Econ 353 Chapter 6

18) Which of the following statements are TRUE? A) Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates were low, they had higher interest rates than U.S. government bonds before World War II. B) Because coupon payments on municipal bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in lower income tax brackets. C) Interest rates on municipal bonds will be higher than comparable bonds without the tax exemption. D) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates.

A) Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates were low, they had higher interest rates than U.S. government bonds before World War II.

36) According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond. A) average B) difference C) multiple D) sum

A) average

32) If the yield curve has a mild upward slope, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting A) constant short-term interest rates in the near future and further out in the future. B) a decline in short-term interest rates in the near future and an even steeper decline further out in the future. C) a decline in short-term interest rates in the near future and a rise further out in the future. D) a rise in short-term interest rates in the near future and a decline further out in the future.

A) constant short-term interest rates in the near future and further out in the future.

26) According to the liquidity premium theory of the term structure, a downward sloping yield curve indicates that short-term interest rates are expected to A) decline sharply in the future. B) rise in the future. C) decline moderately in the future. D) remain unchanged in the future.

A) decline sharply in the future.

19) Everything else held constant, abolishing the individual income tax will A) increase the interest rate on municipal bonds. B) increase the interest rate on Treasury bonds. C) reduce the interest rate on municipal bonds. D) increase the interest rate on corporate bonds.

A) increase the interest rate on municipal bonds

38) According to the segmented markets theory of the term structure A) interest rates on bonds of different maturities do not move together over time. B) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds. C) buyers require an additional incentive to hold long-term bonds. D) buyers of bonds do not prefer bonds of one maturity over another.

A) interest rates on bonds of different maturities do not move together over time.

22) Bonds with relatively low risk of default are called ________ securities and have a rating of Baa (or BBB) and above; bonds with ratings below Baa (or BBB) have a higher default risk and are called ________. A) investment grade; junk bonds B) investment grade; lower grade C) high quality; lower grade D) high quality; junk bonds

A) investment grade; junk bonds

37) If the expected path of 1-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, 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) four years.

A) one year.

29) The mound-shaped yield curve in the figure above indicates that short-term interest rates are expected to A) rise in the near-term and fall later on. B) fall moderately in the near-term and rise later on. C) remain unchanged in the near-term and fall later on. D) fall sharply in the near-term and rise later on.

A) rise in the near-term and fall later on.

47) The steeply upward sloping yield curve in the figure above indicates that A) short-term interest rates are expected to rise in the future. B) short-term interest rates are expected to remain unchanged in the future. C) short-term interest rates are expected to fall sharply in the future. D) short-term interest rates are expected to fall moderately in the future.

A) short-term interest rates are expected to rise in the future.

4) If the federal government were to guarantee payment on municipal bonds, the yield on municipal bonds would ________ and the yield on U.S. Treasury bonds would ________, all else equal. A) increase; decrease B) decrease; increase C) increase; increase D) decreas

B) decrease; increase

23) Which of the following long-term bonds has the highest interest rate? A) U.S. Treasury bonds B) corporate Baa bonds C) corporate Aaa bonds D) municipal bonds

B) corporate Baa bonds

40) When short-term interest rates are expected to fall sharply in the future, the yield curve will A) be an inverted U shape. B) be inverted. C) be flat. D) slope up.

B) be inverted.

7) A decrease in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury securities, everything else held constant. A) increase; decrease B) decrease; increase C) increase; increase D) decrease; decrease

B) decrease; increase

34) If bonds with different maturities are perfect substitutes, then the ________ on these bonds must be equal. A) surprise return B) expected return C) excess return D) surplus return

B) expected return

24) If a corporation begins to suffer large losses, then the default risk on the corporate bond will A) decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will rise. B) increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall. C) increase and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall. D) decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will

B) increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall.

11) If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on corporate bonds will ________ and the expected return on these bonds will ________, everything else held constant. A) decrease; increase B) increase; decrease C) decrease; decrease D) increase; increase

B) increase; decrease

42) The mound-shaped yield curve in the figure above indicates that the inflation rate is expected to A) remain constant in the near-term and fall later on. B) rise moderately in the near-term and fall later on. C) fall moderately in the near-term and rise later on. D) remain unchanged in the near-term and rise later on.

B) rise moderately in the near-term and fall later on.

45) When yield curves are flat A) long-term interest rates are above short-term interest rates. B) short-term interest rates are about the same as long-term interest rates. C) medium-term interest rates are above both short-term and long-term interest rates. D) short-term interest rates are above long-term interest rates.

B) short-term interest rates are about the same as long-term interest rates.

31) If the expected path of 1-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the expectations theory predicts that today's interest rate on the four-year bond is A) 1 percent. B) 2 percent. C) 3 percent. D) 4 percent.

C) 3 percent.

28) If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that today's interest rate on the five-year bond is A) 4 percent. B) 5 percent. C) 6 percent. D) 7 perce

C) 6 percent.

16) Which of the following statements is TRUE? A) The corporate bond market is the most liquid bond market. B) The differences in bond interest rates reflect differences in default risk only. C) A liquid asset is one that can be quickly and cheaply converted into cash. D) The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds.

C) A liquid asset is one that can be quickly and cheaply converted into cash.

15) Which of the following statements is TRUE? A) State and local governments cannot default on their bonds. B) The coupon payment on municipal bonds is usually higher than the coupon payment on Treasury bonds. C) Bonds issued by state and local governments are called municipal bonds. D) All government issued bonds—local, state, and federal—are federal income tax exempt.

C) Bonds issued by state and local governments are called municipal bonds.

