Chapter 07 - The Risk and Term Structure of Interest RatesChapter 07 The Risk and Term Structure of Interest Rates Multiple Choice Questions 1. (p. 148) The bond rating of a security reflects: a. The size of the coupon payment relative to the face value B. The likelihood the lender/borrower will be repaid by the borrower/issuer c. The return a holder is likely to receive d. The size of the coupon rate relative to other interest rates AACSB: Analytic BLOOMS: Knowledge LOD: 1 2. (p. 148) The two best known bond rating services are: a. The Federal Reserve and Moody's Investment Services b. The Federal Reserve and the U.S. Treasury c. Standard & Poor's and the Wall Street Journal D. Standard & Poor's and Moody's Investment Services AACSB: Analytic BLOOMS: Knowledge LOD: 1 3. (p. 148) Investors usually obtain bond ratings from: A. Private bond-rating agencies b. The annual tax returns of the issuer c. The U.S. government from publicly available information d. Public Information made available by the bond issuers AACSB: Analytic BLOOMS: Knowledge LOD: 2 7-1 Chapter 07 - The Risk and Term Structure of Interest Rates 4. (p. 148) Which of the following assigns widely followed bond ratings? a. The Federal Reserve b. The U.S. Treasury c. The New York Stock Exchange D. Standard & Poor's AACSB: Analytic BLOOMS: Knowledge LOD: 2 5. (p. 148) Which of the following assigns widely followed bond ratings? a. The Federal Reserve b. The Wall Street Journal C. Moody's Investor Service d. The Nasdaq AACSB: Analytic BLOOMS: Knowledge LOD: 2 6. (p. 149) What is the highest bond rating assigned by Standard and Poor's? a. AA b. EEE C. AAA d. A AACSB: Analytic BLOOMS: Knowledge LOD: 1 7-2 Chapter 07 - The Risk and Term Structure of Interest Rates 7. (p. 149) The lowest rating for an investment grade bond assigned by Moody's is: A. Baa b. A c. BBB d. Aa AACSB: Analytic BLOOMS: Knowledge LOD: 1 7-3 Chapter 07 - The Risk and Term Structure of Interest Rates 8. (p. 149) Bonds rated as "highly speculative": a. Are rated so because they guarantee high returns for the buyer B. Are commonly referred to as junk bonds c. Are ranked just below investment grade by Standard & Poor's d. Are rated so because they do not have any default risk AACSB: Analytic BLOOMS: Knowledge LOD: 2 9. (p. 149) Which of the following would be most likely to earn an AAA rating from Standard & Poor's? A. A 30-year bond issued by the U.S. Treasury b. A bond issue by a new vegetarian fast-food chain c. A 10-year bond issued by a state or municipality d. Shares of stock in Coca-Cola AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 10. (p. 150) Once a bond rating is assigned, it: a. Never changes over the life of the bond B. Can change as the financial position of the issuer changes c. Can only change if the rating change is approved by the Securities and Exchange Commission d. Can change on the next bond from the issuer but is fixed for the current bond AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-4 Chapter 07 - The Risk and Term Structure of Interest Rates 11. (p. 150) Commercial paper refers to: a. The financial publications read by the CEO's of public corporations b. Any debt security with a maturity exceeding one year c. Short-term collateralized securities issued only by corporations D. Unsecured short-term debt issued by corporations and governments AACSB: Analytic BLOOMS: Comprehension LOD: 1 12. (p. 150) Most commercial paper is: a. Issued with maturities exceeding one year b. Issued with maturities between 50 and 75 days C. Used exclusively for short-term financing needs d. Issued by foreign companies doing business in the United States AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 1 13. (p. 151) If a bond's rating improves it should cause: a. The bond's price and yield to increase, all other factors constant b. The bond's price and yield to decrease, all other factors constant C. The bond's price to increase and its yield to decrease, all other factors constant d. The bond's price to decrease and its yield to increase, all other factors constant AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-5 The demand for this bond to increase. and its yield to increase. all other factors constant d. (p. 152) If a bond's rating improves. The demand for and the yield of this bond to increase.Chapter 07 .The Risk and Term Structure of Interest Rates 14. The demand for this bond to decrease. Both the demand for and the price of the bond to decrease. all other factors constant AACSB: Reflective Thinking BLOOMS: Application LOD: 2 7-6 . all other factors constant b. we would expect: A. all other factors constant c. Is always constant AACSB: Analytic BLOOMS: Comprehension LOD: 2 7-7 . Treasury bond d. Should have a direct relationship with the bond's price c. 151) The risk spread: A. Treasury are referred to as benchmark bonds because: a. Treasury bond of the same maturity c. government have the same rate of interest AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 16. 151) Bonds issued by the U. Assigned by a bond-rating agency AACSB: Analytic BLOOMS: Comprehension LOD: 1 17.Chapter 07 . (p.S. Less than 0 (zero) for a U.S.S.The Risk and Term Structure of Interest Rates 15. Should have an inverse relationship with the bond's yield d. The difference between a bond's purchase price and selling price B. All bonds from the U. They are the closest thing to a risk-free bond c. They are always purchased for a premium B. Is also known as the default-risk premium b. The difference between the bond's yield and the yield on a U. 151) The risk spread is: a. (p. All bonds from national governments are labeled as benchmark bonds d. (p.S. (p. It should have an inverse relationship with the bond's price D. It should have a direct relationship with the bond's yield c.Chapter 07 . It should have a direct relationship with the bond's price AACSB: Reflective Thinking BLOOMS: Application LOD: 2 7-8 .The Risk and Term Structure of Interest Rates 18. It should be higher for highly speculative bonds than investment grade bonds b. 151) All of the following are true about the risk spread except: a. Must always be greater than 0 (zero) d. Is also known as the risk spread c. (p. Is less than 0 (zero) for a U.The Risk and Term Structure of Interest Rates 19. Should vary directly with the bond's yield and inversely with its price b. Treasury bond B. Interest rates only compensate for risk in structured amounts AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-9 .S. U. Is negative for a U.S. (p. 151) The default-risk premium: a. Lower rated bonds will have higher yields c. Treasury bond yields always change by more than other bonds d. (p. Should be lower for a highly speculative bond than for an investment-grade bond d. The interest rates on a variety of bonds will move independently of each other B.Chapter 07 . Treasury bond c. 151) The default-risk premium: A. Should vary directly with the bond's yield and the bond's price AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 21. 152) The risk structure of interest rates says: a.S. Is assigned by a bond-rating agency AACSB: Analytic BLOOMS: Knowledge LOD: 2 20. The Risk and Term Structure of Interest Rates 22. The prices of U. The yields on U. (p.S. Treasury bonds are zero AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 1 7-10 . The yields on U.Chapter 07 . 151) U. Treasury bonds never change c.S.S. Treasury securities are considered to carry no risk spread because: A. They are the closest thing to default-risk free that an investor can obtain b. Treasury bonds never change d.S. The relationship among the interest rates of bonds from the same issuer but different maturities d. (p. Pay 33. Long-term bond yields move together but short-term yields do not b. The relationship among the interest rates of bonds with different maturities B. Pay less interest in total over the life of the loan AACSB: Reflective Thinking BLOOMS: Analysis LOD: 3 25. 