Unit 6

Which of the following best describes the economic phase in which unemployment increases and businesses operate at their lowest capacity levels? A) Contraction B) Trough C) Expansion D) Peak

B) Trough A trough in a business cycle occurs at the end of a contraction phase when businesses are operating at their lowest capacity levels.

A recession is defined as a drop in GDP for: A) six consecutive quarters. B) two consecutive quarters. C) four consecutive quarters. D) three consecutive quarters.

B) two consecutive quarters. A recession is a drop in GDP for two consecutive quarters.

Interest rates are declining. An analyst would be most likely to state that the business cycle is in which stage? A) Trough B) Expansion C) Contraction D) Peak

C) Contraction It is during periods of economic contraction that interest rates tend to decline. They tend to rise during expansions.

A fixed-income investor notices that the short, intermediate, and long ends of the yield curve reflect a similar return. This would be typical of A) a positive yield curve B) an inverted yield curve C) a flat yield curve D) a normal yield curve

C) a flat yield curve If you were to plot this curve, what would it look like? It would be a flat line because, regardless of the maturities, all of the yields are the same. In an inverted (or negative) yield curve, the short end of the curve has higher yields than the long end. A normal (or positive) yield curve slopes upwards, with lower yields at the short end and higher yields at the long end.

When discussing employment and production, which of the following industries are typically more affected by a recession? I. Capital goods II. Consumer durable goods III. Consumer nondurable goods IV. Services A) I and II B) II and IV C) III and IV D) I and III

A) I and II Durable goods and capital goods are more affected by a recession than are nondurable goods and services. This is primarily because they are larger items, last for a longer period, and are somewhat discretionary.

An investor using yield curve analysis would expect to view bonds of A) a single issuer over varying maturities B) varying quality over a number of maturities C) varying quality of similar maturities D) similar quality over varying maturities

A) a single issuer over varying maturities The most common yield curves are drawn using U.S. Treasury securities. The curve is plotted using maturities ranging from the short-term T-bills to the long bonds. There are other curves drawn with bonds from other sectors, such as corporate bonds, to show the yield spread, but that is going beyond the scope of this question.

When investors tend to increase their investments in debt securities on the short end of the spectrum, it generally leads to A) an inverted yield curve B) a positive yield curve C) short-term yields that exceed long-term yields D) a flat yield curve

B) a positive yield curve Investors buying short-term debt rather than long-term debt will have the effect of driving the prices of short-term instruments up and, as a result, their yields down. This will produce a normal, or positive, yield. It is when the demand for bonds on the long end of the spectrum exceed demand for those in the near term that short-term yields exceed those of long-term yields. This creates an inverted or negative yield curve.

Generally, an inverted yield curve is caused by A) rising interest rates. B) declining interest rates. C) investors buying long-term bonds and selling short-term bonds. D) investors buying short-term bonds and selling long-term bonds.

C) investors buying long-term bonds and selling short-term bonds. First of all, what is an inverted yield curve? That is what we get when the yields on short-term debt are higher than the yields on long-term debt. Next, what happens to make the yield of a bond go up? When the price of the bond falls, the yield rises. Conversely, when the price of a bond rises, the yield falls. Finally, what causes the price of a security, any security, to go up or go down? Supply and demand in the marketplace. That is, when there are more buyers than sellers, that demand pushes the price up. Likewise, if there are more sellers than buyers, the price will go down. That's the basic economics of supply and demand. When investor demand is for long-term bonds, the price of those bonds will rise, causing the yields to fall. And, when investors are selling short-term bonds, that selling pressure causes the price to drop and the yields to increase. That is what has happened in this question: more demand for the long-term, resulting in higher prices and lower yields, and more supply for the short-term, resulting in lower prices and higher yields.

A frequently used metric by analysts is the yield, or credit, spread. Common methods of computing this would be comparing which of these? I. Bonds of similar quality and similar maturities II. Bonds of similar quality and different maturities III. Bonds of different quality and different maturities IV. Bonds of different quality and similar maturities A) I and III B) II and III C) I and IV D) II and IV

D) II and IV The term spread always signifies a difference. Therefore, the correct choices have to reflect some kind of difference. One way is when the quality (rating) of the bonds is the same but the length to maturity is different. A very common example of this is the U.S. 2-year Treasury note plotted against the 10-year Treasury note. The other method is to take bonds of different quality (ratings) having the same maturities. An example might be comparing two bonds with a 20-year maturity: one has a AAA rating and the other a BBB rating.

The research department of an investment advisory firm forecasts that the current business cycle should reach its peak within the next 2 months. Under such circumstances, which of the following portfolio adjustments would be most suitable for the firm's customers who actively invest in common stocks? A) Aggressive growth stocks B) Corporate bonds C) Cyclical stocks D) Defensive stocks

D) Defensive stocks The concept of sector rotation involves moving assets from those sectors that are close to their peak and moving into those who will benefit from the next move in the business cycle. Defensive stocks such as those in the food, pharmaceuticals, and public utilities would most likely be suitable for investors who believe the cycle is near its peak. Defensive stocks are least likely to be affected by a reversal in the business cycle.

Some prominent stock market pundits are predicting that the economy will slide into a recession in the near future. Furthermore, they are expecting moderate deflation during the same period. If this were to happen, your clients would probably enjoy the greatest overall return from investing in A) commodities B) common stock C) real estate D) U.S. Treasury bonds

D) U.S. Treasury bonds The combination of recession and deflation leads us to a security with the highest safety. The other 3 choices tend to rise with inflation and, therefore, are often thought of as inflation hedges. But, deflation is the opposite and you'd want to be in fixed investments because their purchasing power will increase.

A bond analyst notices that the yield spread between corporate bonds and government bonds is widening. This is typically predictive of A) an expanding economy. B) increased concern over the national debt. C) increasing interest rates. D) an economic slowdown.

D) an economic slowdown. A widening yield spread shows that the difference in yield between corporate bonds and U.S. Treasury bonds is increasing. This is usually caused by a flight to quality, the pattern of investors moving their investments to the safety of Treasury securities. This is commonly felt to be a prediction of a future recession or economic slowdown. During a slowdown, interest rates generally decline.