected to change.

Question 25

If the interest rate on a one-year bond today is 7.5 percent and the expected interest rate on a one-year bond one year from now is ​5.6 percent, then the interest rate on a two­year bond will be

A)​7 percent
B)​12.5 percent
C)​8.5 percent
D)​6.55 percent

Question 26

Which of the following is likely to happen to short-term and long-term interest rates during recessions?

A)The short-term interest rates rise during recessions but the long-term interest rates fall during recessions.
B)The short-term interest rates fall during recessions but the long-term interest rates rise during recessions.
C)Both the short-term and the long-term interest rates fall during recessions.
D)Both the short-term and the long-term interest rates rise during recessions.

Question 27

The present value of a two­year bond with a future payment of $1,345.50 and the yield to maturity of 3.6 percent is​

A)​$1,300
B)​$1,500.50
C)​$1,253.62
D)​$1,246.72

Question 28

Which of the following is true of the analysis of the term structure of interest rates?​

A)​It assumes that investors in long­term securities face high transaction costs.
B)​It assumes that investors can predict short­term interest rates accurately.
C)​It assumes that the yield curve is always flat.
D)​It assumes that investors in bonds have a preferred habitat.

Question 29

Which of the following bonds has the greatest interest-rate risk?

A)A one-year bond
B)A five-year bond
C)A ten-year bond
D)A thirty-year bond

Question 30

According to the expectations theory of the term structure of interest rates,

A)a short-term interest rate is equal to the average of current and expected future long-term interest rates.
B)a short-term interest rate has no relation to long-term interest rates.
C)a long-term interest rate is equal to the average of current and expected future short-term interest rates.
D)the yield curve is always flat.

Question 31

Term premium refers to

A)the interest rate on a long-term bond minus the average interest rate on future short-term bonds.
B)the interest rate on a long-term bond plus the average interest rate on future short-term bonds.
C)the average interest rate on future short-term bonds.
D)the standard deviation of the interest rate on long-term bonds.

Question 32

Assume that the bond market is in equilibrium.The current interest rate on one-year bonds is 5 percent, the interest rate on one-year bonds, one year from now is 6 percent, and in two years the interest rate on one-year bonds will be 6.5 percent.Assume that there is no term premium on a one-year bond.If the term premium equals 0.5 percent × the number of years to maturity, for two-year bonds and three-year bonds.The interest rate today on the two-year bond is and the interest rate today on a three-year bond is .

A)5.5 percent; 5.8 percent
B)6.0 percent; 6.3 percent
C)6.2 percent; 6.8 percent
D)6.5 percent; 7.3 percent

Question 33

Consider a two-year bond that can be purchased for $550.What is the yield to maturity on the bond if it promises a payment of $890 in two years?​

A)​27.2 percent
B)​20 percent
C)​6 percent
D)​18.1 percent

Question 34

$\text { 38. Which of the following statements is true? }$

A)The prices of debt securities fall during recessions.
B)Interest rates on neither the short-term securities nor the long-term securities fall in recession.
C)Interest rates on long-term securities fall more than the interest rates on short-term securities in recession.
D)Interest rates on short-term securities fall more than the interest rates on long-term securities in recession.

Question 35

Suppose an investor purchases a one-year bond today, for $960.The bond promises a return of $1,000.She purchases another one-year bond, after a year, for $887 that promises a return of $990.What is the yield to maturity earned by the investor on the purchase of these two short­term bonds?​

A)​6.50 percent
B)​7.85 percent
C)​8 percent
D)​10 percent

Question 36

According to the expectations theory of the term structure of interest rates, if the interest rate on a one-year bond today is 3.0 percent, the expected interest rate on a one-year bond one year from now is 4.0 percent, and the expected interest rate on a one-year bond two years from now is 4.5 percent, then the interest rate on a two-year bond today is

A)3.00 percent.
B)3.50 percent.
C)3.83 percent.
D)4.00 percent.

