Chapter 6

A ________ yield curve predicts a future increase in inflation.

(steeply) upward sloping

If 1-year interest rates for the next three years are expected to be 1, 1, and 1 percent, and the 3-year term premium is 1 percent, then the 3-year bond rate will be

2 percent.

Over the next three years, the expected path of 1-year interest rates is 4, 1, and 1 percent. The expectations theory of the term structure predicts that the current interest rate on 3-year bond is

2 percent.

Based on the Expectations Hypothesis, if the short-term interest rate in Year 1 is 5% and the same in Year 2 is expected to be 3%, the interest rate for a 2-year bond would be ______.

4%

If the risk-free rate is 2% and the interest rate on a risky asset is 6%, the risk premium is ____.

4%

Based on the Expectations Hypothesis, if the short-term interest rate in Year 1 is 4%; the same in Year 2 is expected to be 5%; and the same in Year 3 is expected to be 6%, the interest rate for a 2-year bond would be _____ and a 3-year bond would be ______.

4.5%; 5%

Based on the Expectations Hypothesis, if the short-term interest rate in Year 1 is 4% and the same in Year 2 is expected to be 6%, the interest rate for a 2-year bond would be ______.

5%

Which of the following statements is TRUE?

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

Assume that corporate bonds and Treasury bonds are substitutes in investment. A decrease in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury bonds, everything else held constant.

decrease; increase

Everything else held constant, if the federal government were to guarantee today that it will pay creditors if a corporation goes bankrupt in the future, the interest rate on corporate bonds will ________ and the interest rate on Treasury securities will ________.

decrease; increase

Assume that corporate bonds and defaut-free (= risk-free) bonds are substitutes in investment. An increase in default risk on corporate bonds ________ the demand for these bonds, but ________ the demand for default-free bonds, everything else held constant.

lowers; increases

a ______ yield curve will tend to indicate a ______ in the future short-term interest rates.

negative; decrease

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

one year.

A bond with default risk will always have a ________ risk premium and an increase in its default risk will ________ the risk premium.

positive; raise

Assume that corporate bonds and Treasury bonds are substitutes in investment. Other things being equal, a decrease 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 ________.

right; left

U.S. government bonds have no default risk because

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

Differences in ________ explain why interest rates on Treasury securities are not all the same.

time to maturity

Assume that corporate bonds and Treasury bonds are substitutes in investment. An increase in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant.

reduce; increase

The mound-shaped yield curve in the figure above indicates that the inflation rate is expected to

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

The spread between the interest rates on bonds with default risk and default-free bonds is called the

risk premium.

When yield curves are flat

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

When yield curves are downward sloping

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

The steeply upward sloping yield curve in the figure above indicates that

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

Assume that currently, the prime rate is 3% and the LIBOR is 2.9%. If Bank A charges you a prime rate + a risk premium of 2% and Bank B charges you a LIBOR + a risk premium of 2.2%, which bank would you borrow money from?

Bank A

Assume that currently, the prime rate is 4% and the LIBOR is 2.9%. If Bank A charges you a prime rate + a risk premium of 3% and Bank B charges you a LIBOR + a risk premium of 3.2%, which bank would you borrow money from?

Bank B

What level of an individual's credit score would be considered very low and bad?

Below 600

Which of the following credit rating agencies rate individual consumers' credit rating?

Experian and Equifax

Which of the following is a characteristic of yield curves?

They tend to swell (move) up and down together.

Which of the following is/are true?

Risk premium = Interest rate on a Bond with Default Risk - Interest rate on a risk-free bond

If you are to borrow money (=U.S. dollars) outside the U.S. such as London, which of the following interest rate would be most directly relevant to you?

The LIBOR

If you are to borrow money (=U.S. dollars) in the U.S., which of the following interest rate would be most directly relevant to you?

The Prime rate

________ states that yield curves reflect the market's expectation on the future short-term interest rates.

The expectations hypothesis

________ states that yield curves reflect the term-to-maturity premium such that a longer-term bond has a higher term premium.

The liquidity premium hypothesis

A junk bond is ________.

a bond that is classified as a non-investment grade

When short-term interest rates are expected to fall sharply in the future, the yield curve will

be inverted.

Which of the following long-term bonds has the highest interest rate?

corporate Baa bonds

Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant.

decrease; increase

As default risk increases, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant.

decreases; more

The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is

default risk.

Bonds with no default risk are called

default-free or risk-free bonds.

If investors expect interest rates to fall significantly in the future, the yield curve will be inverted. This means that the yield curve has a ________ slope.

downward

The U-shaped yield curve in the figure above indicates that the inflation rate is expected to

fall sharply in the near-term and rise later on.

The typical shape for a yield curve is

gently upward sloping.

Junk bonds, bonds with a low bond rating, are also known as

high-yield bonds.

The interest rate on Baa corporate bonds is ________, on average, than interest rates on Treasuries, and the spread between these rates became ________ in the 1970s.

higher; larger

If a corporation begins to suffer large losses, then the default risk on the corporate bond will

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

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.

increase; decrease

A(n) ________ in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

increase; decrease; increase

A(n) ________ in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

increase; increase; decrease

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.

increase; more

Assume that corporate bonds and Treasury bonds are substitutes in investment. An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury bonds, everything else held constant.

increase; reduce

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 ________.

investment grade; junk bonds

Bonds with relatively high risk of default are called

junk bonds.

When yield curves are steeply upward sloping

long-term interest rates are above short-term interest rates

Given a yield curve, when the short-term interest rate is _____, the yield curve will tend to show a ______ slope.

low; positive high; negative

A yield curve is often synonymously known as _____ of interest rates.

term structure

Municipal bonds have default risk, yet their interest rates are lower than the rates on default-free Treasury bonds. This suggests that

the benefit from the tax-exempt status of municipal bonds exceeds their default risk.

An inverted yield curve predicts that short-term interest rates

will fall in the future.

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

6 percent.

Based on the Expectations Hypothesis, if the short-term interest rate in Year 1 is 5% and the same in Year 2 is expected to be 7%, the interest rate for a 2-year bond would be ______.

6%