ECON CHAPTER 7

According to the expectations hypothesis of the term structure of interest rates (and assuming everything else is held equal), if the current one-year interest rate is 4% and we can reliably guess the one-year rate will be 2% next year, what would we expect the interest rate on a two-year bond issued today to be?

3% Reason: The expectations hypothesis implies that the average of short-term yields over some period will be equal to the long-term yield over that period. So we just average the two one-year bond rates: (4% + 2%)/2 = 3% yield for the long-term (two-year) bond.

Consider a corporate bond and a US Treasury with the same time to maturity. The Treasury pays 3.5% interest, and the default risk premium equals 2%. The corporate bond pays a ______ yield.

5.5%

Consider two bonds that are completely identical, except interest income on Bond A is federally taxed while interest income on Bond B is not. if Bond A pays an 8% yield and the investor has a 30% tax rate, what will the yield be on Bond B, rounded to one decimal place?

5.6 because a tax-exempt bond pays a yield of the taxable bond yield times (1-tax rate) therefore Bond B will pay 8% x (1-.03)+5.6

an inverted yield curve signals that expected future short-term yields will ____ and the economic policy is _____

fall; tight

Suppose the risk premium on U.S. corporate bonds increases. How would the change affect your forecast of future economic activity, and why?

An increasing risk premium can be a sign of impending RECESSION, so you would be more likely to forecast an economic DOWNTURN. During this stage in the business cycle, private companies have A MORE DIFFICULT time repaying their debt while the government is not affected, increasing the risk premium on company debt.

One predictor of a coming economic slowdown is

an inverted yield curve

Moody's and Standard & Poor's are two well-known

bond-rating services.

Which of the following is true about municipal bonds?

bondholders do not have to pay federal taxes on their interest income

Economic slowdown does not affect the risks of holding

government bonds.

Select the circumstance in which the impact on government bond yields of a new source of revenue (such as a natural resource discovery) would be largest.

Before the discovery, the government was heavily indebted with a crippling debt service burden.

A short-term version of a bond is called _______.

commercial paper

Bonds that are not investment grade are called _____

Junk bonds.

Which of the following is true about the subprime mortgage crisis?

Lenders assumed that housing prices would continue to rise

Which of the following is NOT an observation we can make about the term structure of interest rates using U.S Treasury data?

Long-term bond yields tend to be more volatile than short-term bond yields.

Which of the following was NOT typical of the borrowers of subprime loans leading up to the subprime mortgage crisis of the 2000s?

Low LTV ratio

Which of the following contributed to the subprime mortgage crisis?

Low down payments Poor income documentation Relaxed lending standards

Which of the following do NOT require bondholders to pay income tax on interest income?

Municipal bonds

The text discusses three observations about the real-world yield curve: Observation I: Short-term and long-term yields tend to move together. Observation II: Short-term yields tend to be more volatile than long-term yields. Observation III: Long-term yields tend to be higher than short-term yields. Which of these observations cannot be satisfactorily explained by the expectations hypothesis of the term structure of interest rates?

Observation III

The text discusses three observations about the real-world yield curve: Observation I: Short-term and long-term yields tend to move together. Observation II: Short-term yields tend to be more volatile than long-term yields .Observation III: Long-term yields tend to be higher than short-term yields. Which of these observations can be satisfactorily explained by the expectations hypothesis of the term structure of interest rates?

Observations I and II, but not III

Moody's rates commercial paper using which abbreviation?

P-1 and P-2

Using U.S Treasuries data, a group of the risk structure of interest rates _____ the prediction that lower-rated bonds pay higher yield and ______ the prediction that various interest rates move together.

Supports; supports

Which of the following require bondholders to pay income tax on interest income?

Taxable bonds

Which of the following is true about commercial paper?

The amount issued has decreased in recent years.

What does the liquidity premium theory of the term structure of interest rates predict about the slope of the yield curve? is this consistent with the data from U.S Treasuries?

The liquidity premium theory predicts an upward-sloping yield curve, which is consistent with data from U.S Treasuries.

