Deck 7: Risk Structure and Term Structure of Interest Rates

Question 1

Default risk

A)is the probability that a borrower will not pay in full the promised interest or principal.
B)exists only for the bonds of small corporations.
C)is also known as market risk.
D)is zero for bonds issued by cities and states.

Answer 1

is the probability that a borrower will not pay in full the promised interest or principal.

Question 2

Currently, a three-month Treasury bill pays 5% interest and a ten-year Treasury bond pays 4.7% interest. What is the risk premium of the typical A-rated corporate bond that pays 5.5% interest?

A)0.5%
B)0.8%
C)5.5%
D)1.17

Answer 2

0.8%

Question 3

Which of the following is the highest bond rating assigned by Moody's Investors Service?

A)Aaa
B)A
C)B
D)Baa

Answer 3

Aaa

Question 4

Default risk arises from the fact that

A)borrowers differ in their ability to repay in full the principal and interest required by a loan agreement.
B)the tax treatment of financial instruments differs.
C)it is inherently riskier to wait for a capital gain than to receive an immediate interest payment.
D)interest rates are far more likely to go up than to go down.

Question 5

Bond ratings

A)are published annually by the federal government and are based largely on information contained in corporate tax returns.
B)are published annually by the federal government and are based on publicly available information.
C)are published monthly by the federal government and are based on publicly available information.
D)are published by private bond-rating agencies.

Question 6

Currently, a three-year Treasury note pays 4.75%. Assuming that your tax rate is 20%, what is the minimum interest rate that you would you need to earn on a tax-free municipal bond in order to buy it instead?

A)0.95%
B)3.8%
C)5.7%
D)15.25%

Question 7

U.S. Treasury securities

A)are considered risk free because their prices never change.
B)have been defaulted on several time in U.S. history.
C)are considered default-risk-free instruments.
D)have a large default risk premium.

Question 8

The risk structure of interest rates refers to

A)the amount of additional interest necessary to compensate savers for the greater risk of default on some bonds.
B)the relationship among the interest rates on similar bonds with different maturities.
C)the relationship among the interest rates on bonds with the same maturity.
D)the amount of additional interest necessary to compensate savers for the lesser liquidity of some bonds.

Question 9

The default risk premium is

A)relevant only for securities issued by very small companies.
B)the additional yield a saver requires for holding a risky instrument.
C)zero for corporate bonds, but quite substantial for corporate stock.
D)constant across the business cycle.

Question 10

Which of the following assigns widely-followed bond ratings?

A)Standard & Poor's Corporation
B)Securities and Exchange Commission
C)Federal Reserve
D)IBM

Question 11

Which of the following is considered a default-risk-free instrument?

A)A three-month Treasury bill
B)A share of stock issued by Google
C)A three-month commercial paper issued by GE
D)A ten-year bond issued by Intel

Question 12

When a company whose ability to repay its obligations in full is uncertain borrows funds

A)it will have to issue debt with longer maturities than would a company with a lower probability of default.
B)its bonds will sell for higher prices than would the bonds of a company with a lower probability of default.
C)it must offer investors higher yields to compensate them for the risk they take in buying their bonds or making loans.
D)it must do so through financial markets rather than through financial intermediaries.

Question 13

Savers who are risk-averse

A)care only about expected returns.
B)care only about the variability of returns.
C)care about both expected returns and the variability of returns.
D)always prefer an investment with a higher expected return to one with a lower expected return.

Question 14

Because savers are generally risk-averse

A)the long-run return on corporate bonds is greater than the long-run return on corporate stocks.
B)they are more concerned about expected returns than about the variability of those returns.
C)yields incorporate an extra premium for bearing default risk.
D)they prefer higher returns to lower returns, holding default risk constant.

Question 15

The default risk premium is measured

A)by an index published monthly by the Securities and Exchange Commission.
B)by an index published monthly by The Wall Street Journal.
C)as the difference between the yield on the security and the yield on a U.S. Treasury security of the same maturity.
D)as the difference between the nominal yield on the security and the real after-tax yield on the security.

Question 16

If the average risk premium of corporate bonds increases,

A)the average price of corporate bonds will also increase.
B)it's a indicator of a possible upcoming recession.
C)interest rates on those bonds decrease.
D)the risk premium on treasury bonds will also increase.

Question 17

Investors often pay professional analysts to gather and monitor information on the creditworthiness of borrowers because

A)federal law requires it.
B)most investors are risk neutral.
C)the cost of acquiring information about a borrower's creditworthiness can be high.
D)doing so increases the net-of-tax yield on most investments.