41) The steeply upward sloping yield curve in the figure above indicates that ________ interest rates are expected to ________ in the future. A) short-term; remain unchanged B) long-term; fall moderately C) short-term; rise D) short-term; fall moderately

C) short-term; rise

8) Which of the following bonds are considered to be default-risk free? A) junk bonds B) municipal bonds C) U.S. Treasury bonds D) investment-grade bonds

C) U.S. Treasury bonds

43) A key assumption in the segmented markets theory is that bonds of different maturities A) are perfect substitutes. B) are substitutes but not perfect substitutes. C) are not substitutes at all. D) are substitutes only if the investor is given a premium incentive.

C) are not substitutes at all.

3) Bonds with no default risk are called A) no-risk bonds. B) zero-risk bonds. C) default-free bonds. D) flower

C) default-free bonds.

44) The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of shortterm interest rates that individuals expect to occur over the life of the long-term bond, and investors have no preference for short-term bonds relative to long-term bonds. A) liquidity premium theory B) separable markets theory C) expectations theory D) segmented markets theory

C) expectations theory

12) Junk bonds, bonds with a low bond rating, are also known as A) high quality bonds. B) investment grade bonds. C) high-yield bonds. D) zero-coupon bonds.

C) high-yield bonds.

17) If the possibility of a default increases because corporations begin to suffer losses, then the default risk on corporate bonds will ________, and the bonds' returns will become ________ uncertain, meaning that the expected return on these bonds will decrease, everything else held constant. A) decrease; less B) decrease; more C) increase; more D) increase; less

C) increase; more

21) The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ U.S. Treasury bonds. A) lower-yielding than B) tax-exempt unlike C) less liquid than D) less speculative than

C) less liquid than

14) Three factors explain the risk structure of interest rates A) maturity, default risk, and the income tax treatment of a security. B) maturity, default risk, and the liquidity of a security. C) liquidity, default risk, and the income tax treatment of a security. D) maturity, liquidity, and the income tax treatment of a security.

C) liquidity, default risk, and the income tax treatment of a security.

5) The Obama administration increased the tax on the top income tax bracket from 35% to 39%. Supply and demand analysis predicts the impact of this change was a ________ interest rate on municipal bonds and a ________ interest rate on Treasury bonds, all else the same. A) higher; lower B) lower; lower C) lower; higher D) higher;

C) lower; higher

20) A bond with default risk will always have a ________ risk premium and an increase in its default risk will ________ the risk premium. A) negative; raise B) negative; lower C) positive; raise D) positive; lower

C) positive; raise

27) According to this theory of the term structure, bonds of different maturities are not substitutes for one another. A) expectations theory B) separable markets theory C) segmented markets theory D) liquidity premium theory

C) segmented markets theory

30) If 1-year interest rates for the next five years are expected to be 4, 2, 5, 4, and 5 percent, and the 5-year term premium is 1 percent, than the 5-year bond rate will be A) 2 percent. B) 3 percent. C) 4 percent. D) 5 percent.

D) 5 percent.

49) If the expected path of 1-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of A) two years. B) three years. C) four years. D) five years.

D) five years.

13) A(n) ________ in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal. A) increase; decrease; decrease B) decrease; decrease; decrease C) decrease; increase; increase D) increase; increase; decrease

D) increase; increase; decrease

10) Bonds with relatively high risk of default are called A) investment grade bonds. B) zero coupon bonds. C) Brady bonds. D) junk bonds.

D) junk bonds.

2) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the ________ and the demand curve for Treasury bonds to the ________. A) left; left B) right; left C) right; right D) left; rig

D) left; rig

46) When yield curves are steeply upward sloping A) short-term interest rates are above long-term interest rates. B) medium-term interest rates are above both short-term and long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) long-term interest rates are above short-term interest rates.

D) long-term interest rates are above short-term interest rates.

6) An increase in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the ________. A) left; right B) right; right C) left; left D) right; left

D) right; left

When the Treasury bond market becomes less liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________. A) left; left B) right; right C) left; right D) right; left

D) right; left

48) According to the liquidity premium theory of the term structure, a steeply upward sloping yield curve indicates that short-term interest rates are expected to A) decline sharply in the future. B) remain unchanged in the future. C) decline moderately in the future. D) rise in the future.

D) rise in the future.

25) The spread between the interest rates on bonds with default risk and default-free bonds is called the A) junk margin. B) bond margin. C) default premium. D) risk premium.

D) risk premium.

50) In actual practice, short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the A) separable markets theory. B) liquidity premium theory. C) expectations theory. D) segmented markets theory.

D) segmented markets theory.

1) U.S. government bonds have no default risk because A) they are backed with gold reserves. B) they are issued in strictly limited quantities. C) they can be exchanged for silver at any time. D) the federal government can increase taxes or print money to pay its obligations

D) the federal government can increase taxes or print money to pay its obligations

35) According to the liquidity premium theory of the term structure A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time. B) the interest rate for each maturity bond is determined by supply and demand for that maturity bond. C) because of the positive term premium, the yield curve will not be observed to be downward sloping. D) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium.

D) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium.

39) The expectations theory and the segmented markets theory do not explain the facts very well, but they provide the groundwork for the most widely accepted theory of the term structure of interest rates A) the Keynesian theory. B) the asset market approach. C) the separable markets theory. D) the liquidity premium theory.

D) the liquidity premium theory.

33) Differences in ________ explain why interest rates on Treasury securities are not all the same. A) liquidity B) tax characteristics C) risk D) time to maturity

D) time to maturity