152) A borrower who has to pay an interest rate of 8% rather than 6% due to risk spread will: a.The Risk and Term Structure of Interest Rates 23. U.Chapter 07 . 156) Which of the following is true? a. Pay 2% in net interest d. Long-term bond yields are usually the same as short-term yields AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-11 . Short-term bond yields move together but long-term yields do not C. The additional interest required to compensate the buyer for the longer maturity of the bond AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 24. 152) The risk structure of interest rates refers to: a. (p. (p. The relationship among the interest rates of bonds with the same maturities c.S. Pay $20 more in interest annually for every $100 borrowed B. Treasury Bill yields are lower than the yields on commercial paper d.3% higher interest in dollar terms c. 155) Taxes play an important role in bond returns because: a. 154) Municipal bonds are issued by: a. All governments (federal. but the proceeds can only be used by cities c. (p. Earns a 10% after-tax return because interest on U. state. Would be indifferent between this bond and a municipal bond offering $7 annually per $100 of face value.S. The U. (p. assuming the same default risk d. Some bond interest is exempt from some government taxation. so investors should always seek higher returns from other bonds AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 27. municipal) tax bonds similarly C.S.S. Only U. States and cities. government taxation AACSB: Analytic BLOOMS: Knowledge LOD: 1 28.Chapter 07 . All interest from owning bonds is taxed b. Earns a 1% return after-tax AACSB: Analytic BLOOMS: Analysis LOD: 3 7-12 . Cities only b. Treasury bond: a. 155) An investor in a 30% marginal tax bracket. States and cities and their interest is exempt from U.S. Treasury bonds is tax exempt at the federal level b. (p.S.The Risk and Term Structure of Interest Rates 26. Treasury bonds are tax-exempt. earning $10 in interest annually for a $100 U. Earns a 3% return after-tax C. Treasury. so after tax returns across bonds can vary considerably d. but their interest is taxable only at the federal level D. 155) The yield on a tax-exempt bond: A.5% yield c.5% yield AACSB: Analytic BLOOMS: Application LOD: 3 31. A taxable bond with a 8.25% yield d. income taxes AACSB: Analytic BLOOMS: Comprehension LOD: 2 30. A taxable bond with a 4. A taxable bond with a 7. (p. an investor earning 4% from a tax-exempt bond who is in a 20% tax bracket would be indifferent between that bond and: a. 155) Holding risk constant. (p.0% yield C. Equals the taxable bond yield times one minus the tax rate b. Is called the risk-free yield d. A taxable bond with a 5% yield d. A taxable bond with a 6% yield AACSB: Application BLOOMS: Application LOD: 3 7-13 .The Risk and Term Structure of Interest Rates 29.5% yield b.S. an investor earning 6% from a tax-exempt bond who is in a 25% tax bracket would be indifferent between that bond and: A. A taxable bond with a 6. 155) Holding risk constant. A taxable bond with a 8% yield b. Is equal to the yield on a U. (p.S. A taxable bond with a 7.Chapter 07 . Only applies to foreign bonds because they are exempt from U. 30-year bond c. The Risk and Term Structure of Interest Rates 32.3% C.9% AACSB: Analytic BLOOMS: Application LOD: 2 34. (p. 6. Yields on these bonds will increase AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-14 . nor will the yield on Treasury bonds c. 2. (p.Chapter 07 . (p. Retired investors who have no other taxable income b. The yield on these bonds will not change. 2% b. 155) Municipal bonds are usually purchased by: a. 6% d. Investors looking for securities to buy for their IRA accounts c. How will this affect the market for these bonds? a. Investors who are in high marginal tax brackets AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 33. Investors who live in cities with high municipal tax rates D. ratings agencies downgraded bonds issued by the State of California several times. 155) In 2003. Yields on these bonds will decrease and the yield on Treasury bonds will increase b. The yield on these bonds and on Treasury bonds will both decrease D. 155) Suppose the tax rate is 25% and the taxable bond yield is 8%. What is the taxexempt bond yield? a. Include U. Municipal bonds will become more attractive to investors AACSB: Reflective Thinking BLOOMS: Application LOD: 3 37. (p.The Risk and Term Structure of Interest Rates 35. 2%. 8% AACSB: Analytic BLOOMS: Application LOD: 3 7-15 .3% d. 4%. 2. 155) If a local government eliminates the tax exemption on municipal bonds.7% b. Generate higher returns for the bondholder when purchased through a tax-exempt retirement account b.S. Are most beneficial to those who pay higher income tax rates d. 155) Tax-exempt bonds: a. A decrease in the gap in yields on taxable and tax-exempt bonds c. and 5% over the next four years. 158) According to the Expectations Theory of the term structure. 4. we'd expect to see: a. 4% c. (p. A decrease in the yield on municipal bonds d. if interest rates are expected to be 2%. Are not affected by changes in yields on taxable bonds C.Chapter 07 . An increase in the yield on taxable bonds B. Treasury securities because the Internal Revenue Service does not charge income tax on interest earned from these bonds AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 36. (p. what is the yield on a three-year bond today? A. 159) Which fact about the term structure is the Expectations Theory able to explain? a. Why interest rates on bonds with different terms to maturity tend to move together over time b. Why yields on short-term bonds are more volatile than yields on long-term bonds C. Why yields on short-term bonds are more volatile than yields on long-term bonds c.Chapter 07 . Interest rates are expected to fall in the future b. According to the Expectations Hypothesis. Why interest rates on bonds with different terms to maturity tend to move together over time b. 157) Suppose the economy has an inverted yield curve. The term spread is positive AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2 39. Investors prefer bonds with less interest-rate risk d. Why yields on short-term bonds are more volatile than yields on long-term bonds and why longer-term yields tend to be higher than shorter-term yields AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Comprehension LOD: 2 40. (p. 159) Which fact about the term structure is the Expectations Theory unable to explain? a. Why interest rates on bonds with different terms to maturity tend to move together over time and why yields on short-term bonds are more volatile than yields on long-term bonds AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-16 . (p.The Risk and Term Structure of Interest Rates 38. Why longer-term yields tend to be higher than shorter-term yields d. Why longer-term yields tend to be higher than shorter-term yields D. Investors prefer bonds with more interest-rate risk c. (p. which of the following interpretations could be used to explain this? A. The risk spread always increases as we approach the end of the year B. income tax rates AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 43. The Russian government defaulted on some of its bonds c.S. See their bond rating maintained or actually increase c. 163) The risk spread on bonds fluctuates mainly because: a. See the demand and price for their bonds decrease AACSB: Reflective Thinking BLOOMS: Application LOD: 2 7-17 .The Risk and Term Structure of Interest Rates 41. There was a significant increase in U. (p. Taxes tend to increase over time b. See an increase in the yield of their bonds and the price of the bond increases B. See the demand for their bonds decrease and their yields decrease d. (p. 163) A company that continues to have strong profit performance during an economic downturn when many other companies are suffering losses or failing should: a. Bond rating agencies are often inconsistent C. There was an extraordinarily large amount of corporate fraud being reported in 1998 d. New information about a borrowers financial condition becomes available d.Chapter 07 . 