Suppose the yields on tax-exempt local government bonds initially were below the Treasury yields of the same maturity. Suppose then that your local government, threatened with bankruptcy, decided to tax the interest income on its own bonds as part of an effort to rectify serious budgetary woes. If the tax-exempt status were then removed from the local government bonds, would you expect their yield spreads versus Treasuries to narrow, to disappear, or to change sign?

The loss of tax-exempt status along with the usual risk premium implies that the yields on the local bonds will now be higher than those on Treasuries, so the spread changes sign.

How do you think the abolition of investor protection laws would affect the risk spread between corporate and government bonds?

These laws are likely to be much more important to protecting purchasers of CORPORATE BONDS. Their abolition would RAISE the relative riskiness of corporate bonds, WIDENING the spread between corporate and government bond yields.

Data on the risk structure of interest rates in the US indicates that the majority of fluctuations in yields over time come from fluctuations in

Treasury yields

The misrating of mortgage-backed securities by rating agencies contributed to the financial crisis of 2007-2009. What recommendations would you make to avoid such mistakes in the future?

You should test models to assess the default risk of the securities in extreme circumstances and you should change the relationship between rating agencies and issuers to avoid conflicts of interest.

A bond that was once investment grade, but no longer holds that title is called _____.

a fallen angel

If Moody's changes an issuer's rating from Aaa to Baa, then the issuer has experienced

a rating downgrade

if Moody's changes an issuer's rating from Baa to Aaa, then the issuer has experienced

a ratings upgrade

A loan made to someone with a low credit score, high LTV, and insufficient documentation is called ______.

a subprime loan.

Bond rating services are used to

access the likelihood that the bondholder will be repaid.

U.S Treasuries

act as benchmark bonds.

Investors tend to base decisions on

after-tax yield

Interest rate spreads are described as

an increase in some interest rates and a decrease in others.

As it applies to term structure of interest rates of Treasury yields, the bulk of the variation in short- and long-term interest rates is in the same direction. From this we can conclude that

interest rates of different maturities tend to move together.

According to the liquidity premium theory of the term structure of interest rates, the yield curve slopes upward because (all else equal)

long-term bonds have more inflation and interest-rate risk than short-term bonds.

When interest rates are expected to rise,

long-term interest rates are higher than short-term interest rates. the yield curve will slope up

The term structure of interest rates refers to the relationship among bonds with the same risk, but different

maturity dates

An inverted yield curve is seen ____ and slopes _____

rarely; downward

At the onset of a recession, the risk premium on privately-issued bonds ______ and the risk premium on government bonds ______

rises; does not change

Default risk premium is sometimes called

risk spread

The expectations hypothesis of the term structure of interest rates assumes perfect certainty about present and future yields. This certainty implies that

short-term and long-term bonds will be perfect substitutes for each other.

According to the expectations hypothesis of the term structure of interest rates, an upward-sloping yield curve indicates that investors expect

short-term yield to rise

an inverted yield curve

slopes downward

When we say that U.S Treasuries act as benchmark bonds, we mean that yields on other bonds are measured in the terms of the _______ over Treasuries.

spead

The difference between 10-year and 3-month yields is called

term spread

The yield curve graphically depicts the _____ structure of interest rates and has _____ on its horizontal axis.

term; time to maturity

According to the expectations hypothesis of the term structure of interest rates

the average of current and future short-term yields will equal the current long0term yield over the same period.

Under both the Moody's and Standard & Poor's rating systems

the highest-quality bonds are rated triple-A.

Which of the following is NOT true about investment-grade bonds?

they are made up only of government bonds

The term structure of interest rates describes the relationship between the yield on a security and its

time to maturity

Speculative-grade commercial paper

was originally issued as prime-grade.

Suppose your federal government, threatened with bankruptcy, decided to tax the interest income on its own bonds as part of an effort to rectify serious budgetary woes. What would you expect to see happen to the yields on these bonds?

you would expect the yields to RISE due to INCREASED default risk.