Chapter 4

Which of the following are likely consequences of rising inflation? Check all that apply. a. Savers wanting to save less and borrowers wanting to borrow more b. A redistribution of wealth away from the wealthy to those who depend on wages and salaries c. An improved price-signaling mechanism d. A redistribution of wealth in favor of the wealthy

a. Savers wanting to save less and borrowers wanting to borrow more d. A redistribution of wealth in favor of the wealthy

A yield curve generally slopes upward but may slope downward if short-term interest rates on bonds are higher than longer-term interest rates. a. True b. False

a. True

Your friend Jacob is looking at a steep yield curve and makes an attempt to understand the implications using segmented market theory. He says more information will be needed to make economic predictions, as this type of yield curve could be either good news or bad news. Are his comments about this yield curve, using segmented market theory, true or false? a. True b. False

a. True

Which of the following is true about municipal (muni) bonds? a. Generally, investors prefer municipal bonds over corporate bonds. b. The interest paid on muni bonds is not subject to federal income tax. c. The interest paid on muni bonds is subject a lower than average federal income tax. d. Generally, investors are indifferent between corporate bonds and muni bonds.

b. The interest paid on muni bonds is not subject to federal income tax.

Inflation is a benefit in the short run to a. both borrowers and lenders. b. no one. c. borrowers. d. lenders.

c. borrowers.

Armand buys a 10-year, $10,000 bond that pays him $500 every year for 10 years and repays the face value in year 10. During the 10-year period, the rate of inflation holds steady at 3% per year. The real rate of return on Armand's investment is a. 3%. b. 0%. c. 5%. d. 2%.

d. 2%.

The risk that the borrower will not pay interest or principal or both as promised.

default risk

The rate at which a lender is compensated for taking on more default risk.

default risk premium (DRP)

The difference in yields between assets with different levels of default risk.

default risk premium spread

Using the expected rate of inflation.

ex ante

Using the actual rate of inflation.

ex post

Movement of financial resources from financial instruments with default risk to financial interests with lower levels of default risk. Often occurs because of increased uncertainty over future economic or market conditions.

flight to quality

Bonds or debt issued by state governments, local governments, and/or local municipalities

municipal, or muni bonds

A framework where long-term interest are based on the expectation of what short-term interest rates will be in the future.

pure expectations theory

The rate of return earned after controlling for inflation.

real realized rate of return

Also called the segmented markets theory or the market segmentation theory, a framework where the short-term, medium-term, and long term bond markets are all different or segmented markets.

segmented market theory

A framework where longer-term bonds have higher yields than shorter-term bonds as a way of creating an incentive for bond buyers to purchase the less desirable longer-term bonds.

term premium theory

Graph of the yields of bonds or debt at one point in time.

yield curve

If the before-tax rate of return on a corporate bond is 7%, an individual in the 25% marginal tax bracket would earn a _____ rate of return on the bond. a. 5.25% b. 4.55% c. 7% d. 5.95%

a. 5.25%

Which of the following explain why financial instruments, such as bonds or loans, carry a default risk? Check all that apply. a. A natural disaster b. A household that took out a mortgage loan improved its financial status beyond what the loan officer expected c. A discovery of new a natural resource d. Economic recession

a. A natural disaster d. Economic recession

Which of the following is consistent with the pure expectations theory of the yield curve? Check all that apply. a. An inverted yield curve suggests that the market thinks short-term interest rates in the future will be lower than they are today. b. An upward-sloping yield curve implies that the market thinks short-term interest rates are going to be higher in the future than they currently are. c. A flat yield curve suggests that the market thinks interest rates in the future will be the same as they are today. d. Long-term interest rates are based on expectations of what short-term interest rates will be in the future.

a. An inverted yield curve suggests that the market thinks short-term interest rates in the future will be lower than they are today. b. An upward-sloping yield curve implies that the market thinks short-term interest rates are going to be higher in the future than they currently are. c. A flat yield curve suggests that the market thinks interest rates in the future will be the same as they are today. d. Long-term interest rates are based on expectations of what short-term interest rates will be in the future.

Which of these groups of people is most hurt by inflation? a. Lenders and working class people b. Working class people c. Borrowers and the wealthy d. The very wealthy

a. Lenders and working class people

Which of the following accurately describes a principal argument of the term premium theory of the yield curve? a. Longer-term bonds have higher yields than shorter-term bonds to incentivize investors to purchase longer-term bonds, which are generally less desirable than shorter-term bonds. b. Short-term and long-term bonds are traded in segmented markets. c. Long-term interest rates are based on the expectations of what short-term interest rates will be in the future. d. Short-term and long-term bonds are usually traded in the same market.

a. Longer-term bonds have higher yields than shorter-term bonds to incentivize investors to purchase longer-term bonds, which are generally less desirable than shorter-term bonds.

The risk that a bond issuer will not be able to live up to the promise they make when they issue a bond is known as __________ risk. a. default b. bankruptcy c. inflation d. default premium

a. default

Imagine you run a company that produces recycled paper products. The selling price for items you produce is going up, so you increase production. After a time, you see that you have increased production more than the market is actually demanding. Which of these is the most likely reason for less demand than you had estimated based on a higher price for your items? a. Scarcity of alternatives b. Inflation c. Changing interest rates d. Default risk

b. Inflation

Which of the following is a key argument for the segmented market theory? a. Longer-term bonds have higher yields than shorter-term bonds to incentivize investors to purchase longer-term bonds, which are generally less desirable than shorter-term bonds. b. The short-term, medium-term, and long-term bond markets are all different markets, characterized by market players who have different objectives in participating in these market. c. Short-term and long-term bonds are usually traded in the same market. d. Long-term interest rates are based on the expectations of what short-term interest rates will be in the future.

b. The short-term, medium-term, and long-term bond markets are all different markets, characterized by market players who have different objectives in participating in these market.

Which of the following are properties of yield curves? Check all that apply. a. Generally, a yield curve slopes downward. b. The slope of a yield curve can and does change. c. Generally, a yield curve slopes upward. d. A yield curve shows yields of bonds of different maturities at one point in time.

b. The slope of a yield curve can and does change. c. Generally, a yield curve slopes upward. d. A yield curve shows yields of bonds of different maturities at one point in time.

Sarah is considering the purchase of a 10-year, $10,000 bond being issued by Disreputable, Inc. The bond offers an interest rate of 5.5%. The rate on a similar US Treasury bond is 2.5%. All else equal, what will Sarah's default premium be if she purchases the Disreputable, Inc. bond? a. 3.5% b. 5.5% c. 3.0% d. 2.5%

c. 3.0%

A thorough study has shown that the economic situation and prospects in the United States and New Zealand are very similar. Nevertheless, Frances decides to invest in Air Wizard. Ceteris paribus, which of the following best explains Frances's choice? a. Real interest rate in the United States is lower than in New Zealand. b. The United States has more renewable resources than New Zealand. c. Unemployment rates in the United States are lower than in New Zealand. d. Inflation in New Zealand is more than 2.2% higher than in the United States. e. Inflation in the United States is more than 2.2% higher than in New Zealand.

d. Inflation in New Zealand is more than 2.2% higher than in the United States.