ECON 311 Exam 2 (Chapter 6)

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 a 3-year bond is

2 percent

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 percent

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, then the 3-year bond rate will be

4 percent

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, then the 5-year bond rate will be

5 percent

If the expected path of 1-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 percent

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

The spread between the interest rates on Baa corporate bonds and U.S. government bonds is very large during the Great Depression year 1930-1933. Explain this difference using the bond supply and demand analysis.

During the Great Depression many businesses failed. The default risk for the corporate bond increased compared to the default-free Treasury bond. The demand for corporate bonds decreased while the demand for Treasury bonds increased resulting in a larger risk premium.

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

If a higher inflation is expected, what would you expect to happen to the shape of the yield curve? Why?

The yield curve should have a steep upward slope. Nominal interest rates will increase if the inflation rate increases, therefore, bond purchasers will require a higher term premium to hold the riskier long-term bond.

T/F: A liquid asset is one that can be quickly and cheaply converted into cash.

True

T/F: 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.

True

T/F: Bonds issued by state and local governments are called municipal bonds.

True

T/F: The expected return on corporate bonds decreases as default risk increases.

True

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

U.S. 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

U.S. Treasury bonds

If the federal government were to raise the income tax rates, would this have any impact on a state's cost of borrowing funds? Explain.

Yes, if the federal government raises income tax rates, demand for municipal bonds which are federal income tax exempt would increase. This would lower the interest rate on the municipal bonds thus lowering the cost to the state of borrowing funds.

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"

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. U.S. Treasury bond b. Municipal bond c. Corporate bond with a rating of Aaa d. Corporate bond with a rating of Baa

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

When the yield curve is flat or downward-sloping, it suggests that the economy is more likely to enter

a recession

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

a yield curve

The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and

are less liquid than U.S. Treasury bonds

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

When short-term interest rates are expected to fall sharply in the future, the yield curve will

be inverted

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

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

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

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

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.

downward

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

A U-shaped yield curve indicates that short-term interest rates and inflation rates are expected to

fall sharply in the near-term and rise later on

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, then the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of

five years

Typically, yield curves are

gently upward sloping

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

According to the liquidity premium theory of the term structure

if yield curve 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 imperial 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

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

If the possibility of a default increases because corporations begin to suffer losses, then the default risk on corporate bonds will ________, and the bond's returns will become ____ uncertain, meaning that the expected return on these bonds will decrease, everything else held constant.

increase, more

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

The collapse of the subprime mortgage market

increased the 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

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 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 term structure

interest rates on bonds of different maturities move together over time

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, junks bonds

Bonds with relatively high risk of default are called

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

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 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, then the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of

one year

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

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

A mound-shaped yield curve indicates that short-term interest rates are expected to

rise in the near-term and fall later on

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

rise moderately 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

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

A steeply upward sloping yield curve indicates that

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

An inverted yield curve

slopes down

A __________ yield curve predicts a future increase in inflation.

steeply upward sloping

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 suggest 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

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 term structure

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