FNCE 4500 CH. 5
Suppose you buy a one-year discount bond that pays no coupons, has a face value of $1,000 and you hold it for the entire year. If you pay $963 for it, what is the corresponding interest rate?
(1,000-963)/963=3.8%
The asset market approach emphasizes flows rather than stocks of assets to determine asset prices.
False
The difference in the default risk among bonds is the sole determinant of the risk premium.
False
The liquidity preference framework suggests that interest rate is determined by the supply and demand for bonds.
False
When there is a "flight to qualify" in the bond market, the spread between bonds rated BBB and US Treasury bonds narrows.
False
If there is an increase in the growth rate of the money supply, the resulting liquidity effect is smaller than the combined income, price-level, and expected inflation effects, and inflationary expectations adjust quickly, then the interest rate will immediately rise and rise further over time.
True
The price of a bond and the interest rate are always negatively related for any type of bond, whether a discount or coupon.
True
If the expectations theory of the term structure of interest rates is true, and if the one-year bond rate is 4% and the two-year bond rate is 5%, then participants in the bond market must think that next year's one-year bond rate will be 6%.
(4+6)/2= 5% True
What three events would shift the supply of bonds to the right?
1. An increase in expected profitability of investment opportunities. 2. An increase in expected inflation. 3. An increase in the budget deficit.
Yield curves almost always slope downward.
False
An increase in the riskiness of stocks causes a. bond demand to shift right b. bond demand to shift left c. bond supply to shift right d. bond supply to shift left
a. bond demand to shift right
Which of the following would be considered to be "high-yield bonds?" a. junk bonds b. speculative grade bonds c. bonds rated Caa d. all of the above are correct
d. all of the above are correct
A plot of the interest rates on default-free government bonds with different terms to maturity (yield curve) is known as a term structure curve.
False
According to the liquidity premium theory of the term structure of interest rates, a flat yield curve indicates that short-term interest rates are expected to stay the same.
False
According to the theory of asset demand, an increase in the volatility of returns in the stock market decreases the quantity demanded of bonds.
False
An increase in the riskiness of bonds causes bond demand to increase, the price of bonds to rise and interest rates to fall.
False
If a corporate bond pays 10% while a municipal bond pays 7.5%, a bondholder in a 15% marginal income tax bracket would prefer to hold the municipal bond, given that the bonds are otherwise identical.
False
If the price of bonds is below the equilibrium price, there will be an excess supply of bonds, and interest rates will rise.
False
In the liquidity preference framework, an increase in income, ceteris paribus, causes money demand to shift left and interest rates to fall.
False
The segmented markets theory of the term structure of interest rates cannot explain why yield curves slope upward.
False
The spread between the interest rate on a one-year US Treasury bond and a 20-year Treasury bond is known as the risk premium.
False
The change in interest rates that results from a change in expected inflation is known as what?
Fisher Effect
Suppose there is a decrease in expected inflation. Use the bond market to explain the impact of this event on interest rates.
For each price of bonds, the real interest rate on bonds increases, causing bond demand to shift right and bond supply to shift left, causing prices to rise and interests to fall.
What are the two main credit-rating agencies? What are these firms advising investors about? What name do we attach to bonds rated Baa (or BBB) or higher? What name do we attach to bonds rated below Baa (or BBB)?
Moody's, Standard and Poors. They advise investors about probability of default on corporate and municipal bonds. (Junk bonds)
A one-year discount bond for which the owner pays $937, holds it for the entire one year, and receives $1,000 at maturity, generates an interest rate of 6.7%.
True
According to the liquidity premium theory of the term structure of interest rates, people prefer to hold short-term bonds, so they must be compensated with higher interest rates in order to be induced to hold long-term bonds.
True
According to the theory of asset demand, an increase in expected returns in the stock market decreases the quantity demanded of bonds.
True
An increase in expected inflation decreases real returns at each price of bonds causing bond demand to shift left, bond supply to shift right, the price of bonds to fall, and interest rates to rise.
True
An increase in the government's budget deficit shifts the supply of bonds to the right, decreases the price of bonds, and increases the interest rate.
True
An increase in the money supply, other things held constant, causes interest rates to fall.
True
If General Motors Corporation unexpectedly defaults on a bond issue, the spread between US Treasury bonds and corporate bonds will widen.