163) In the fall of 1998 we saw an increase in the risk spread because: a. (p. People change their attitudes towards risk quickly AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 42. Can have different yields due to different maturities c. Always have the same yield B.The Risk and Term Structure of Interest Rates 44. (p. Will still have different yields depending on their face values AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-18 .Chapter 07 . 155) Bonds with the same tax status and ratings: a. Should sell for the same price d. Increase reflecting the possibility of higher default risk for commercial paper c. Yield curves usually slope upwards B. and reflects the difference in risk c. Shows the relationship among bonds with the same risk characteristics but different maturities b.S. Decrease d. 156) Which of the following statements pertaining to the yield curve is not true? a. (p. (p. The yield curve shows the relationship among bonds with the same risk characteristics but different maturities d. Fluctuate on a daily basis AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2 47. Treasury yield curve: A. Always has a positive slope d. 157) The U. The yield curve can be flat or downward sloping depending on market conditions AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2 7-19 .S. Always has a negative slope AACSB: Analytic BLOOMS: Comprehension LOD: 1 46. (p. The yield curve shows the difference in default risk between securities c.The Risk and Term Structure of Interest Rates 45. 162) During a recession you would expect the difference between the commercial paper rate and the yield on U. T-bills of the same maturity to: a. Be the same since their maturities are the same B. Assumes maturities are constant.Chapter 07 . Usually results in a downward sloping yield curve AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-20 . Corporate bonds would rise b. (p. Always results in an upward sloping yield curve B. Usually results in a flat yield curve d. Corporate bonds would fall while the price of municipal bonds would rise D. State income tax but not federal b. 156) The term structure of interest rates: a. Both state and federal income taxes d. (p. From city income taxes AACSB: Analytic BLOOMS: Knowledge LOD: 1 50. the price of: a. Represents the variation in yields for securities differing in maturities c.Chapter 07 . Municipal bonds would fall while the price of corporate bonds would rise AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 49. 155) Interest on most bonds issued by states is usually exempt from: a. From federal income tax but not state C. Municipal bonds would rise c. 155) If the federal government replaced the current income tax with a national sales tax.The Risk and Term Structure of Interest Rates 48. (p. The yield curve usually slopes upward B. Long-term yields to be higher than short-term yields AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-21 . (p. The Federal Reserve is going to ease monetary policy D. (p. Interest rates of different maturities tend to move together C. The yield curve usually has a positive slope at first then becomes inverted c. Treasury may default on its obligations c. 156) The yield curve for U. people are expecting: a. The yield curve shows the relationship among securities of different maturities d. 156) Which of the following statements in not true of the yield curve for U. An economic slowdown b. 164) When the yield curve is upward sloping. Treasury securities? a. Yields on short-term securities are more volatile than yields on long-term bonds AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 53. (p. The yield curve can shift over time AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 52.The Risk and Term Structure of Interest Rates 51.Chapter 07 . Treasury securities allows us to draw the following conclusions.S.S. Long-term rates tend to equal short-term rates d. Long-term yields tend to higher than short term yields b. The U.S. except that: a. People are expecting higher inflation in the future d. 164) When the yield curve is downward sloping: A. (p. Why short-term yields are usually higher than long-term yields d. (p. The risk premium increases with longer maturities AACSB: Analytic BLOOMS: Knowledge LOD: 1 7-22 . 157) The Expectations Hypothesis assumes: a. (p. Securities of different maturities are not perfect substitutes for each other d.Chapter 07 . People are expecting an economic slowdown b.The Risk and Term Structure of Interest Rates 54. Why the yields of different maturities tend to move together C. A high level of uncertainty regarding the future of long-term yields B. The upward slope of the yield curve b. 156) Any theory of the term structure of interest rates needs to explain each of the following. Investors know the yields on bonds today and form expectations of the yields on short-term bonds in future time periods c. Short-term yields are lower than long term yields c. People could be expecting a tightening in monetary policy AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 55. except: a. Why long-term yields are usually higher than short-term yields AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 56. The yield curve should usually be downward sloping b.Chapter 07 . Treasury security is 6. 157) Assume the Expectation Hypothesis regarding the term structure of interest rates is correct. The slope of the yield curve depends on the expectations for future short-term rates AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 58. Then. The future one-year rate to be 5% AACSB: Reflective Thinking BLOOMS: Application LOD: 3 7-23 . The future one-year rate to be 4% B. This data: a.S. 157) The Expectations Hypothesis suggests: a.The Risk and Term Structure of Interest Rates 57. The future one-year rate to be 8% c. Indicate the yield curve is upward sloping d.5%. The future one-year rate to be 6% d. (p. The slope of the yield curve reflects the risk premium associated with longer-term bonds D. the yield on a 2-year U. if the current one-year interest rate is 4% and the two-year interest rate is 6%. Indicate the yield curve is flat since the risk premium needs to be added for longer maturities C. Treasury bond is 4. Indicate the yield curve is downward sloping b. then investors are expecting: a. (p. (p. Indicate that people expect inflation to decrease in the future AACSB: Reflective Thinking BLOOMS: Application LOD: 2 59. 157) The yield on a 30-year U.0%.S. The yield curve should usually be upward sloping c. then investors expect: A. 5% C. 157) Assume the Expectations Hypothesis regarding the term structure of interest rates is correct. 