Question 18

Savers generally are

A)more concerned about expected returns than about the variability of those returns.
B)risk-neutral.
C)risk-averse.
D)unconcerned about expected returns, but very concerned about the variability of those returns.

Question 19

Risk-neutral savers care

A)only about expected returns and not about the variability of those returns.
B)only about the variability of returns and not about their expected value.
C)about both expected returns and the variability of those returns.
D)about neither expected returns nor about the variability of those returns.

Question 20

The default risk premium

A)brings the expected yield on a security into equality with the expected yield on a default-free security.
B)compensates risk-neutral investors for increased variability in yields.
C)required by risk-neutral investors is always greater than that required by risk-averse investors.
D)is always zero for risk-neutral investors.

Question 21

Financial instruments with high information costs

A)will usually be more liquid than similar instruments with low information costs.
B)will have lower yields than U.S. Treasury securities.
C)may not be offered for sale in some states.
D)will have lower prices than similar instruments with low information costs.

Question 22

A flight to quality refers to a shift by savers from

A)bonds and into stocks.
B)stocks and into gold or other precious metals.
C)bonds and into real assets, such as real estate.
D)low-quality bonds and into high-quality bonds.

Question 23

Suppose that savers become less willing to purchase medium-quality corporate bonds. The result will be that the prices of medium-quality corporate bonds will

A)fall relative to the price of U.S. Treasury securities, but rise relative to the price of high-quality corporate bonds.
B)rise relative to the price of U.S. Treasury securities, but fall relative to the price of high-quality corporate bonds.
C)rise relative to the prices of U.S. Treasury securities and high-quality corporate bonds.
D)fall relative to the prices of U.S. Treasury securities and high-quality corporate bonds.

Question 24

The liquidity premium

A)compensates savers for the illiquidity of an asset.
B)is announced quarterly for each asset by the Securities and Exchange Commission.
C)is published by private bond-rating agencies.
D)compensates savers for the lower yield they would otherwise receive on highly taxed assets.

Question 25

In the early 1980s, when a recession raised concern about corporations' ability to repay debt, there was a dramatic increase in

A)the yield on medium-quality corporate bonds relative to the yield on long-term Treasury securities.
B)the yield on long-term Treasury securities relative to the yield on medium-quality corporate bonds.
C)the yield on six-month T-bills relative to the yield on long-term Treasury securities.
D)the yield on interest-earning checking deposits in commercial banks relative to the yield on six-month T-bills.

Question 26

If new information becomes available indicating that a company's profits will be much less than previously believed, the flow of funds into the market for its securities will decline

A)unless the expected real interest rate on its securities rises.
B)unless the expected real interest rate on its securities falls.
C)unless the expected real interest rate on its securities remains unchanged.
D)irrespective of changes in the expected real interest rate on its securities.

Question 27

Suppose that savers become much more willing to purchase a certain type of municipal bond. The result will be that the bond's price will

A)fall relative to the price of U.S. Treasury securities but rise relative to the price of corporate bonds.
B)rise relative to the price of U.S. Treasury securities but fall relative to the price of corporate bonds.
C)rise relative to the prices of U.S. Treasury securities and corporate bonds.
D)fall relative to the prices of U.S. Treasury securities and corporate bonds.

Question 28

Which of the following statements about junk (high-risk) bonds is true?

A)They never outperform treasury bonds since they're too risky.
B)The price of junk bonds increase as their perceived risk increases.
C)They tend to perform best during recessions.
D)One can profit by owning them if market perceptions of their risk decline.

Question 29

The default risk premium fluctuates mainly

A)because bond rating agencies tend to be inconsistent in their ratings of bonds.
B)because risk-neutral investors will often become risk-averse as time passes.
C)because taxes tend to rise over the long run.
D)as new information about a borrower's creditworthiness becomes available.

Question 30

Which of the following is the lowest rating given to an investment-grade bond by Standard and Poor's?

A)AA
B)A
C)BBB
D)B

Question 31

The default of the Penn Central Railroad in the early 1970s

A)led indirectly to a fall in the price of U.S. Treasury securities.
B)strongly affected the market for municipal bonds.
C)resulted from the lack of liquidity in the U.S. Treasury bill market.
D)resulted in an increase in the default-risk premium in the commercial paper market.

Question 32

The risk premium

A)is slightly higher on U.S. Treasury securities than on the bonds of large corporations.
B)is not subject to federal income tax.
C)compensates savers both for default risk and for illiquidity of assets.
D)falls whenever illiquidity rises.

