econ 345 - ch. 6 (the risk and term structure of interest rates) m/c's

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

When the yield curve is flat or downward-sloping, it suggest that the economy is more likely to enter A) a recession. B) an expansion. C) a boom time. D) a period of increasing output.

A) a recession.

A key assumption in the segmented markets theory is that bonds of different maturities A) are not substitutes at all. B) are perfect substitutes. C) are substitutes only if the investor is given a premium incentive. D) are substitutes but not perfect substitutes.

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

A) average

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) expected return

Corporate bonds are not as liquid as government bonds because A) fewer corporate bonds for any one corporation are traded, making them more costly to sell. B) the corporate bond rating must be calculated each time they are traded. C) corporate bonds are not callable. D) corporate bonds cannot be resold.

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

The typical shape for a yield curve is A) gently upward sloping. B) mound shaped. C) flat. D) bowl shaped.

A) gently upward sloping.

Economists' attempts to explain the term structure of interest rates A) illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence. B) illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate movements. C) prove that the real world is a special case that tends to get short shrift in theoretical models. D) have proved entirely unsatisfactory to date.

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

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) increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall.

An increase in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield of Treasury bonds, everything else held constant. A) increase; increase B) reduce; reduce C) increase; reduce D) reduce; increase

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

A) increase; increase; decrease

As default risk decreases, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant. A) increases; less B) increases; more C) decreases; less D) decreases; more

A) 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. A) increases; lowers B) lowers; increases C) does not change; greatly increases D) moderately lowers; does not change

A) increases; lowers

The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ U.S. Treasury bonds. A) less liquid than B) less speculative than C) tax-exempt unlike D) lower-yielding than

A) less liquid than

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

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) 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 A) one year. B) two years. C) three years. D) four years.

A) one year.

A bond with default risk will always have a ________ risk premium and an increase in its default risk will ________ the risk premium. A) positive; raise B) positive; lower C) negative; raise D) negative; lower

A) positive; raise

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 A) rise in the future. B) remain unchanged in the future. C) decline moderately in the future. D) decline sharply in the future.

A) rise in the future.

The mound-shaped yield curve in the figure above indicates that short-term interest rates are expected to A) rise in the near-term and fall later on. B) fall moderately in the near-term and rise later on. C) fall sharply in the near-term and rise later on. D) remain unchanged in the near-term and fall later on.

A) rise in the near-term and fall later on.

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) risk premium.

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

A) segmented markets theory.

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

A ________ yield curve predicts a future increase in inflation. A) steeply upward sloping B) slight upward sloping C) flat D) downward sloping

A) steeply upward sloping

The segmented markets theory can explain A) why yield curves usually tend to slope upward. B) why interest rates on bonds of different maturities tend to move together. C) why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high. D) why yield curves have been used to forecast business cycles.

A) why yield curves usually tend to slope upward.

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, than the 3-year bond rate will be A) 1 percent. B) 2 percent. C) 3 percent. D) 4 percent.

B) 2 percent.

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 A) 1 percent. B) 2 percent. C) 3 percent. D) 4 percent.

B) 2 percent.

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

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 A) a rise in short-term interest rates in the near future and a decline further out in the future. B) constant short-term interest rates in the near future and further out in the future. C) a decline in short-term interest rates in the near future and a rise further out in the future. D) a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

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

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) expectations theory

The U-shaped yield curve in the figure above indicates that short-term interest rates are expected to A) rise in the near-term and fall later on. B) fall sharply in the near-term and rise later on. C) fall moderately in the near-term and rise later on. D) remain unchanged in the near-term and rise later on.

B) fall sharply in the near-term and rise later on.

According to the liquidity premium theory of the term structure A) bonds of different maturities are not substitutes. B) 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. C) yield curves should never slope downward. D) interest rates on bonds of different maturities do not move together over time.

B) 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.

A(n) ________ in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal. A) increase; increase; increase B) increase; decrease; increase C) decrease; increase; increase D) decrease; decrease;decrease

B) increase; decrease; increase

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

B) increase; more

As their relative riskiness ________, the expected return on corporate bonds ________ relative to the expected return on default-free bonds, everything else held constant. A) increases; increases B) increases; decreases C) decreases; decreases D) decreases; does not change

B) increases; decreases

According to the expectations theory of the term structure A) the interest rate on long-term bonds will exceed the average of short-term interest rates that people expect to occur over the life of the long-term bonds, because of their preference for short-term securities. B) interest rates on bonds of different maturities move together over time. C) buyers of bonds prefer short-term to long-term bonds. D) buyers require an additional incentive to hold long-term bonds.