True
If more people are participating in the corporate bond market so the corporate bonds are considered to be more liquid, bondholders will increase their demand for corporate bonds, decrease their demand for US Treasury bonds, and the risk premium will fall.
True
If there is an increase in the growth rate of the money supply and the resulting liquidity effect is smaller than the combined income, price-level, and expected inflation effects, then the interest rate will eventually rise above the initial interest rate.
True
The expectations theory of the term structure of interest rates assumes that bonds of different maturities are perfect substitutes.
True
The term structure of interest rates is the relationship among interest rates on bonds with different terms to maturity.
True
When US marginal income tax rates were very low, municipal bonds generally paid higher interest than US Treasury bonds of the same maturity.
True
When expected inflation rises causing interest rates to rise, we have seen a demonstration of the Fisher Effect.
True
The segmented markets theory of the term structure of interest rates is based on the assumption that a. bonds of different maturities are not substitutes b. bonds of different maturities are perfect substitutes c. long-term bonds are preferred to short-term bonds d. long-term interest rates are an average of the expected short-term rates
a. bonds of different maturities are not substitutes
A business expansion cycle causes a. both bond demand and bond supply to shift right b. both bond demand and bond supply to shift left c. bond demand to shift right and bond supply to shift left d. bond demand to shift left and bond supply to shift right
a. both bond demand and bond supply shift right
Along the supply curve for bonds, and increase in the price of bonds a. decreases the interest rate and increases the quantity of bonds supplied b. decreases the interest rate and decreases the quantity of bonds supplied c. increases the interest rate and increases the quantity of bonds supplied d. increases the interest rate and decreases the quantity of bonds supplied
a. decreases the interest rate and increases the quantity of bonds supplied
What is the interest rate on a one-year discount bond that pays $1,000 at maturity, is held for the entire year, and the purchase price is $955? a. 4.5% b. 4.7% c. 5.5% d. 9.5%
b. 4.7%
Which of the following bonds tends to pay the highest interest rate? a. US Treasury bonds b. Corporate AAA bonds c. Municipal AAA bonds d. They all pay the same interest rate
b. Corporate Aaa bonds
A plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations is known as a. a term-structure curve b. a yield curve c. a risk-structure curve d. an interest-rate curve
b. a yield curve
A decrease in the wealth of the economy causes a. bond demand to shift right, the price of the bonds to rise, and interest rates to fall b. bond demand to shift left, the price of bonds to fall, and the interest rates to rise c. bond supply to shift right, the price of bonds to fall, and interest rates to rise d. bond supply to shift left, the price of bonds to rise, and interest rates to fall
b. bond demand to shift left, bond supply to shift right, and interest rates to rise
If the demand for bonds shifts to the left, the price of bonds a. decrease and interest rates fall b. decrease and interest rates rise c. increase and interest rates rise d. decrease and interest rates fall
b. decrease and interest rates rise
Which of the following would cause the demand for long-term bonds to shift right? a. stocks become less risky b. people expect interest rates to fall in the future c. brokerage firms reduce their commissions on stock transactions d. people increase their expectations of inflation
b. people expect interest rates to fall in the future
Suppose there is an increase in the growth rate of the money supply. If the liquidity effect is smaller than the output, price-level, and expected inflation effects, then in the long run, interest rates a. remain unchanged when compared to their initial value b. rise when compared to their initial value c. fall compared to their initial value d. become unpredictable
b. rise when compared to their initial value
In which of the following situations would you choose to hold the corporate bond over the municipal bond, assuming that corporate and municipal bonds have the same maturity, liquidity, and default risk? a. The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 35% b. the corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25% c. the corporate bond pays 10%, the municipal bond pays 8%, and your marginal income tax rate is 25% d. the corporate bond pays 10%, the municipal bond pays 9%, and your marginal income tax rate is 20%
b. the corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%
Which of the following effects from an increase in the money supply causes interest rates to decrease in the short run? a. the income effect b. the liquidity effect c. the expected inflation effect d. the price-level effect
b. the liquidity effect
According to the expectations theory of the term structure of interest rates, if the one-year bond rate is 3%, and the two-year bond rate is 4%, next year's one-year rate is expected to be a. 3% b. 4% c. 5% d. 6%
c. 5%
When an increase in expected inflation causes interest rates to rise, this is known as the a. liquidity effect b. output effect c. Fisher effect d. deficit effect
