Ch5

(I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left.

Both are false

the relative ease with which an asset can be converted

Liquidity

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

Municipal bonds

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. A) average B) sum C) difference D) multiple

a

According to this theory of the term structure, bonds of different maturities are not substitutes for one another. A) Segmented markets theory B) Expectations theory C) Liquidity premium theory D) Separable markets theory

a

Which of the following long-term bonds has the highest interest rate? A) Corporate Baa bonds B) U.S. Treasury bonds C) Corporate Aaa bonds D) Municipal bonds

a

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.

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

the interest rates on a long term bond will be equal to the average of the interest rates people expect to occur through the lifetime of the long term bond

expectations theory

interest payments are subject to federal income tax

federal bonds

A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the ________.

left; right

When the Treasury bond market becomes more 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

bonds of different maturities are partial (NOT perfect) substitutes

liquidity premium

Of the four 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 the

segmented markets theory

Everything else held constant, if the tax-exempt status of municipal bonds were eliminated, then

the interest rate on municipal bonds would exceed the rate on Treasury bonds

If income tax rates were lowered, then

the interest rates on municipal bonds would rise

If income tax rate rises, then

the interest rates on treasury bonds will rise

The risk structure of interest rate is

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

The term structure of interest rates is

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

Yield curves can be classified as

upward-sloping; downward-sloping; flat

According to the expectations theory of the term structure,

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

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

yield curve

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

1 year

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

A) market segmentation theory B) expectations theory C) liquidity premium theory D) both A and B of the above E) both A and C of the above Answer: E

The expectations theory is able to explain why yield curves are usually upward-sloping

False

The market segmentations theory is able to explain why inters rates on bonds of different maturities move together over time.

False

The risk premium on corporate bonds becomes smaller as the liquidity of bonds falls

False

The term structure of interest rates describes how interest rates move over time.

False

When yield curves are downward-sloping, long-term interest rates are above short-term interest rates.

False

A mildly upward-sloping yield curve suggests that the market is predicting constant short-term interest rates.

True

According to the expectations theory, the interest rate on a long-term bond is the average of the short-term interest rates expected of the life of the long-term bond.

True

An increase in income tax rates will cause the inters rates on tax-exempt municipal bonds to fall relative to the inters rate on taxable corporate securities.

True

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. A) segmented markets theory B) expectations theory C) liquidity premium theory D) separable markets theory

b

The risk structure of interest rates is A) the structure of how interest rates move over time. B) the relationship among interest rates of different bonds with the same maturity. C) the relationship among the term to maturity of different bonds. D) the relationship among interest rates on bonds with different maturities.

b

U.S. government bonds have no default risk because A) they are backed by the full faith and credit of the federal government. B) the federal government can increase taxes to pay its obligations. C) they are backed with gold reserves. D) they can be exchanged for silver at any time.

b

According to the segmented markets 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. B) buyers of bonds do not prefer bonds of one maturity over another. C) interest rates on bonds of different maturities do not move together over time. D) buyers require an additional incentive to hold long-term bonds.

c

Bonds with no default risk are called A) flower bonds. B) no-risk bonds. C) default-free bonds. D) zero-risk bonds.

c

Municipal bonds have default risk, yet their interest rates are lower than the rates on default-free Treasury bonds. This suggests that A) the benefit from the tax-exempt status of municipal bonds is less than their default risk. B) the benefit from the tax-exempt status of municipal bonds equals their default risk. C) the benefit from the tax-exempt status of municipal bonds exceeds their default risk. D) Treasury bonds are not default-free.

c

Other things being equal, an increase 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 ________. A) right; right B) right; left C) left; right D) left; left

c

When yield curves are flat, A) long-term interest rates are above short-term interest rates. B) short-term interest rates are above long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) medium-term interest rates are above both short-term and long-term interest rates.

c

Which of the following bonds are considered to be default-risk free? A) Municipal bonds B) Investment-grade bonds C) U.S. Treasury bonds D) Junk bonds

c

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 A) interest rate risk. B) inflation risk. C) moral hazard. D) default risk.

d

The term structure of interest rates is A) the relationship among interest rates of different bonds with the same maturity. B) the structure of how interest rates move over time. C) the relationship among the term to maturity of different bonds. D) the relationship among interest rates on bonds with different maturities.

d

A decrease in marginal tax rates would likely have the effect of ______ the demand for municipal bonds and ______ the demand for U.S. government bonds.

decreasing; increasing

probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

default risk

The risk structure of interest rates is explained by

default risk; liquidity; tax considerations.