157) Assume the Expectations Hypothesis regarding the term structure of interest rates is correct.The Risk and Term Structure of Interest Rates 60. (p. if the current two-year interest rate is 5% and the current one-year rate is 6%. The future one-year rate to be 4% b. 4% d. The future one-year rate to be 6% d. (p. Assuming the Expectations Hypothesis of the term structure of interest rates is correct: a. 8% AACSB: Analytic BLOOMS: Application LOD: 3 62. The future one-year rate to be 1% AACSB: Analytic BLOOMS: Application LOD: 3 61. The current one-year interest rate must equal the current 3-year interest rate AACSB: Reflective Thinking BLOOMS: Analysis LOD: 3 7-24 . The three consecutive one-year bonds must have the same interest rate d. If the current one-year interest rate is 3% and the expected one-year interest rate is 5%. The future one-year rate to be 5% c. 3% b. (p. then the current two-year interest rate should be: a. 157) Assume an investor has a choice of 3 consecutive one-year bonds or one 3-year bond.Chapter 07 . The interest rate of the 3-year bond should equal the average interest rate of the 3 one-year bonds c. Then. The average interest rate of the three consecutive one-year bonds should be less than the 3year bond to reflect the risk premium B. Drive down the price of the short-term bond and drive up the price of the long-term bond B. they would act so as to: a. 157) According to the Expectations Hypothesis: a. Why yield curves usually slope upward d. Expectations of future short-term rates equal estimates of current short-term rates AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 64. When short-term interest rates are expected to rise in the future.The Risk and Term Structure of Interest Rates 63. Why short-term yields are more volatile than long term yields C. (p. Drive up the price of the short-term bond and drive down the price of the long-term bond c. the long-term interest rates are equal to current short-term interest rates b. (p. When short-term rates are expected to remain constant in the future. Drive up the prices of both the short. (p. for a given holding period. the long-term interest rates are higher than current short-term interest rates C. Why yield curves usually slope downward AACSB: Reflective Thinking BLOOMS: Analysis LOD: 1 7-25 . the average of the expected future short-term yields was greater than the longterm yield for the holding period. Drive down the prices of both the short.and long-term bonds d. Short-term bonds are perfect substitutes for long-term bonds d. 157) The Expectations Hypothesis cannot explain: a. if investors believed that. Why yields on securities of different maturities move together b. 157) According to the Expectations Hypothesis.and long-term bonds AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 65.Chapter 07 . a downward-sloping yield curve suggests: A. Investors expect future short-term interest rates to remain constant AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Evaluation LOD: 1 67. According to the liquidity premium theory. Upward sloping and very steep B. Bonds of different maturities are perfect substitutes AACSB: Analytic BLOOMS: Comprehension LOD: 2 68. Investors expect future short-term interest rates to rise c. there is a risk premium for longer-term bonds. Bonds of different maturities have the same risk characteristics d. 157) Under the Expectations Hypothesis. the yield curve should be: a. Bonds of different maturities are not perfect substitutes c. 161) Suppose that interest rates are expected to remain unchanged over the next few years. Vertical AACSB: Reflective Thinking BLOOMS: Application LOD: 2 7-26 . Inverted d. This is a trick question.Chapter 07 . Investors expect future short-term interest rates to fall b. (p. (p. Long-term bond rates are equal to the average of current and expected future short-term interest rates B. (p.The Risk and Term Structure of Interest Rates 66. However. Upward sloping and relatively flat c. the yield curve always slopes upward d. 157) The Expectations Hypothesis assumes each of the following. except: a. (p.The Risk and Term Structure of Interest Rates 69. More than 5% AACSB: Analytic BLOOMS: Application LOD: 3 7-27 . According to the Liquidity Premium Theory. A decrease in the term spread C. An inverted yield curve b. (p. 161) Suppose the economy has an inverted yield curve. 162) The economy enters a period of robust economic growth that is expected to last for several years. 5% c. Investors expect an economic slowdown c. More than 4% but less than 5% b. which of the following interpretations could be used to explain this? a. (p.Chapter 07 . the Liquidity Premium Theory suggests the yield today on a two-year bond will be: a. An increase in yields on tax-exempt bonds AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 71. The term spread has increased AACSB: Reflective Thinking BLOOMS: Analysis LOD: 3 70. Interest rates are expected to rise in the future B. Investors are indifferent between bonds with different time horizons d. 4% D. How would this be reflected in the risk and term structures of interest rates? a. A decrease in the interest rate spread d. 162) If a one-year bond currently yields 4% and is expected to yield 6% next year. We always have inflation C. Yield curves are flat AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 73. Maturity b. (p. Interest-rate risk D. The inflation rate always increase over time b. (p.The Risk and Term Structure of Interest Rates 72. Yield curves usually slope upward b. 165) The reason for the increase in inflation risk over time is due to the fact that: a. It is more difficult to forecast inflation over longer periods of time d. Inflation risk increases c. 163) The risk premium that investors associate with a bond increases with all of the following except: a. An improved bond rating AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 1 7-28 . (p. 162) The addition of the Liquidity Premium Theory to the Expectations Hypothesis allows us to explain why: A. Investors are more focused on nominal returns than real returns AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Evaluation LOD: 1 74.Chapter 07 . Long-term interest rates are less volatile than short term interest rates d. Interest rates on bonds of different maturities move together c. Chapter 07 . Short-term interest rates are expected to decrease d. if investors expect short-term interest rates to remain constant. Short-term interest rates are expected to remain constant C. Long-term interest rates are higher than short-term interest rates AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 76. Have a positive slope b. 164) Under the expectations hypothesis. the yield curve's slope: a. (p. Be flat d. the yield curve should: A. There is no risk premium for longer-term maturities b. 162) Under the Liquidity Premium Theory. Have an increasing slope AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 77. 162) Under the Liquidity Premium Theory a flat yield curve implies: a. Will be vertical AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-29 . (p.The Risk and Term Structure of Interest Rates 75. Will become flat C. Have a negative slope c. (p. Will become more upward sloping b. Will be negative d. if expectations are for lower inflation in the future than what it currently is. Become flatter c. if investors become less certain about future monetary policy. the yield curve should: A. Become inverted d.S. Investors to purchase more junk bonds in search of a higher yield AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-30 . Risk spread and term spread increase c. (p. Treasury securities b. Risk spread and term spread decrease b.Chapter 07 . Become more upward sloping b. (p. 165) Under the liquidity premium theory. The risk spread to increase more between Aaa and Baa securities than U.The Risk and Term Structure of Interest Rates 78. Treasuries and Aaa securities d. (p. Be vertical AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2 80. 