c. Fisher effect
Which of the following would cause the risk premium on corporate bonds to fall? a. there are fewer participants in the bond markets causing a reduction in the daily volumes of transactions b. there is an increase in brokerage commissions c. Forecasters predict that the economy will grow more quickly for the next few years d. US Treasury bonds become more liquid
c. Forecasters predict that the economy will grow more quickly for the next few years
In the theory of asset demand, which of the following will decrease the quantity demand of an asset? a. an increase in the wealth of the buyer b. an increase in the expected return on the asset relative to alternative assets c. an increase in the risk of the asset relative to alternative assets d. an increase in the liquidity of the asset relative to the alternative assets
c. an increase in the risk of the asset relative to the alternative assets
An increase in expected inflation causes a. bond demand to shift left, bond supply to shift right, and interest rates to fall b. bond demand to shift right, bond supply to shift left, and interest rates to rise c. bond demand to shift left, bond supply to shift right, and interest rates to rise d. bond demand to shift right, bond supply to shift left, and interest rates to fall
c. bond demand to shift left, bond supply to shift right, and interest rates to rise
In the long run, if the output, price-level, and expected inflation effects outweigh the liquidity effect, to reduce interest rates the Federal Reserve should a. maintain the growth rate of the money supply b. increase the growth rate of the money supply c. decrease the growth rate of the money supply d. none of the above
c. decrease the growth rate of the money supply
Suppose there is an increase in the growth rate of the money supply. If the liquidity effect is smaller than the income, price-level, and expected inflation effects, and if inflationary expectations adjust slowly, then the short run interest rates a. remain unchanged b. rise c. fall d. become unpredictable
c. fall
The expectations theory of the term structure of interest rates implies that yield curves should usually be a. upward sloping b. downward sloping c. flat d. vertical
c. flat
According to the liquidity premium and preferred habitat theories of the term structure of interest rates, a flat yield curve indicates that a. future short-term interest rates are expected to rise b. future short-term interest rates are expected to stay the same c. future short-term interest rates are expected to fall d. bondholders no longer prefer short-term bonds to long-term bonds
c. future short-term interest rates are expected to fall
The price of bonds and interest rates are ____________? a. uncorrelated b. positively correlated c. negatively correlated d. either positively or negatively correlated depending on whether the market participant is a bond buyer or a bond seller
c. negatively correlated
According to the liquidity premium theory of the term structure of interest rates, a mildly upward-sloping yield curve suggests that a. short-term interest rates are expected to rise b. short-term interest rates are expected to fall c. short-term interest rates are expected to stay the same d. bondholders prefer long-term bonds to short-term bonds
c. short-term interest rates are expected to stay the same
If the risk premium on corporate bonds increases, then a. the price of corporate bonds has decreased b. the price of default-free bonds has decreased c. the spread between the interest rate on corporate bonds and the interest rate on default-free bonds has become greater d. the spread between the interest rate on corporate bonds and the interest rate on default-free bonds has become smaller
c. the spread between the interest rate on corporate bonds and the interest rate on default-free bonds has become greater
According to the liquidity premium theory of the term structure of interest rates, if the one-year bond rate is expected to be 4%, 5%, and 6% over each of the next three years, what is the interest rate on a three-year bond if the liquidity premium on a three-year bond is 0.5%? a. 4% b. 4.5% c. 5% d. 5.5% e. 6%
d. 5.5%
Which of the following statements about the bond market is true? a. bond demand corresponds to willingness to lend b. bond supply corresponds to willingness to borrow c. the supply and demand of bonds are measured in terms of "stocks" of assets, so it can be considered an asset market approach tot he determination of asset prices and returns d. all of the above are true
d. all of the above are true
If the price of bonds is below the equilibrium price, there is an excess a. supply of bonds, the price of bonds will fall, and the interest rate will rise b. supply of bonds, the price of bonds will rise, and the interest rate will fall c. demand for bonds, the price of bonds will fall, and the interest rate will rise d. demand for bonds, the price of bonds will rise, and the interest rate will fall
d. demand for bonds, the price of bonds will rise, and the interest rate will fall
If the default risk on corporate bonds increase, the demand for corporate bonds shifts a. right, the demand for US Treasury bonds shifts left, and the risk premium rises b. left, the demand for US Treasury bonds shifts right, and the risk premium falls c. right, the demand for US Treasury bonds shifts left, and the risk premium falls d. left, the demand for US Treasury bonds shifts right, and the risk premium rises