Question 33

The flight to quality during the early years of the Great Depression resulted in

A)the yield on government securities being pushed close to zero.
B)a decline in spread between medium-quality corporate bonds and long-term Treasury securities.
C)a fall in the commercial paper rate relative to the T-bill rate.
D)a decline in the price of T-bills.

Question 34

During the recession of the early 1980s the prices of U.S. Treasury securities

A)rose relative to the prices of corporate bonds.
B)fell relative to the prices of corporate bonds.
C)remained in the same relative position to the prices of corporate bonds.
D)were frozen by order of the federal government.

Question 35

If lenders anticipate no changes in liquidity, information costs, and tax differences, the yield on a risky security should be

A)greater than that on a safe security and the price of a risky security should also be greater than that of a safe security.
B)less than that on a safe security and the price of a risky security should also be less than that of a safe security.
C)greater than that on a safe security and the price of a risky security should be lower than that of a safe security.
D)less than that on a safe security and the price of a risky security should be greater than that on a safe security.

Question 36

In August 1998, the risk premium rose because

A)investors feared a revival of inflation.
B)large tax increases in the United States reduced corporate profits and led to fears of increased defaults.
C)of the Asian financial crisis.
D)of fraud in the market for municipal bonds.

Question 37

The greatest appeal of U.S. Treasury securities is that

A)they have high yields.
B)they have no default risk.
C)the U.S. Treasury will repurchase them at any time.
D)their market prices fluctuate very little.

Question 38

A company that retains a high bond rating during a recession in which many other companies see their bond ratings cut will experience

A)an increased flow of funds into the market for its securities.
B)an increased demand for its securities, driving up the expected return on them.
C)a decreased demand for its securities, driving down the expected return on them.
D)a decreased flow of funds into the market for its securities.

Question 39

Which of the following bond ratings by Moody's Investors Service would NOT be considered to be below investment grade?

A)Baa
B)Ba
C)B
D)All of these ratings are considered below investment grade.

Question 40

During the 1974-1975 recession, the rate on commercial paper increased relative to the rate on T-Bills. This was an indication of the fact that

A)investors had become nervous about the ability of the federal government to meet its financial obligations.
B)the inflation rate had increased significantly.
C)investors had become concerned about default risk in the short-term market.
D)interest on commercial paper had lost its exemption from the federal income tax.

Question 41

Interest and capital gains are taxed differently in the United States in that

A)interest is exempt from state and local taxes.
B)interest is taxed as paid, but capital gains are taxed only when realized.
C)interest is taxed as paid, but capital gains are taxed as accrued.
D)capital gains when realized are exempt from state and local taxes.

Question 42

According to the National Bureau of Economic Research an increase in risk premiums is

A)a leading indicator of the business cycle.
B)a lagging indicator of the business cycle.
C)a coincident indicator of the business cycle.
D)unrelated to the business cycle.

Question 43

Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on a thirty-year corporate bond is 10%. You would be indifferent between buying this corporate bond and buying a thirty-year municipal bond (ignoring differences in liquidity, risk, and costs of information) if the municipal bond has a yield of

A)6.5%.
B)7.0%.
C)9.5%.
D)10.0%.

Question 44

Differences in the taxation of returns

A)only affect the yields of illiquid credit market instruments.
B)have a negligible effect on the yields of credit market instruments.
C)only affect the yields of high-information cost credit market instruments.
D)create differences in yields among credit market instruments.

Question 45

If a country has a poorly functioning risk structure of corporate bond yields,

A)yields on long-term bonds will be relatively low.
B)the country's tax code will have to be adjusted to reflect this.
C)low interest rates will lead to rapid rates of growth in physical capital.
D)corporations will rely more heavily on bank loans and on new equity issues.

Question 46

Government obligations, such as Treasury bills and bonds, have

A)high liquidity and high information costs.
B)low liquidity and low information costs.
C)low liquidity and high information costs.
D)high liquidity and low information costs.

Question 47

When the yield curve is downward-sloping,

A)short-term yields are higher than long-term yields.
B)long-term yields are higher than short-term yields.
C)the bond market is anticipating the U.S. Treasury may default on its obligations.
D)the inflation rate is expected to rise.

Question 48

The yield on commercial paper minus the yield on U.S. Treasury bills

A)rises when financial markets believe that a recession is imminent.
B)falls when financial markets believe that a recession is imminent.
C)is an unreliable indicator of future economic activity.
D)is strongly affected by marginal federal income tax rates.

