Mishkin 6 & 7

Corporate bonds are not as liquid as government bonds because

fewer corporate bonds for any one corporation are traded, making them costlier to sell.

A decrease in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury securities, everything else held constant.

decrease; increase

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

decrease; increase

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

According to the segmented markets theory of the term structure

interest rates on bonds of different maturities do not move together over time.

According to the segmented markets theory of the term structure

the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

According to the liquidity premium theory of the term structure

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 term premium.

Periodic payments of net earnings to shareholders are known as

dividends.

According to the expectations theory of the term structure

interest rates on bonds of different maturities move together over time.

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%

In asset markets, an asset's price is

set by the buyer willing to pay the highest price

Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate of return of 10%, the current price of the stock would be

$100.10.

Using the one-period valuation model, assuming a year-end dividend of $1.00, an expected sales price of $100, and a required rate of return of 5%, the current price of the stock would be

$96.19

If the expected path of 1-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the expectations theory predicts that today's interest rate on the four-year bond is

3%

If 1-year interest rates for the next five years are expected to be 4, 2, 5, 4, and 5 percent, and the 5-year term premium is 1 percent, than the 5-year bond rate will be

5%

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%

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

Which of the following statements is TRUE?

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

_______ occurs when market participants observe returns on a security that are larger than what is justified by the characteristics of that security and take action to quickly eliminate the unexploited profit opportunity.

Arbitrage

The elimination of unexploited profit opportunities requires that ________ market participants be well informed.

a few

When the yield curve is flat or downward-sloping, it suggests that the economy is more likely to enter

a recession

A plot of the interest rates on default-free government bonds with different terms to maturity is called

a yield curve

If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economics would say that expectation formation is

adaptive

The view that expectations change relatively slowly over time in response to new information is known in economics as

adaptive expectations

New information that might lead to a decrease in a stock's price might be

an expected decrease in the level of future dividends.

A stock's price will fall if there is

an increase in the required rate of return

A key assumption in the segmented markets theory is that bonds of different maturities

are not substitutes at all.

According to rational expectations theory, forecast errors of expectations

are unpredictable.

Financial markets quickly eliminate unexploited profit opportunities through changes in

asset prices

When yield curves are flat

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

An inverted yield curve

slopes down

Which of the following securities has the lowest interest rate?

U.S. Treasury bonds

In rational expectations theory, the term "optimal forecast" is essentially synonymous with

the best guess.

If expectations are formed rationally, then individuals

change their forecast when faced with new information

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%

If additional information is not used when forming an optimal forecast because it is not available at that time, then expectations are

still considered to be formed rationally.

The theory of rational expectations, when applied to financial markets, is known as

the efficient markets hypothesis

U.S. government bonds have no default risk because

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

Which of the following statements are TRUE?

The expected return on corporate bonds decreases as default risk increases.

Which of the following bonds are considered to be default-risk free?

U.S. Treasury bonds

The additional incentive that the purchaser of a Treasury security requires to buy a long-term security rather than a short-term security is called the

term premium

According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond.

average

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

be inverted.

According to the liquidity premium theory, a yield curve that is flat means that

bond purchasers expect interest rates to fall in the future.

If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to

change the way they form expectations about future values of the variable.

If the yield curve has a mild upward slope, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting

constant short-term interest rates in the near future and further out in the future.

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

decline in the future.

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

decline sharply in the future.

Economists have focused more attention on the formation of expectations in recent years. This increase in interest can probably best be explained by the recognition that

expectations influence the behavior of participants in the economy and thus have a major impact on economic activity.

The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond, and investors have no preference for short-term bonds relative to long-term bonds.

expectations theory

According to rational expectations,

expectations will not differ from optimal forecasts using all available information.

If bonds with different maturities are perfect substitutes, then the ________ on these bonds must be equal.

expected return

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

five years.

According to the efficient markets hypothesis, the current price of a financial security

fully reflects all available relevant information.

The typical shape for a yield curve is

gently upward sloping.

According to the liquidity premium theory of the term structure

if yield curves are downward sloping, then short-term interest rates are expected to fall by so much that, even when the positive term premium is added, long-term rates fall below short-term rates.

Economists' attempts to explain the term structure of interest rates

illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence

A decrease in the liquidity of corporate bonds will ________ the yield of corporate bonds and ________ the yield of Treasury bonds, 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

A decrease in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant.

increase; reduce

An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury securities, everything else held constant.

increase; reduce

The collapse of the subprime mortgage market

increased the Baa-Aaa spread.

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

People have a strong incentive to form rational expectations because

it is costly not to do so.

The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market,

it will be quickly eliminated.

Which of the following bonds would have the highest default risk?

junk bonds

The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ U.S. Treasury bonds.

less liquid than

The preferred habitat theory of the term structure is closely related to the

liquidity premium theory of the term structure

Three factors explain the risk structure of interest rates

liquidity, default risk, and the income tax treatment of a security.

When yield curves are steeply upward sloping

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

The global financial crisis lead to a decline in stock prices because

of a lowered expected dividend growth rate.

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

The value of any investment is found by computing the

present value of all future cash flows.

Increased uncertainty resulting from the global financial crisis ________ the required return on investment in equity.

raised

If a forecast is made using all available information, then economists say that the expectation formation is

rational

Stockholders are residual claimants, meaning that they

receive the remaining cash flow after all other claims are paid.

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

An expectation may fail to be rational if

relevant information is available but ignored at the time the forecast is made.

Information plays an important role in asset pricing because it allows the buyer to more accurately judge

risk

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

risk premium

According to this theory of the term structure, bonds of different maturities are not substitutes for one another.

segmented markets theory

In actual practice, short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the

segmented markets theory

When yield curves are downward sloping

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

If a forecast made using all available information is not perfectly accurate, then it is

still a rational expectation

the expectations theory and the segmented markets theory do not explain the facts very well, but they provide the groundwork for the most widely accepted theory of the term structure of interest rates

the liquidity premium theory

If the optimal forecast of the return on a security exceeds the equilibrium return, then

the market is inefficient.

In the generalized dividend model, the current stock price is the sum of

the present value of the future dividend stream

The risk structure of interest rates is

the relationship among interest rates of different bonds with the same maturity.

The major criticism of the view that expectations are formed adaptively is that

this view ignores that people use more information than just past data to form their expectations.

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

time to maturity

Another way to state the efficient markets condition is: in an efficient market,

unexploited profit opportunities will be quickly eliminated.

If expectations are formed adaptively, then people

use only the information from past data on a single variable to form their expectations of that variable.

A stockholder's ownership of a company's stock gives her the right to

vote and be the residual claimant of all cash flows.

The spread between interest rates on low quality corporate bonds and U.S. government bonds

widened significantly during the Great Depression.

An inverted yield curve predicts that short-term interest rates

will fall in the future.

According to the expectations theory of the term structure

yield curves should be equally likely to slope downward as slope upward.

Rational expectations forecast errors will on average be ________ and therefore ________ be predicted ahead of time.

zero; cannot