d. left, the demand for US Treasury bonds shifts right, and the risk premium rises
In the liquidity preference framework, interest rates are determined by the supply and demand for a. bonds b. stocks c. output d. money
d. money
The risk premium on a bond may be affected by all of the following except a. liquidity b. risk of default c. income tax treatment d. term to maturity
d. term to maturity
Which of the following will cause interest rates to rise? a. the stock has become more volatile b. firms become pessimistic about the future profitability of new plant and equipment c. people reduce their expectations of inflation d. the government increases its budget deficit
d. the government increases its budget deficit
Which of the following statements is NOT true? a. interest rates on bonds of different maturities tend to move together over time b. yield curves almost always slope upward c. when short-term interest rates are high, yield curves tend to be downward sloping d. when short-term interest rates are low, yield curves tend to be inverted
d. when short-term interest rates are low, yield curves tend to be inverted
According to the segmented markets theory of the term structure of interest rates, if bondholders prefer short-term bonds to long-term bonds, the yield curve will be a. flat b. upward sloping c. downward sloping d. vertical
upward sloping
You are watching the national news with you parents. The news anchor says that interest rates are higher than the historical average. Your parents know that you will begin looking to buy a house in just a few years. Your father says, "I hope that someone is appointed soon to run the Fed that will expand the money supply faster. If more money is available, borrowing rates will go down, and it will be much cheaper for you to buy a home." 1. If the liquidity effect is smaller than the income, price-level, and expected inflation effects, is it true that increasing the growth rate in the money supply will decrease interest rates? Explain for both the near term and the longer run. 2. If it is going to be a significant amount of time before you buy a home, is a faster or slower growth rate in the money supply likely to create lower interest rates for you? Explain.
1. Not necessarily. In the near term, if people are slow to adjust their expectations of inflation, interest rates will first fall. But in the longer run, the interest rate will rise to a point higher than the original rate (income, price-level, expected inflation effects). If people, adjust their inflationary expectations quickly, then the liquidity effect is overwhelmed by the expected inflating effect Benin the near term and interest rates will rise in both the near term and long term. 2. The empirical evidence suggests that while there is a small short-term liquidity effect from a change in the growth rate of money, in the long run the liquidity effect is dominated by the income, price-level, and expected inflation effects. Therefore, after all the effects are accounted for, a reduction on the money growth tends to cause interest rates to decline.
In the theory of asset demand, what are the four factors that affect whether to buy one asset, rather than another?
1. Wealth 2. Expected return relative to alternative assets 3. Risk relative to alternative assets 4. Liquidity relative to alternative assets
You are presented with two alternatives: You can buy a three-year bond with a yield to maturity of 7%, or you can buy a one-year bond with a yield to maturity of 6%, then purchase another one-year bond with a yield to maturity of 7%, and when the second bond matures, purchase another one-year bond with a yield to maturity of 8%. 1.) What is your expected annual rate of return for the first strategy? 2.) What is your expected annual return for the second strategy? 3.) What can you say about the two expected returns? 4.) If the liquidity premium theory of the term structure of interest rates is correct, which one of these choices would you pick? Why?
1.) 7% 2.) (6+7+8)/3= 7% 3.) The expected returns are the same 4.) The three one-year bonds are preferred. Other things the same, people prefer short-term securities. Thus, people require a liquidity premium in order to be induced to hold longer-term bonds, and this this three-year bond does not pay a liquidity premium.
Suppose a corporate bond pays an interest rate of 10%. What interest rate would you expect an identical (same maturity, risk, liquidity..) municipal bond to pay if the marginal tax rate is 25%?
10%(1-.25)= 7.5%
Suppose your marginal income tax rate is 25%. If a corporate bond pays 10%, what interest rate would be an otherwise identical municipal bond have to pay in order for you to be indifferent between holding the corporate bond and the municipal bond? a. 12.5% b. 10% c. 7.5% d. 2.5%
7.5%
If there is an excess demand for bonds, is the price of bonds above or below the equilibrium price? Explain the price adjustment to equilibrium.
Below; an excess demand for bonds means desired lending exceeds desired borrowing, thus, price falls and interest rises.
U.S. brokerage firms close many Middle East offices due to threats from terrorists.
Decrease; because bonds have become less liquid.
Your brokerage firm lowers its commissions on stock transactions but keeps its commissions the same on bond transactions.
Decrease; because the relative liquidity of bonds has decreased.