The liquidity premium theory of the term structure

does none of the above...

The risk premium on corporate bonds becomes smaller if

either the liquidity of corporate bonds increases or the riskiness of corporate bonds decrease.

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

cannot explain why yield curves usually slope upward

expectations theory

explains why interest rates on bonds with different maturities move together over time.

expectations theory

explains why yield curves tend to slope up when short-term rates are low and slope down when short term rates are high

expectations theory

Corporate bonds are not as liquid as government bonds because

fewer bonds for any one corporation are traded, making them more costly to sell.

short and long term rates are the same

flat yield curve

Typically, yield curves are

gently upward-sloping

Everything else held constant, the interest rate on municipal bonds rises relative to the interest rate on Treasury securities when

income tax rates are lowered

Holding everything else constant, if a corporation begins to suffer large losses, then the default risk on its bonds will ________ and the expected return on those bonds will ________.

increase; decrease

An increase in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield of Treasury bonds, everything else held constant

increase; increase

Everything else held constant, 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

According to the expectations theory of the term structure,

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

Bonds with relatively low risk of default are called

investment-grade bonds

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

leftward; rises

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

- default free - interest payments are exempt from federal income tax

municipal bonds

slope of yield curve (recession)

negative

long term rates are below short term rates

negative yield curve

A moderately upward-sloping yield curve indicates that short-term interest rates are expected to

neither rise nor fall in the near future

slope of yield curve (expansion)

positive

long-term rates are above short-term rates

positive sloping yield curve

When the default risk on corporate bonds decreases, other things equal, the demand curve for corporate bonds shifts to the ______ and the demand curve for Treasury bonds shifts to the ______.

right; left

the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury Bonds

risk premium

Bonds of different maturities are NOT substitutes at all. Investors have preferences for bonds of one maturity over another

segmented markets theory

bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different

term structure of interest rates

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

explains why yield curves are upward sloping

segmented markets theory

the expected return of one bond has no effect on the other

segmented markets theory

the interest rate for each bond with a different maturity is determined by the demand for and supply of that bond

segmented markets theory

(I) The risk premium widens as the default risk on corporate bonds increases. (II) The risk premium widens as corporate bonds become less liquid.

Both are true

the most liquid long term bonds

US treasury bonds

A positive liquidity premium indicates that investors prefer long-term bonds over short-term bonds

False

Which of the following statements are true? A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds. B) The expected return on corporate bonds decreases as default risk increases. C) A corporate bond's return becomes less uncertain as default risk increases. D) As their relative riskiness increases, the expected return on corporate bonds increases relative to the expected return on default-free bonds.

b

Which of the following statements is true? A) State and local governments cannot default on their bonds. B) Bonds issued by state and local governments are called municipal bonds. C) All government issued bonds local, state, and federal are federal income tax exempt. D) The coupon payment on municipal bonds is usually higher than the coupon payment on Treasury bonds.

b

A particularly attractive feature of the ________ is that it tells you what the market is predicting about future short-term interest rates by just looking at the slope of the yield curve. A) segmented markets theory B) expectations theory C) liquidity premium theory D) separable markets theory

c

investors generally prefer bonds with shorter maturities that have less interest-rate risk, the demand for long term bonds

reason for positive sloping yield curve

Holding everything else the same, if a corporation's earnings rise, then the default risk on its bonds will ______ and the expected return on those bonds will ______.

increase; decrease

When the corporate bond market becomes more 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

When yield curves are steeply upward sloping,

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

-less direct approach to modify the expectations hypothesis -investors prefer short term bonds over longer term bonds

preferred habitat theory

According to the market segmentation theory of the term structure,

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

a plot of interest rate and the time to maturity of the debt for a given borrower in a given currency

yield curve

(I) if a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II) The spread between the interest rates on bonds with the default risk and default-free bonds is called the risk premium.