164) As GDP rises the: a.S. Risk spread decreases and the term spread increases AACSB: Reflective Thinking BLOOMS: Analysis LOD: 1 79. The risk to increase for U. The risk spread to increase more between U. Treasury Securities and Aaa securities than between Aaa and Baa securities C.S. Risk spread increases and the term spread decreases D. 163) When the growth rate of the economy slows we would expect: a. 163) We would expect the risk spread between Baa bonds and U. Vary inversely with economic growth d.S. 163) We would expect the relationship between the risk spread on Baa bonds and U. Towards securities of other countries and away from U. Remain relatively constant over the business cycle c. Vary directly with economic growth b. Widen during periods of economic recession b. Show no variation over the business cycle C. Breakdown with economic growth AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-31 . (p. Towards precious metals and away from U. Treasury securities of the same maturities to: A. Away from low-quality bonds towards high-quality bonds AACSB: Analytic BLOOMS: Comprehension LOD: 1 82.S. 163) A flight to quality refers to a move by investors: a. (p. Decrease during economic slowdowns d.S. Treasury securities of similar maturities to: a. (p. Away from bonds towards stocks b.The Risk and Term Structure of Interest Rates 81. Treasury bonds D.Chapter 07 . Increase during economic growth periods AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 83.S. Treasuries c. The yield curve seldom is inverted and can signal an economic slowdown c.Chapter 07 . 164) An inverted yield curve is a valuable forecasting tool because: a.The Risk and Term Structure of Interest Rates 84. and this usually signals an economic slowdown d. Risk spreads decreased significantly AACSB: Reflective Thinking BLOOMS: Application LOD: 2 86. 163) A flight to quality should result in: a. Treasury securities fell while yields on corporate bonds rose c. The yield curve usually is inverted so it reflects a growing economy B. Treasury securities rose while prices of corporate bonds rose d. Yields on U. Treasury securities falling and the price of corporate bonds falling AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 85. (p. The yield on corporate bonds falling and the price of U. The yield on U. Risk spreads decreased significantly B.S. Treasury Securities rising D. Treasury Securities falling and the price of corporate bonds rising c.S.S. Inverted yield curves signal better economic times are expected AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-32 . (p. Investors are expecting higher short-term rates in the future.S.S. (p. Treasury Securities rising and the price of corporate bonds rising b. The yield on U.S. The price of U. 163) When the Russian government defaulted on its bonds in August 1998: a. Yields on U. The Risk and Term Structure of Interest Rates 87. Usually with a one-year lag c. Usually with a two-year lag AACSB: Analytic BLOOMS: Comprehension LOD: 1 7-33 . (p. Usually within a few weeks d. 164) The slope of the yield curve seems to predict the performance of the economy: a. Usually with a 3-month lag B.Chapter 07 . S.Chapter 07 . 165) A proposed increase in the federal income tax rate should: A. Triggered a flight to quality in the bond market b. (p.S. Favorably. cities to respond to a proposed significant reduction in U. Favorably. the price of municipal bonds should increase and their yields fall d. Treasury securities to fall and the yields on corporate bonds to fall d. 155) How would you expect the mayors of most U. Cause the slope of the yield curve to become negative c. Flatten the yield curve AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 89.S. Have no impact on the slope of the yield curve since the tax laws impact all maturities the same b. (p. Caused the demand for U. (p. the demand for municipal bonds will fall and their yields will increase c. No reaction. this should have no impact on municipal bonds at all AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 90. 2001: A. income taxes? a. Caused the price of U.S. Did not have any significant impact since the risk on all bonds increased AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-34 .The Risk and Term Structure of Interest Rates 88. 166) The terrorist attack on the World Trade Center on September 11. Unfavorably. Treasury securities to fall and the demand for corporate bonds to rise c. Increase the slope of the yield curve since it increases the risk premium of longer maturities d. since this will significantly increase the demand for municipal bonds B. Result in the price of U. Treasury securities to decrease b. Cause the price of U. Treasury bonds and other bonds to decrease C. We should expect the yield curve to possibly become inverted c. Result in U. (p. The slope of the yield curve would become larger d. 163) Increased borrowing by the U.Chapter 07 . Treasury to finance growing budget deficits will: a. (p. We should expect the yield curve to steepen AACSB: Reflective Thinking BLOOMS: Application LOD: 2 92.S.S. Treasury bonds to increase and the yield on other bonds to decrease AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 93.S. but still be lower than corporate bonds d. It should have no impact on the slope of the yield curve B. Cause the yield on U.S. 163) Increasing tensions in many parts of the world should: a.S. Cause the risk spread between U. Treasury bonds rising C.The Risk and Term Structure of Interest Rates 91.S. Result in lower yields on corporate bonds AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-35 . Treasury bonds to increase and the yield on other bonds to increase d.S. 163) If the Federal Reserve announces an easing of monetary policy and this move was not expected: a. Treasury bonds to increase. (p. Cause the demand for all government securities including U. Cause the price of U. Treasury yields being higher than high-grade corporate bonds b.S. The Risk and Term Structure of Interest Rates 94. Decrease the demand for all bonds C. Is exists even if an investor plans on holding the bond to maturity B. This should: a. Can be eliminated by holding only short-term bonds AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 1 96. Treasury securities and decrease the demand for corporate bonds d. The yield curve always slopes upward B.Chapter 07 . 163) Imagine a scandal that finds the officers of bond rating agencies have been taking bribes to inflate the rating of specific bonds.S. Have no impact on the bond market since bond markets are highly efficient b. (p. Is not reflected in the risk premium d. Decrease the risk spread AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2 7-36 . (p. Arises because of a mismatch between the investor's investment horizon and the maturity of the bond c. 162) The presence of a term spread that is usually positive indicates that: a. We should expect the yield curve to usually slope downward AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 95. 163) The interest-rate risk that is associated with bond investing: a. Bonds of similar risk but with different maturities are not perfect substitutes c. (p. Increase the demand for U. We should expect the yield curve to usually be flat d. People may be expecting short-term rates will be higher in the future c. Market forces would always have long-term interest rates equal the average of the current and expected short-term rate c.The Risk and Term Structure of Interest Rates 97. Short-term rates could be expected to remain constant d. 165) A yield curve that slopes upward says each of the following. 