Question 49

Municipal bonds are issued

A)only by local governments.
B)only by state governments.
C)by both state and local governments.
D)by the federal government, and by state and local governments.

Question 50

Holding all other factors that affect yields constant, following passage of the Tax Reform Act of 1986which lowered marginal income tax ratesyields on

A)municipal bonds should have fallen relative to yields on U.S. Treasury securities.
B)U.S. Treasury securities should have fallen relative to yields on corporate bonds.
C)municipal bonds should have risen relative to yields on corporate bonds.
D)corporate bonds should have risen relative to the yields on U.S. Treasury securities.

Question 51

The existence of rating agencies has

A)lowered returns on corporate bonds.
B)raised returns on corporate bonds.
C)left returns on corporate bonds largely unaffected.
D)raised returns on both corporate bonds and Treasury securities.

Question 52

Which of the following is NOT true of the yield curve for U.S. Treasury securities?

A)Typically, it slopes upward.
B)It depicts the relationship among yields on securities of different maturities.
C)Typically, it shifts up or down rather than twists.
D)Typically, it slopes downward.

Question 53

Interest on most bonds issued by state governments is

A)exempt from state and federal income taxes.
B)exempt from state, but not from federal, income taxes.
C)exempt from federal, but not from state, income taxes.
D)subject to both state and federal income taxes.

Question 54

If the federal government replaced the current income tax with a consumption tax

A)the prices of corporate and municipal bonds would rise.
B)the prices of corporate and municipal bonds would fall.
C)the prices of corporate bonds would rise, while the prices of municipal bonds would fall.
D)the prices of corporate bonds would fall, while the prices of municipal bonds would rise.

Question 55

The term structure of interest rates

A)represents the variation in yields for related instruments differing in maturity.
B)reflects differing tax treatment received by different instruments.
C)always results in an upward-sloping yield curve.
D)usually results in a downward-sloping yield curve.

Question 56

Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state and local tax rates is 5%, and the yield on thirty-year U.S. Treasury bonds is 10%. You would be indifferent between buying a thirty-year Treasury bond and buying a thirty-year municipal bond (ignoring differences in liquidity, risk, and costs of information) if the municipal bond has a yield of

A)6.5%.
B)7.0%.
C)9.5%.
D)10.0%.

Question 57

Financial instruments with high interest rates due to higher information costs

A)tend to have less risk than similar financial instruments with low information costs.
B)also tend to be relatively illiquid.
C)also tend to have higher prices than similar financial instruments with low information costs.
D)are usually heavily traded, which serves to partially offset their having high information costs.

Question 58

Many savers are willing to accept a lower interest rate on municipal bonds than on comparable instruments because

A)the after-tax yield on municipal bonds is greater.
B)municipal bonds invariably have lower default risk.
C)municipal bonds are more liquid than most other instruments.
D)the yield on municipal bonds is considered inflation proof.

Question 59

The term structure is usually defined with yields on which securities?

A)Corporate bonds
B)Commercial paper
C)U.S. Treasury securities
D)Municipal bonds

Question 60

Suppose that information costs fall with respect to medium-quality corporate bonds. The result will be that the prices of medium-quality corporate bonds will

A)fall relative to the price of U.S. Treasury securities, but rise relative to the price of high-quality corporate bonds.
B)rise relative to the price of U.S. Treasury securities, but fall relative to the price of high-quality corporate bonds.
C)rise relative to the prices of U.S. Treasury securities and high-quality corporate bonds.
D)fall relative to the prices of U.S. Treasury securities and high-quality corporate bonds

Question 61

The segmented markets theory

A)has difficulty explaining why yield curves usually slope up.
B)has difficulty explaining why yield curves usually slope down.
C)has difficulty explaining why yields on instruments of different maturities tend to move together.
D)provides a good explanation of why yields on instruments of different maturities tend to move together.

Question 62

Which of the following statements is true of the yield curve?

A)Typically, it changes its shape without shifting up or down.
B)Typically, it shifts up or down without changing its shape.
C)Typically, if it shifts up or down it will also change its shape.
D)It only rarely shifts up or down or changes its shape.

Question 63

The segmented markets theory

A)explains upward-sloping yield curves as resulting from the demand for long-term bonds being high relative to the demand for short-term bonds.
B)explains upward-sloping yield curves as resulting from the demand for long-term bonds being low relative to the demand for short-term bonds.
C)explains upward-sloping yield curves as resulting from the favorable tax treatment of long-term bonds.
D)is unable to account for upward-sloping yield curves.

Question 64

If the expected path of interest rates on one-year bonds over the next five years is 2%, 4%, 3%, 2%, and 1%, 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)five years.