Question 37

Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates.The current interest rate on one-year bonds is 3.0 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 3.5 percent.Assume that there is no term premium on a one-year bond.Suppose there is a term premium equals 0.75 percent × the number of years to maturity, for the two- year bond.The interest rate today on the two-year bond is

A)3.25 percent.
B)4.00 percent.
C)4.75 percent.
D)5.00 percent.

Question 38

Which of the following bonds is likely to have the highest term premium?

A)A one-year bond
B)A five-year bond
C)A ten-year bond
D)A thirty-year bond

Question 39

What does an upward-sloping yield curve imply, according to the expectations theory of the term structure of interest rates?

A)Investors expect long-term interest rates to fall in the future.
B)Investors expect future short-term interest rates to be lower than the current short-term interest rate.
C)Investors expect future short-term interest rates to be the same as the current short-term interest rate.
D)Investors expect future short-term interest rates to be higher than the current short-term interest rate.

Question 40

What does a downward-sloping yield curve imply, according to the expectations theory of the term structure of interest rates?

A)Investors expect long-term interest rates to rise in the future.
B)Investors expect future short-term interest rates to be lower than the current short-term interest rate.
C)Investors expect future short-term interest rates to be the same as the current short-term interest rate.
D)Investors expect future short-term interest rates to be higher than the current short-term interest rate.

Question 41

What is the reason for a low rated security to generate a high yield to maturity?

Question 42

What do steep upward-sloping yield curves indicate about the business cycle?

Question 43

Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates.You observe the following interest rates available today on bonds with differing times to maturity.(You may ignore transactions costs.)
$$\begin{array} { l l } \text { Time to maturity } & \text { Yield to maturity } \\\text { 1 year } & 5.0 \% \\\text { 2 years } & 7.0 \% \\\text { 3 years } & 7.5 \%\end{array}$$

The term premium for the two-year bond is the extra yield to maturity paid on a two-year bond compared with buying two separate one-year bonds (one today and another after one year).You believe that the term premium on the two-year bond is 0.5 percent.
The term premium for the three-year bond is the extra yield to maturity paid on a three-year bond compared with buying three separate one-year bonds (one today, another after one year, and another after two years).You believe that the term premium on the three-year bond is 1.0 percent.
Given your beliefs about the term premiums on two-year and three-year bonds, calculate the interest rates on one- year bonds that you expect to prevail one year from now and two years from now.In other words, what do you expect to be the yield to maturity on a one-year bond one year from now and what do you expect to be the yield to maturity on a one-year bond two years from now? Explain and show all your work.

Question 44

A sharp upward sloping yield curve indicates that

A)an economic expansion has just begun.
B)an economic expansion has been going on for several years.
C)a recession is about to begin.
D)an economic expansion is nearly over.

Question 45

Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 5 percent today, a two- year bond paying 5.4 percent today, a three-year bond paying 5.8 percent today, or a four-year bond paying 6.2 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 6 percent, a one-year bond purchased two years from now is expected to have an interest rate of 7 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 8 percent.Explain with the help of suitable calculations, which of the following would the investor decide to do?
a.The investor will purchase a one-year bond today, followed by three successive one-year bonds.
b.The investor will purchase a two-year bond today, followed by two successive one-year bonds.
c.The investor will purchase a three-year bond today, followed by a one-year bond.
d.The investor will purchase a four-year bond today.

Question 46

Which of the following statements is true?

A)The yield curve slopes downward when the term spread is positive.
B)Researchers suggest that the smaller the term spread, the higher the chance is of a recession in the coming year.
C)The yield curve slopes upward when the term spread is negative
D)Researchers suggest that the larger the spread, the higher the chance is of a recession in the coming year.

Question 47

Term spread is the interest rate on a long-term debt security_____the interest rate on a short-term debt security.

A)minus
B)plus
C)times
D)divided by the interest rate on a short-term debt

Question 48

Which of the following statements is true?