155) A proposed increase in the federal income tax rates may actually be viewed favorably by many mayors of cities because: a. Expectations of future interest rates are uncertain and therefore cannot be included in the analysis d. (p. It will cause the price of municipal bonds to increase and their yields to decrease AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-37 . (p.Chapter 07 . It will allow them to also raise their tax rates b. Long-term interest rates are higher than current short-term rates AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 98. except: A. People will pay less attention to local taxes D. bonds of different maturities are assumed to be perfect substitutes because: a. It will cause the demand for municipal bonds to increase and their yields to increase c. Short-term rates are expected to decrease b. The risk premium is assumed to be negative B. (p. 157) Under the Expectations Hypothesis. Bond markets are very liquid AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 99. The role of bond rating agencies to become more important c. The risk spread to increase AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 Short Answer Question 101. AACSB: Analytic BLOOMS: Knowledge LOD: 1 102. AACSB: Analytic BLOOMS: Knowledge LOD: 2 7-38 . we should expect: A.The Risk and Term Structure of Interest Rates 100. 148) What is the main purpose (function) of bond rating services? These companies monitor the status of individual bond issuers and assess the likelihood that a lender/bondholder will be repaid by a borrower/issuer. but their issuer fell on hard times. which were at one time investment grade bonds. 163) As technology allows information regarding the financial health of corporations to become easier to obtain. there are the fallen angels. (p.Chapter 07 . (p. There are two types of junk bonds. (p. A decrease in the number of participants in the bond market d. 148) Briefly describe the two different types of junk bonds (high-yield bonds). The risk spread to decrease b. The second type results because little is known about the issuer. These bonds originate as junk bonds. usually with a one-year lag. Treasuries are the closest thing to risk free and the reason for the Treasury bill is that T-Bills.65% as equal to four consecutive one-year securities. 5.65% AACSB: Analytic BLOOMS: Application LOD: 3 105. (p. 4. (p.S. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 104. like commercial paper have very short maturities. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-39 . what is his/her risk premium? 0.Chapter 07 . Usually the yield curve turning inverted predicts an economic slowdown. Treasury bill.0%. 151) An investor sees the current twelve-month rate at 4% and expects the following future twelve-month rate for each of the subsequent years.The Risk and Term Structure of Interest Rates 103. The reason is U.5% and 6.S. which security would he/she use and why? He or she should use the U.5%. (p. 164) Why do economists pay particular attention to inverted yield curves? Inverted yield curves can be highly useful for forecasting economic slowdowns. usually less than 360 days. If this investor views a four-year maturity at 5. 151) If an investor wants to compare commercial paper to a corresponding risk-free investment. 154) Explain why many mayors of cities facing the need to borrow for infrastructure improvements. their prices will fall and their yields will need to increase to attract investors. (p. As a result of the decrease in demand. A reduction in the federal income tax rate decreases the attractiveness of these bonds. the expected future short-term interest rate(s) must be lower than the current short-term rate because liquidity premium theory assigns a positive risk premium to longer maturities. what do you know about the expected future short-term interest rate? If the yield curve is flat. AACSB: Reflective Thinking BLOOMS: Application LOD: 1 108. 162) If the yield curve is flat. 152) What does the risk structure of interest rates predict about the yield on bonds of the same maturities? The risk structure of interest rates predicts that the interest rates on a variety of bonds will move together and that lower rated bonds will have higher yields. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 107. using liquidity premium theory.The Risk and Term Structure of Interest Rates 106. (p. may not look favorably on a large federal income tax rate reduction? The interest earned on municipal bonds is exempt from federal income taxes. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-40 . which is why the yield curve usually slopes upward.Chapter 07 . (p. which when divided by the $1. the middleincome family will benefit. (c). (a) A 20-year old college student who earns low income through working over summers and breaks. Therefore. He uses a tax-exempt pension fund for all of his savings. The 20-year old college student earns low income.50. (c) A middle-income household saving up to move into a larger home. (b) The CEO of a large company who is currently in the highest tax bracket. so her tax savings are relatively low.25% AACSB: Analytic BLOOMS: Application LOD: 3 110. The $70 is taxed at 25%.25%. AACSB: Reflective Thinking BLOOMS: Evaluation LOD: 2 7-41 . he saves nothing from buying a taxexempt bond in lieu of a taxable bond. Each investor has $1000 in a savings account that he/she plans to use to buy bonds. (a). if the investor is in a 25% marginal tax bracket? Explain. (d) The CEO has the most to gain because she is in the highest marginal tax break. (p. The student plans to graduate next year. Finally. Rank each according to who has the most to gain from investing in 30-year tax-exempt municipal bonds. but their savings will not be as significant as those of the CEO. 155) Consider the following four investors. 155) What is the effective after-tax yield to an investor from a bond paying $70 per $1. (p. she would receive the largest benefit from investing in tax-exempt bonds.000 provides an effective yield of 5. Therefore.The Risk and Term Structure of Interest Rates 109. (d) A 60-year old nurse who plans to retire at age 62. (b).Chapter 07 . the nurse will receive no benefit from purchasing a tax-exempt bond because he uses a tax-exempt pension to purchase his assets. Explain briefly why you ranked the investors this way. Similarly.000 annually. leaving the bondholder with $52. 5. How does this yield curve compare to the one you computed using the Expectations Hypothesis? Using the Expectations Hypothesis.625% Using the Liquidity Premium Theory. AACSB: Reflective Thinking BLOOMS: Application LOD: 3 7-42 .5% (given) 2-year: 3% 3-year: 3.5% (given) 2-year: 3. This is caused by the presence of a risk premium attached to the longer-term bonds.The Risk and Term Structure of Interest Rates 111. compute the yields for a two-year. the interest rates are as follows: 1-year: 2.33% 4-year: 3. the yield curve has a steeper positive slope.625% Using the Liquidity Premium Theory.33% 4-year: 5. 