Question 65

A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a two-year bond according to the preferred habitat theory?

A)4.5%
B)4.75%
C)4.95%
D)4.975%

Question 66

A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a three-year bond according to the preferred habitat theory?

A)4.5%
B)4.68%
C)4.85%
D)5.05%

Question 67

A steep yield curve may be an indicator of

A)expectations of a significant increase in inflation.
B)an upcoming recession.
C)an economic slowdown.
D)lower future short-term interest rates.

Question 68

Under the expectations theory if market participants expect that future short-term rates will be higher than current short-term rates, the yield curve will

A)slope upward.
B)slope downward.
C)be flat.
D)slope upward, slope downward, or be flat, depending on risk, liquidity, cost of information, and tax considerations.

Question 69

According to the preferred habitat theory, what does a flat yield curve indicate?

A)Short-term interest rates are expected to remain stable.
B)Short-term interest rates are expected to rise.
C)Short-term interest ratess are expected to fall.
D)Long-term interest rates are expected to fall.

Question 70

Which of the following is true of the segmented markets theory?

A)It assumes that borrowers have particular periods for which they want to borrow.
B)It assumes that lenders always lend for short periods.
C)It provides a good explanation for why yield curves usually slope upward.
D)It assumes that instruments with different maturities are perfect substitutes.

Question 71

Which of the following statements is true?

A)The more liquid the bond, the lower the interest rate.
B)Tax-free bonds normally have a higher interest rate than other types of bonds.
C)The price of a bond increases as it becomes more risky.
D)The yield curve illustrates the relative risks of alternative types of bonds.

Question 72

Unlike the segmented markets theory, the expectations theory attributes the slope of the yield curve to

A)tax considerations.
B)the fact that short-term bonds are not perfect substitutes for long-term bonds.
C)market expectations.
D)the variance in the inflation rates over the business cycle.

Question 73

The implication of the expectations theory that expected returns for a holding period must be the same for bonds of different maturities depends on the assumption that

A)yield curves usually slope upward.
B)yield curves usually slope downward.
C)instruments with different maturities are perfect substitutes.
D)savers are usually risk averse.

Question 74

The expectations theory

A)has difficulty explaining why U.S. Treasury securities have lower yields than corporate bonds.
B)has difficulty explaining why yields on bonds of different maturities move together.
C)has difficulty explaining why yield curves usually slope upward.
D)accounts well for the fact that yield curves usually slope upward.

Question 75

Which of the following is NOT true of the expectations theory?

A)It assumes that instruments with different maturities are perfect substitutes.
B)It implies that a long-term bond rate equals the average of short-term rates covering the same investment period.
C)It implies that the yield curve will usually slope upward.
D)It implies that the shape of the yield curve depends on the expected pattern of future short-term rates.

Question 76

The yield on a thirty-year Treasury bond is 8% at the same time as the yield on two-year Treasury note is 5%. This occurrence

A)indicates that the yield curve is downward sloping.
B)is well explained by the segmented markets theory.
C)is largely explained by the favorable tax treatment of Treasury notes.
D)indicates that the bond market is anticipating that inflation will fall.

Question 77

According to the expectations theory, if investors believed that, for a holding period the average of the expected future short-term yields was greater than the long-term yield, they would act so as to

A)drive up the price of the short-term security and drive down the price of the long-term security.
B)drive down the price of the short-term security and drive up the price of the long-term security.
C)drive down the prices of the short-term and long-term securities.
D)drive up the prices of the short-term and long-term securities.

Question 78

According to the preferred habitat theory, the yield curve normally has a positive slope because

A)short-term interest rates are expected to rise.
B)term premiums rise as the time to maturity increases.
C)risk premiums rise over time.
D)long-term bonds are more liquid than short-term bonds.

Question 79

What is the most important contrast between the segmented markets theory and the expectations theory?

A)The expectation theory states that investors view similar assets that differ only with respect to maturity as perfect substitutes.
B)The segmented markets theory states that investors view similar assets that differ only with respect to maturity as perfect substitutes.
C)The expectations theory does a better job of explaining why yield curves typically are upward-sloping.
D)The segmented markets theory does a better job of explaining why yields on instruments of different maturities tend to move together.

Question 80

The expectations theory suggests that

A)the yield curve should normally be upward-sloping.
B)the yield curve should normally be downward-sloping.
C)the slope of the yield curve depends on the expected future path of short-term rates.
D)the slope of the yield curve reflects the risk premium incorporated into the yields on long-term bonds.