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

An increase in default risk on corporate bonds ________ the demand for these bonds, but ________ the demand for default-free bonds, everything else held constant. A) increases; lowers B) lowers; increases C) does not change; greatly increases D) moderately lowers; does not change

B) lowers; increases

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 A) rise in the future. B) remain unchanged in the future. C) decline moderately in the future. D) decline sharply in the future.

B) remain unchanged in the future.

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 ________. A) right; right B) right; left C) left; left D) left; right

B) 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 ________. A) right; right B) right; left C) left; right D) left; left

B) 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 ________. A) right; right B) right; left C) left; right D) left; left

B) right; left

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

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 A) risk premium. B) term premium. C) tax premium. D) market premium.

B) term premium

According to the segmented markets theory of the term structure A) bonds of one maturity are close substitutes for bonds of other maturities, therefore, interest rates on bonds of different maturities move together over time. B) the interest rate for each maturity bond is determined by supply and demand for that maturity bond. C) investors' strong preferences for short-term relative to long-term bonds explains why yield curves typically slope downward. D) because of the positive term premium, the yield curve will not be observed to be downward-sloping.

B) 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 A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time. B) 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. C) because of the positive term premium, the yield curve will not be observed to be downward sloping. D) the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

B) 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.

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

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) a rise in short-term interest rates in the near future and a decline further out in the future. B) constant short-term interest rates in the near future and further out in the future. C) a decline in short-term interest rates in the near future and a rise further out in the future. D) constant short-term interest rates in the near future and a decline further out in the future.

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

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) a yield curve.

When short-term interest rates are expected to fall sharply in the future, the yield curve will A) slope up. B) be flat. C) be inverted. D) be an inverted U shape.

C) be inverted.

According to the liquidity premium theory, a yield curve that is flat means that A) bond purchasers expect interest rates to rise in the future. B) bond purchasers expect interest rates to stay the same. C) bond purchasers expect interest rates to fall in the future. D) the yield curve has nothing to do with expectations of bond purchasers.

C) bond purchasers expect interest rates to fall 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 A) rise in the future. B) remain unchanged in the future. C) decline moderately in the future. D) decline sharply in the future.

C) decline moderately in the future.

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

C) decrease; increase

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

C) default-free bonds.

A decrease in the liquidity of corporate bonds will ________ the yield of corporate bonds and ________ the yield of Treasury bonds, everything else held constant. A) increase; increase B) decrease; decrease C) increase; decrease D) decrease; increase

C) increase; decrease

An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury securities, everything else held constant. A) increase; increase B) reduce; reduce C) increase; reduce D) reduce; increase

C) increase; reduce

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

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) 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 ________. A) right; right B) right; left C) left; right D) left; left

C) left; right

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

C) liquidity premium theory

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) liquidity premium theory of the term structure.

An increase in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant. A) increase; increase B) reduce; reduce C) reduce; increase D) increase; reduce

C) reduce; increase

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

An inverted yield curve A) slopes up. B) is flat. C) slopes down. D) has a U shape.

C) slopes down.

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) the separable markets theory. C) the liquidity premium theory. D) the asset market approach.

C) the liquidity premium theory.

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) time to maturity

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 A) 2 percent. B) 3 percent. C) 4 percent. D) 5 percent.

D) 5 percent.

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) a rise in short-term interest rates in the near future and a decline further out in the future. B) constant short-term interest rates in the near future and a decline further out in the future. C) a decline in short-term interest rates in the near future and a rise further out in the future. D) a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

D) a decline in short-term interest rates in the near future and an even steeper decline further out 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 A) rise in the future. B) remain unchanged in the future. C) decline moderately in the future. D) decline sharply in the future.

D) decline sharply in the future.

A decrease in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury securities, everything else held constant. A) increase; increase B) decrease; decrease C) increase; decrease D) decrease; increase

D) decrease; increase

As default risk increases, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant. A) increases; less B) increases; more C) decreases; less D) decreases; more

D) decreases; more

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) liquidity risk. D) default risk.

D) default risk.

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. A) steep upward B) slight upward C) flat D) downward

D) downward

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 A) two years. B) three years. C) four years. D) five years.

D) five years.

A decrease in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant. A) increase; increase B) reduce; reduce C) reduce; increase D) increase; reduce

D) increase; reduce

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 ________. A) right; right B) right; left C) left; left D) left; right

D) left; right

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) the relationship among interest rates on bonds with different maturities.

An inverted yield curve predicts that short-term interest rates A) are expected to rise in the future. B) will rise and then fall in the future. C) will remain unchanged in the future. D) will fall in the future.

D) will fall in the future.

According to the expectations theory of the term structure A) when the yield curve is steeply upward sloping, short-term interest rates are expected to remain relatively stable in the future. B) when the yield curve is downward sloping, short-term interest rates are expected to remain relatively stable in the future. C) investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward. D) yield curves should be equally likely to slope downward as slope upward.

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