ECON 311 Test 2

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%, 4%, 2%, and 1%, 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 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 percent

Assume the expectations theory of the term structure of interest rates over the next five years are 3%, 4%, 5%, 5%, 6%,. The interest rate on 4 year bonds today is:

4.25%

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 premium is 1 percent, then the 5-year bond rate will be

5 percent

If the expected path of one-year interest rates over the next five years is 4%, 5%, 7%, 8%, and 6%, then the expectations theory predicts that todays interest rate on the 5-year bond is

6%

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 Baa

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

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

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

What is the most important contrast between the segmented markets theory and the expectations theory?

The expectation theory states that investors view similar assets that differ only with respect to maturity as perfect substitutes.

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 WWII.

True

The expected return on corporate bonds DECREASES as default risk INCREASES.

True

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

U.S. Treasury Bonds

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

U.S. 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 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 tat the marker is predicting

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

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 rise 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 in quality

A key assumption in the segmented market 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 purchases 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) indicated 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 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 term structure; downward sloping yield curve indicates that short-term interest rates are expected to

decline sharply in the future

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

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

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 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 bonds

The ___________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average 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 the bonds must be equal....

expected return

Segmented markets theory

explains upward-sloping yield curves as resulting from the demand for long-term bonds being low relative to the demand for short-term bonds.

According to the liquidity premium, a flat yield curve suggests investors are expecting short term rates to

fall

The U-shaped yield curve indicates that inflation rate is expected to

fall sharply in the near-term and rise later on

Corporate bonds are not as liquid as government 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 the maturity of

five years

Typically, yield curves are

gently upward sloping

The expectations theory

has difficulty explaining why yield curves usually slope upward

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 impacts of this change was a ______ interest rate on municipal bonds and a _______ interest rate on Treasury Bonds.

higher; lower

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.

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 the 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

The collapse of the subprime mortgage market

increased Baa-Aaa spread

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

According to the expectations theory of term structure

interest rates on bonds of different maturities move together over time

Bonds with relatively low risk of default are called ______ securitites 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

A decrease in the liquidity of corporate bonds, other things constant, 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 shift the demand curve of 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

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 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

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

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

If a one-year currently yields 5% and is expected to yield 7% next year, the liquidity premium theory predicts that the yield today on a two- year bond will be

more than 6%

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 the maturity of

one year

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

one year

The interest rates on bonds of different maturities are likely to move together if the bonds are:

perfect substitutes

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

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

The term structure of interest rates

represents the variation in yields for related instruments differing in maturity

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

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 mound-shaped yield curve in the figure above indicated that short-term interest rates are expected to

rise in the near-term and fall later on

the mound shaped yield curve indicates that the inflation rate is expected to

rise moderately in the neat-term and fall later on

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

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 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

steeply upward curving yield curve

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

When the yield curve is downward sloping

short-term yields are higher than long-term yields

The steeply upward sloping yield indicates that interest rates are expected to _______ in the future

short-term; rise

Under the expectations theory if market participants expect that future short-term rates will be higher than current short-term rates, the yield curve will

slope upward

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 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

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

Risk structure of interest rates

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

Term Structure of Interest Rates

the relationship among interest rates on bonds with different maturities.

The expectations theory suggests that

the slope of the yield curve depends on the expected future path of short-term rates

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 at all the same

time to maturity

The U-shaped yield curve in the figure above indicates that short-term interest rates are

to fall sharply in the near-term, and rise later on

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

true

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

true

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

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

yield curve

According to the expectations theory of the term structure

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