ECON 2035 Chapter 6

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%

Bonds with no default risk are called:

default free bonds

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

defualt risk

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

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

expected return

Corporate bonds are not as liquid as government bonds because

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

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 segmented markets theory of the term structure

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

According to the expectations theory of the term structure

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

Bonds with relatively high risk of default are called

junk bonds

Which of the following bonds would have the highest default risk? A) Municipal bonds B) Investment-grade bonds C) U.S. Treasury bonds D) Junk bonds

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

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.

liquidity premium theory

The ________ of the term structure states the following: the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a term premium that responds to supply and demand conditions for that bond.

liquidity premium theory

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

liquidity premium theory of the term structure.

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

liquidity premium theory.

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.

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

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

remain unchanged in the future.

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

rise in the future.

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

risk premium

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 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.

An inverted yield curve

slopes down

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

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.

U.S. government bonds have no default risk because

the federal government can increase taxes to pay its obligations.

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.

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

- decrease - decrease

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

If 1-year interest rates for the next three years are expected to be 4, 2, and 3 percent, and the 3-year term premium is 1 percent, than the 3-year bond rate will be

4 %

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

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

Everything else held constant, 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

The Bush tax cut reduced the top income tax bracket from 39% to 35% over a ten-year period. Supply and demand analysis predicts the impact of this change was a ________ interest rate on municipal bonds and a ________ interest rate on Treasury bonds.

- higher - lower

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

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

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

As their relative riskiness ________, the expected return on corporate bonds ________ relative to the expected return on default-free bonds, everything else held constant.

- increases - decreases

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

- increases - less

A decrease in default risk on corporate bonds ________ the demand for these bonds, and ________ the demand for default-free bonds, everything else held constant.

- increases - lowers

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

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

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

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 ________.

- 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

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

- positive - raise

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 increase 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 ________.

- right - left

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

When the Treasury 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 ________.

- right - left

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 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 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 %

Which of the following statements is 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 liquid asset is one that can be quickly and cheaply converted into cash.

Which of the following statements are true? A) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates. B) Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates were low, they had higher interest rates than U.S. government bonds before World War II. C) Interest rates on municipal bonds will be higher than comparable bonds without the tax exemption. D) 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 lower income tax brackets.

Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates were low, they had higher interest rates than U.S. government bonds before World War II.

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.

Bonds issued by state and local governments are called municipal bonds.

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

Corporate Baa bonds

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

Segmented markets theory

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.

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

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

US Treasury Bonds

Which of the following securities has the lowest interest rate? A) Junk bonds B) U.S. Treasury bonds C) Investment-grade bonds D) Corporate Baa bonds

US Treasury bonds

If you have a very low tolerance for risk, which of the following bonds would you be least likely to hold in your portfolio?

a corporate bond with a rating of Baa

If the yield curve slope is flat for short maturities and then slopes steeply upward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting

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

If the yield curve is flat for short maturities and then slopes downward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting.

a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

The collapse of the subprime mortgage market increased the spread between Baa and default-free U.S. Treasury bonds. This is due to

a flight to quality

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

a yield curve

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

are not substitutes at all.

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

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 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.

During the Great Depression years 1930-1933 there was a very high rate of business failures and defaults, we would expect the risk premium for ________ bonds to be very high.

corporate

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

decline moderately 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.

Typically, yield curves are

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.

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.

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.

Everything else held constant, abolishing all taxes will

increase the interest rate on municipal bonds.

The collapse of the subprime mortgage market

increased the Baa-Aaa spread.

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.

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.

Everything else held constant, if income tax rates were lowered, then

the interest rate on municipal bonds would rise.

The risk structure of interest rates 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.

During a "flight to quality"

the spread between Treasury bonds and Baa bonds increases.

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

time to maturity

The segmented markets theory can explain

why yield curves usually tend to slope upward.

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.