You wreck your uninsured automobile.
Decrease; because your wealth has decreased.
How does the expectations theory of the term structure of interest rates explain the fact that interest rates on bonds of different maturities move together over time?
If long-term rates average an average of expected short-term rates, then an increase in the short-term rates and expected future short-term rates will increase long-term rates too.
Suppose the Fed has tightened monetary policy and has temporarily pushed short-term interest rates unusually high. People expect the Fed to sharply lower short-term rates in the future. According to the liquidity premium theory of the term structure, what is the likely shape of the yield curve in this situation?
If people expect short-term rates to fall in the future, the yield curve will slope down.
Your brokerage firm offers discount commissions if you use the Internet for bond transactions.
Increase; because bond liquidity has increased.
You become more pessimistic about future returns in the stock market.
Increase; because the bonds have relatively high expected returns.
You are risk averse. You anticipate more volatility in the future stock returns.
Increase; because the relative risk of bonds has decreased.
Your grandmother dies and leaves you a bequest of $100,000.
Increase; because your wealth has increased.
If rising rates are associated with economic booms and falling interest rates with recessions, what would most likely follow a steeply upward-sloping yield curve--inflation or recession? Why?
Inflation. An upward sloping yield curve means people expect future short-term rates to rise, so people expect a boom. Prices tend to rise during an economic boom.
According to the liquidity preference framework, in what direction do interest rates move in response to an increase in the money supply, other things unchanging? What is the name of this effect?
Interest rates decrease; liquidity effect.
How does the expectations theory of the term structure of interest rates explain the fact that yield curves almost always slope upward.
It can't. The expectations theory alone suggests that, on average, yield curves 5/6 times.
Suppose people expect lower interest rates in the future. Use the bond market to explain the impact of this event on interest rates.
Lower interest rates in the future means higher bond prices in the future and an increase in expected returns on bonds purchased today, shifting bond demand to high prices and low interests.
What three characteristics of a bond are collectively embedded in the risk structure of interest rates? How does a change in each affect the spread or risk premium?
Risk of default, liquidity, and income-tax treatment. An increase in the risk of default or a decrease in the liquidity of a corporate bond causes the risk premium to rise
Why are interest rates on US Treasury bonds usually higher than on municipal bonds when US Treasury bonds are default-free and municipal bonds have some default risk?
Tax exempt treatment of municipal bonds outweigh the lower risk of Treasury bonds.
What is the risk premium?
The amount of additional interest people must earn in order to hold a risky bond
In Keyne's liquidity preference framework, what is the opportunity cost of holding money? Why?
The invest rate; because, since he assumes money earned no interest, the interest rate is what is sacrificed when holding money instead of bonds.
If the Federal Reserve increases the growth rate of the money supply, which effect works in the opposite direction from the others? Explain.
The liquidity effect suggests that interest rates will fall, but the income, price-level, and expected inflation effects all suggest that interest rates will rise.
Municipal bonds tend to pay lower interest rates than US Treasury bonds because a. interest payments received from holding municipal bonds are except from federal income tax b. municipal bonds are default-free c. municipal bonds are more liquid than US Treasury bonds d. all of the above are true
a. interest payments received from holding municipal bonds are except from federal income tax
A reduction in income tax rates shifts the demand for municipal bonds to the a. left, shifts the demand for US Treasury bonds to the right, and increases interest rates on municipal bonds relative to US Treasury bonds b. left, shifts the demand for US Treasury bonds to the right, and decrease interest rates on municipal bonds relative to US Treasury bonds c. right, shifts the demand for US Treasury bonds to the left, and increase interest rates on municipal bonds relative to US Treasury bonds d. right, shifts the demand for US Treasury bonds to the left, and decreases interest rates on municipal bonds relative to US Treasury bonds
a. left, shifts the demand for US Treasury bonds to the right, and increases rates on municipal bonds relative to US Treasury bonds
An increase in the price-level causes a. money demand to shift to the right and interest rate to increase b. money demand to shift to the left and interest rates to decrease c. the money supply to shift to the right and interest rates decrease d. the money supply to shift tot he left and interest rates to decrease
a. money demand to shift to the right and interest rates increase
Which of the following theories of the term structure of interest rates best explains the observed empirical facts about the relationship among interest rates on bonds with different terms to maturity? a. the liquidity premium theory b. the expectations theory c. the segmented markets theory d. the risk premium theory
a. the liquidity premium theory