(I) is false, (II) is true.

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

3%

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

True

The risk structure of interest rates describes the relationship between the interest rates of different bonds with the same maturities

True

During a "flight to quality" A) the spread between Treasury bonds and Baa bonds increases. B) the spread between Treasury bonds and Baa bonds decreases. C) the spread between Treasury bonds and Baa bonds is not affected. D) the change in the spread between Treasury bonds and Baa bonds cannot be predicted.

a

If a corporation begins to suffer large losses, then the default risk on the corporate bond will A) increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall. B) increase and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall. C) decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall. D) decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will rise.

a

If bonds with different maturities are perfect substitutes, then the ________ on these bonds must be equal. A) expected return B) surprise return C) surplus return D) excess return

a

The spread between the interest rates on bonds with default risk and default-free bonds is called the A) risk premium. B) junk margin. C) bond margin. D) default premium.

a

The steeply upward sloping yield curve in the figure above indicates that A) short-term interest rates are expected to rise in the future. B) short-term interest rates are expected to fall moderately in the future. C) short-term interest rates are expected to fall sharply in the future. D) short-term interest rates are expected to remain unchanged in the future.

a

Bonds with relatively high risk of default are called A) Brady bonds. B) junk bonds. C) zero coupon bonds. D) investment grade bonds.

b

Everything else held constant, if income tax rates were lowered, then A) the interest rate on municipal bonds would fall. B) the interest rate on Treasury bonds would rise. C) the interest rate on municipal bonds would rise. D) the price of Treasury bonds would fall.

c

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, A) the Keynesian theory. B) separable markets theory. C) liquidity premium theory. D) the asset market approach.

c

The preferred habitat theory of the term structure is closely related to the A) expectations theory of the term structure. B) segmented markets theory of the term structure. C) liquidity premium theory of the term structure. D) the inverted yield curve theory of the term structure.

c

A plot of the interest rates on default-free government bonds with different terms to maturity is called A) a risk-structure curve. B) a default-free curve. C) a yield curve. D) an interest-rate curve.

c

The steeply upward sloping yield curve in the figure above indicates that ________ interest rates are expected to ________ in the future. A) short-term; rise B) short-term; fall moderately C) short-term; remain unchanged D) long-term; fall moderately

a

Three factors explain the risk structure of interest rates: A) liquidity, default risk, and the income tax treatment of a security. B) maturity, default risk, and the income tax treatment of a security. C) maturity, liquidity, and the income tax treatment of a security. D) maturity, default risk, and the liquidity of a security.

a

When yield curves are steeply upward sloping, A) long-term interest rates are above short-term interest rates. B) short-term interest rates are above long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) medium-term interest rates are above both short-term and long-term interest rates.

a

Which of the following statements are true? A) A liquid asset is one that can be quickly and cheaply converted into cash. B) The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds. C) The differences in bond interest rates reflect differences in default risk only. D) The corporate bond market is the most liquid bond market.

a

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 ________. A) investment grade; lower grade B) investment grade; junk bonds C) high quality; lower grade D) high quality; junk bonds

b

When yield curves are downward sloping, A) long-term interest rates are above short-term interest rates. B) short-term interest rates are above long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) medium-term interest rates are above both short-term and long-term interest rates.

b

Differences in ________ explain why interest rates on Treasury securities are not all the same. A) risk B) liquidity C) time to maturity D) tax characteristics

c

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. A) decrease; increase B) decrease; decrease C) increase; increase D) increase; decrease

d

The collapse of the subprime mortgage market A) did not affect the corporate bond market. B) increased the perceived riskiness of Treasury securities. C) reduced the Baa-Aaa spread. D) increased the Baa-Aaa spread.

d

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