FIN 319 Ch 5

If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, then the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of

5 years.

. (I) If a corporate bond becomes less liquid, its demand will fall, causing the interest rate to rise. (II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.

(I) is true, (II) false.

Yield curves can be classified as

-upward-sloping. -downward-sloping. -flat.

Which of the following statements are true?

1. 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 higher income tax brackets. 2. An increase in tax rates will increase the demand for municipal bonds, lowering their interest rates. 3. Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption.

The liquidity premium theory of the term structure

1. assumes investors tend to prefer short-term bonds because they have less interest-rate risk. 2. assumes that interest rates on the long-term bond respond to demand and supply conditions for that bond. 3. assumes that an average of expected short-term rates is an important component of interest rates on long-term bonds.

According to the liquidity premium theory of the term structure, a downward-sloping yield curve indicates that short-term interest rates are expected to

1. decline sharply in the future.

Since yield curves are usually upward sloping, the ________ indicates that, on average, people tend to prefer holding short-term bonds to long-term bonds.

1. market segmentation theory 2. liquidity premium theory

According to the market segmentation theory of the term structure,

1. the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity. 2. bonds of one maturity are not substitutes for other maturities; interest rates on bonds of different maturities do not move together over time. 3. investors' preference for short-term relative to long-term bonds explains why yield curves typically slope upward.

According to the expectations theory of the term structure,

1. the interest rate on long-term bonds will exceed the average of expected future short-term rates. 2. interest rates on bonds of different maturities move together over time. 3. buyers of bonds prefer short-term to long-term bonds.

According to the expectations theory of the term structure,

1. when the yield curve is steeply upward-sloping, short-term rates are expected to rise in the future. 2. when the yield curve is downward-sloping, short-term rates are

According to the expectations theory of the term structure,

1. yield curves should be equally likely to slope downward as to slope upward. 2. when the yield curve is steeply upward-sloping, short-term rates are expected to rise in the future. 3. interest rates on bonds of different maturities move together over time.

According to the liquidity premium theory of the term structure, A) 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 liquidity premium.

B) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of different maturities move together over time. C) even with a positive liquidity premium, if future short-term interest rates are expected to fall significantly, then the yield curve will be downward-sloping.

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

Corporate Baa bonds

Which theory of the term structure proposes that bonds of different maturities are not substitutes for one another?

Market segmentation theory

Which of the following long-term bonds should have the lowest interest rate?

Municipal bonds

. ________ cannot explain the empirical fact that interest rates on bonds of different maturities tend to move together.

The market segmentation theory

If the yield curve slope is flat, the liquidity premium theory indicates that the market is predicting

a mild decline in short-term interest rates in the near future and a continuing mild decline further out in the future.

The relationship among interest rates on bonds with identical default risk but different maturities is

bond demand curve

Based on the expectations hypothesis, the steep upward sloping yield curve in June of 2013 indicted that short-term rates would ________ in the future.

climb

As a result of the subprime collapse, the demand for low-quality corporate bonds ________, the demand for high-quality Treasury bonds ________, and the risk spread ________.

decreased; increased; increased

If Moody's or Standard and Poor's downgrades its rating on a corporate bond, the demand for the bond ________ and its yield ________.

decreases; increases

In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major shortcoming of the

expectations theory

Typically, yield curves are

gently upward-sloping.

An increase in marginal tax rates would likely have the effect of ________ the demand for municipal bonds and ________ the demand for U.S. government bonds.

increasing; decreasing

The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent over the next ten years. As a result of this tax cut, the demand for municipal bonds should shift to the ________ and the interest rate on municipal bonds should ________.

left; increase

When the corporate 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 ______.

left; right

The ________ theory is the most widely accepted theory of the term structure of interest rates because it explains the major empirical facts about the term structure so well.

liquidity premium

Of the theories that explain how interest rates on bonds with different terms to maturity are related, the one that views long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond is the

pure expectations theory.

When a municipal bond is given tax-free status, the demand for municipal bonds shifts ________, causing the interest rate on the bond to ________.

rightward; fall

Of the theories that explain how interest rates on bonds with different terms to maturity are related, the one that assumes that bonds of different maturities are not substitutes for one another is

segmented markets theory.

According to the liquidity premium theory of the term structure, when the yield curve has its usual slope, the market expects

short-term interest rates to stay near their current levels.

Which of the following statements is not true if income tax rates rise?

the interest rate on municipal bonds will rise.

If income tax rates were lowered, then

the interest rate on municipal bonds would rise

The term structure of interest rates is

the relationship among interest rates on bonds with different maturities but similar risk

The spread between interest rates on low-quality corporate bonds and U.S. government bonds ________ during the Great Depression.

widened significantly

If a bond has a favorable tax treatment, its required interest rate (all else equal)

will be lower