A)During recessions, there is an increase in the demand for debt securities.
B)During recessions, there is an increase in the supply of debt securities.
C)During recessions, the supply-curve of debt securities shift comparatively more, to the left, than the demand- curve for securities.
D)During recessions, the demand-curve for debt securities shift comparatively more, to the left, than the supply- curve of securities.

Question 49

If the interest rate on three-month Treasury securities is 5 percent and the interest rate on ten-year Treasury securities is 6 percent, then the odds of a recession are

A)less than 15 percent.
B)about 25 percent.
C)about 40 percent.
D)about 80 percent.

Question 50

When an economic expansion has been going on for several years, you are likely to observe that

A)the yield curve is sharply upward sloping.
B)the yield curve is somewhat upward sloping.
C)the yield curve is flat or inverted.
D)the yield curve is a vertical straight line.

Question 51

Which of the following is a possible outcome of a negative or low term spread?

A)A low of negative spread may indicate higher short-term interest rates in the future.
B)A low or negative spread may cause the yield curve to slope upward.
C)A low or negative spread may reduce lending by banks.
D)A low or negative spread may indicate the early stages of economic expansions.

Question 52

Which of the following is likely to happen to short-term and long-term interest rates during expansions?

A)Both the short-term and the long-term interest rates rise during expansions.
B)The short-term interest rates fall during expansions but the long-term interest rates rise during expansions.
C)Both the short-term and the long-term interest rates fall during expansions.
D)The short-term interest rates rise during expansions but the long-term interest rates fall during expansions.

Question 53

Compare a two-year bond with two successive one-year bonds, in which an investor buys a one-year bond today, then another one-year bond when the first matures.Suppose the two-year bond has an annual interest rate of 4 percent.
Consider the pattern of interest rates on the one-year bonds listed below and explain whether an investor should buy the two-year bond or the one-year bond today, assuming that the only thing that matters to the investor is the amount of money she has at the end of the two years; that is, she is risk neutral.In each case, how much would an investor have at the end of two years if she invested $1,000 today? Show your work.Round to the nearest penny ($0.01).In each case be sure to say which bond the investor would buy today.
a.The interest rate on a one-year bond today is 1 percent, and the interest rate on a one-year bond purchased in one year from now is 8 percent.

b.The interest rate on a one-year bond today is 2 percent; and the interest rate on a one-year bond purchased one-year from now is 6 percent.

c.The interest rate on a one-year bond today is 3 percent; and the interest rate on a one-year bond purchased one-year from now is 5 percent.

d.The interest rate on a one-year bond today is 5 percent; nd the interest rate on a one-year bond purchased one-year from now is 3 percent.

Question 54

Put the following securities in order according to their after-tax interest rates, from lowest to highest.The federal tax rate on interest income is 30 percent.Show your work.
A: A corporate bond that pays an interest rate of 6 percent.B: A corporate bond that pays an interest rate of 7 percent.
C: A local government bond identical that pays an interest rate of 4.5 percent.

Question 55

If you observe that the current yield curve is upward sloping, it is likely that

A)an economic expansion has just begun.
B)an economic expansion has been going on for several years.
C)a recession is about to begin.
D)a recession is nearly over.

Question 56

If the interest rate on three-month Treasury securities is 6 percent and the interest rate on ten-year Treasury securities is 4 percent, then

A)the economy has probably just emerged from a recession.
B)the yield curve slopes upward steeply.
C)a recession is likely to occur.
D)the economy is probably in the middle of an economic expansion.

Question 57

Explain how an economist could use the slope of the yield curve to analyze the probability that a recession will occur.
Explain why the spread may matter.

Question 58

Which of the following is true of the yield curve?

A)The yield curve is steep and is upward sloping when the recession ends and the economy starts to recover.
B)The yield curve is flat and is downward sloping when the recession ends and the economy starts to recover.
C)The yield curve is flat or inverted when the term premium is small.
D)The yield curve is downward sloping when the term premium is large.