162) Using the information provided and the Expectations Hypothesis. three-year. three-year.Chapter 07 . compute the yields for a two-year. the interest rates are as follows: 1-year: 2.5% 3-year: 4. and four-year bonds. (p. and four-year bonds. suppose there is a risk premium attached to each bond. These risk premia are given in the table below: Using the information above and the Liquidity Premium Theory. Now. 5% What is the expected one-year rate for three years from now? Explain.20% AACSB: Analytic BLOOMS: Application LOD: 3 113.5% as the expected one year rate or three years from now.0%. Substituting. this leaves us 5. AACSB: Analytic BLOOMS: Analysis LOD: 3 7-43 .5. which is: In this case n = 4 and we know int = 5. using a little algebra allows us to solve for ie1t + 3. which is 14.0% The expected one-year rate for two years from now is 5.0% The current one-year interest rate is 4.The Risk and Term Structure of Interest Rates 112. (p.Chapter 07 . (p. and given the following information: The current four-year interest rate is 5. The general statement of the Expectations Hypothesis is that the interest rate on a bond with n years to maturity is the average of n expected future one year interest rates.0% The expected one-year rate for one year from now is 5.tax rate). In this case 4 x 5 = 20 and subtract the sum of the first three short-term rates. The tax exempt bond yield = (8%) x (1-0.35) = 5. 5. The tax-exempt bond yield = (Taxable bond yield) x (1 . 158) Assuming the Expectations Hypothesis is correct. 155) What is the equivalent tax-exempt bond yield for a taxable bond with an 8% yield and a bondholder in a 35% marginal tax rate? Explain.20%. Chapter 07 . (p. (the yield curve usually slopes upward). AACSB: Analytic BLOOMS: Comprehension LOD: 1 7-44 .The Risk and Term Structure of Interest Rates 114. and #3) Long-term yields are usually higher than short-term yields. 156) Any theory of the yield curve must be able to explain what three general conditions? #1) The interest rates of different maturities will move together. #2) Yields on short-term bonds will be more volatile than yields on long-term bonds. the greater both types of risk. (p. 162) The usually upward sloping yield curve indicates that long-term bonds have higher yields than short-term bonds. To use only expectations hypothesis implies that investors usually expect short-term interest rates to rise.and interest-rate risk. The longer the term of the bond. Why is this? Bondholders face both inflation. What it cannot do is explain why yield curves usually are upward sloping.Chapter 07 . (p. which certainly is not the case. AACSB: Analytic BLOOMS: Comprehension LOD: 1 116. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-45 . 159) Why can't the Expectations Hypothesis stand alone as an adequate theory to explain yield curves? The Expectations Hypothesis does a good job of explaining why interest rates of different maturities move together and for explaining why short-term rates are more volatile than longterm rates.The Risk and Term Structure of Interest Rates 115. This implies that the risk premium increases with maturity. 162) Consider the yield curve below.The Risk and Term Structure of Interest Rates 117. Using the Expectations Hypothesis. what conclusion can we draw from the data? Now. (p. cite two possible conclusions we can draw from the data.Chapter 07 . 7-46 . using the Liquidity Premium Theory. (p. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 118. 163) What impact should an economic slowdown have on the risk structure of interest rates? An economic slowdown should increase the risk premium on privately issued bonds since some firms may find it increasingly difficult to meet their financial obligations. AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Application LOD: 2 7-47 . It is important to note. however. that a slowdown or recession does not affect the risk of holding government bonds. which is why the risk premium increases for private bonds.Chapter 07 . or (2) there is a positive risk premium associated with longer-term bonds. an upward sloping yield curve implies that interest rates are expected to increase in the future.The Risk and Term Structure of Interest Rates According to Expectations Theory. The Liquidity Premium Theory has two possible interpretations of the yield curve: (1) interest rates are expected to increase. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 120. (p. This was certainly what was observed when the Russia government defaulted.S. investors (savers) will seek out high quality bonds and shun low quality bonds. 163) When we compare the graphs of GDP growth over time to the corresponding risk spread on Baa bonds compared to 10-year U.The Risk and Term Structure of Interest Rates 119. it is highly likely that firms that were already in a precarious position regarding their finances (junk bonds) would feel the most difficulty. (p. This can have very significant impacts on the prices and yields of high and low quality bonds. Treasury bonds and junk bonds? While it is true that during economic slowdowns most private bond issuers may feel increased difficulty. the risk spread increases and vice versa. The concept of flight to quality implies that during any economic downturn or turmoil in financial markets.S. what relationship can be inferred? There seems to be an inverse relationship between GDP growth and the size of the risk spread. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 121. 163) Describe the concept of flight to quality in terms of the Russian government default of August 1998. thus significantly increasing the risk premium on those issues the most. 163) During economic slowdowns why would you expect the risk premium to increase the most between U. adding to the volatility of financial markets. Treasury bonds. (p. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 1 7-48 . As GDP growth slows.Chapter 07 . So even if investors expected short term rates to remain constant.The Risk and Term Structure of Interest Rates 122. and the risk premium increases with maturities. So an inverted yield curve signals an expected decrease in short-term interest rates. 165) If an economy is experiencing rapid economic growth. (p. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 124.Chapter 07 . In addition. 162) Why do yield curves usually slope upward? The upward sloping yield curve is the most common since it includes the risk premium for longer maturities. the yield curve would slope upward. 164) Explain why an inverted yield curve is a valuable forecasting tool? An inverted yield curve is a valuable forecasting tool because it predicts a general economic slowdown. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-49 . we would still observe an upward sloping yield curve. explain what you would expect to happen to the yield curve and why? If an economy is experiencing rapid economic growth we may see the slope of the yield curve increase for two reasons. one as the economy expands lenders will raise interest rates as they allocate the relatively scarce loanable funds to a growing demand. as the Federal Reserve becomes concerned about inflation they may tighten monetary policy which will raise short-term interest rates. Even if short-term rates were expected to remain constant. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 1 123. (p. (p. Most retired individuals are not working and as a result. 157) Does the Expectations Hypothesis allow for people to have a preference for longerterm investments? Explain Not really. a key assumption of the Expectations Hypothesis is that bonds of different maturities are perfect substitutes. 154) Explain why most retired individuals are not likely to be heavily invested in municipal bonds. usually occur when there are troubled economic times. As a result. (p. we would expect to see the risk spread increase in anticipation of economic slowdowns as we would view the inverted yield curve as an omen of an economic slowdown. 163) Why might we expect to see a high correlation between increases in the risk structure of interest rates and the yield curve becoming inverted? Both situations. (p. AACSB: Reflective Thinking BLOOMS: Application LOD: 2 7-50 . AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 2 126. As a result. the tax-exempt status of municipal bond interest is less beneficial and hence. which basically implies that investors are indifferent between different maturities and that the yield of consecutive short-term investments will equal the yield of a long-term investment over the same investment horizon. the risk structure of interest rates increasing and the inverted yield curve.Chapter 07 . less attractive to them. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 127. (p. they may find themselves in a relatively low marginal tax bracket.The Risk and Term Structure of Interest Rates 125. Chapter 07 . What else is important? A recession is associated both with an inverted yield curve and with an increase in the risk spread.The Risk and Term Structure of Interest Rates 128. But the slope of the yield curve is only part of the story. (p. This raised concerns that a recession might be on the way. and sometimes downward sloping (inverted). As illustrated in the text. well below levels associated with recessions.S. AACSB: Reflective Thinking BLOOMS: Comprehension LOD: 2 7-51 . 167) At the beginning of 2006 the yield curve was usually flat. in 2006 Baa bond yields were less than two percentage points above U. Treasury yields. In the Treasury bond market. what happens in each market? If the corporate bonds have a longer maturity than the Treasury bonds what would happen? If corporate bonds are expected to be default-risk free. this will result in the price of Treasury bonds increasing while their yields fall. the risk premium would be 0 (zero) so the price and yield should be the same across both bonds. thus the price of the bond will rise and the yield will decrease. Assume the corporate and Treasury bonds have the same maturity.The Risk and Term Structure of Interest Rates Essay Questions 129. The demand for the corporate bonds will decrease since longer maturity bonds carry more risk. where in the corporate bond market. The demand for corporate bonds will decrease. the demand will increase. and the demand for Treasury bonds will rise. so the price will fall and the yield will increase. if the corporate bonds are default-risk free what could you tell about the price and yields of each? Explain. In the Treasury bond market. This will cause their price to fall and the yield to rise.Chapter 07 . If the corporate bonds are now viewed as having the possibility of default. their price will rise and the yield will fall. what happens in each market? If the corporate bonds are granted tax-exempt status. (p. The demand for these bonds will increase. 151) Please use the graphs to show what happens to the risk (yield) differential in each situation and why. the price decreases and the yields increase. AACSB: Reflective Thinking BLOOMS: Analysis LOD: 2 7-52 . the demand will decrease. were the potential problems identified by the bond rating services? If yes. then people may question their true value in the future. AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Synthesis LOD: 2 131. The corporate accounting scandals certainly will fuel a flight to quality. the financial markets were hit by many corporate accounting scandals.Chapter 07 . (p. Treasury decision to phase out the 30-year bond and to only focus on 3month. (p. If the bond rating services were oblivious to these scandals. Discuss these scandals and the impact they would have not only in terms of a flight to quality. the phasing out of the 30-year bond would have no impact on the decisions made by savers.S. but also in terms of the faith that people place in bond rating agencies. Thus.The Risk and Term Structure of Interest Rates 130. A key assumption of the Expectations Hypothesis is savers look at all maturities as perfect substitutes because they have certainty regarding the future of interest rates. 5-year and 10-year bonds? This decision should not have any impact in terms of the Expectations Hypothesis. which should cause the risk premium to increase as the demand for Treasury bonds increases and the demand for corporate bonds decreases. then people may have more faith in them in the future. AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Comprehension LOD: 2 7-53 . The faith that people place in bond rating agencies is more difficult to assess. 162) Under the Expectations Hypothesis of the term structure of interest rates. A key factor is the information being provided before the scandals broke. 1-year. 163) In 2002 and 2003. explain the impact of a U. however the U. this may depend on the selection of instruments used by the Treasury.S. this is not a term spread.S. For example. Other bonds will still have their yield calculated by taking the risk-free rate (now perhaps higher) and adding the appropriate risk premium to this rate. a U. Treasury bill. 163) The paper-bill spread refers to the interest rate spread between commercial paper and Treasury bills with the same maturity. the price of these bonds will adjust to market forces.The Risk and Term Structure of Interest Rates 132. Treasury would likely result in an increase in all yields.S. Treasury may certainly cause interest rates to increase. in this case the subsequent market forces may cause the slope of the yield curve to decrease. greater borrowing by the U. Since the terms are the same. Regarding the term structure. if the Treasury decides to finance the deficit by issuing only long-term (30 year) bonds.Chapter 07 . (p. AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Synthesis LOD: 3 133. 163) We have heard the predictions regarding the large number of people that will be retiring over the next 25-50 years and the strain this is going to place on the federal budget. AACSB: Reflective Thinking BLOOMS: Analysis BLOOMS: Synthesis LOD: 2 7-54 . As a result. A similar argument could be offered if the Treasury decided to finance the deficit with mainly short-term instruments. Treasury will still be the benchmark bond or the risk-free bond. In order to attract buyers their price may fall and their yields increase causing the slope of the yield curve to increase. what is the likely impact going to be on the risk and term structure (if any) of interest rates and why? Increased borrowing by the U. This doesn't imply anything about the yield curve per se. Is this a risk spread or a term spread? How do you expect the paper-bill spread is related to GDP growth? What is the intuition for this result? What does this imply about the yield curve? This is a risk spread because it compares the commercial paper yield to a benchmark bond. Risk spreads generally increase when GDP growth decreases. This happens because the default risk premium associated with commercial paper increases when economic conditions worsen. because the two bonds have the same terms to maturity. (p.S. Assuming that federal borrowing will have to increase. How will this affect long-term rates and the yield curve? What does the slope of the yield curve reveal about the effectiveness of the Fed's policy? Explain in the context of the Liquidity Premium Theory. 166) Suppose that the Federal Reserve is concerned about rising inflation. (p. the yield on long-term bonds decreases. The increase in the short-term rate may cause the yield curve to be inverted.The Risk and Term Structure of Interest Rates 134. As the risk premium declines.Chapter 07 . AACSB: Reflective Thinking BLOOMS: Synthesis LOD: 3 7-55 . the policy will reduce expected inflation. reducing the risk premium associated with longer-term bonds. The more inverted the yield curve becomes. so they increase short-term interest rates. In addition to raising short-term rates. the greater the reduction in expected inflation (relative to the increase in short-term rates).