Chapter 2 ECON 355

Which of the following statements are true? 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 higher income tax brackets and An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates are true statements. Interest rates on municipal bonds will be higher than on comparable bonds without the tax exemption.

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 higher income tax brackets.

(I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left.

Both are false.

(I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the left. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the right.

Both are true.

(I) The risk premium widens as the default risk on corporate bonds increases. (II) The risk premium widens as corporate bonds become less liquid.

Both are true.

What do credit-rating agencies do?

They are investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default.

________ bonds are the most liquid of all long-term bonds.

U.S. Treasury

________ is the total resources owned by an individual, including all assets.

Wealth

Factors that can cause the supply curve for bonds to shift to the left include

a decrease in expected inflation.

When the quantity of bonds demanded equals the quantity of bonds supplied, there is

a market equilibrium.

When the interest rate on a bond is ________ the equilibrium interest rate, there is excess ________ in the bond market and the interest rate will ________.

above; demand; fall

By the end of July 2007, the interest rate on Baa-rated bonds rose by 280 basis points. At the same time, the interest rate on Treasury bonds

fell by 80 basis points.

A bond rating of Aa or AA would mean that the quality of the bond is

high

Lower expected interest rates in the future ________ the demand for long-term bonds and shift the demand curve to the ________.

increase; right.

When the demand for bonds ________ or the supply of bonds ________, bond prices rise.

increases; decreases

When the demand for bonds ________ or the supply of bonds ________, interest rates fall.

increases; decreases

When the expected inflation rate decreases, the demand for bonds ________, the supply of bonds ________, and the interest rate ________.

increases; decreases; falls

When bond prices become less volatile, the demand for bonds ________ and the interest rate ________.

increases; falls

During an economic expansion, the supply of bonds ________ and the supply curve shifts to the ________.

increases; right

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

positive

When a municipal bond is given tax-free status, the demand for municipal bonds shifts ________, causing the interest rate on the bond to ________.

rightward; fall

A decrease in the expected rate of inflation causes the demand for bonds to ________ and the supply of bonds to ________.

rise; fall

The supply curve for bonds has the usual upward slope, indicating that as the price ________, ceteris paribus, the ________ increases.

rises; quantity supplied

During business cycle expansions when income and wealth are rising, the demand for bonds ________ and the demand curve shifts to the ________.

rises; right

The demand for an asset rises if ________ falls.

risk relative to other assets

When the inflation rate is expected to increase, the real cost of borrowing declines at any given interest rate; as a result, the ________ bonds increases and the ________ curve shifts to the right.

supply of; supply

When the price of a bond is above the equilibrium price, there is excess ________ in the bond market and the price will ________. Correct!

supply; fall

When the federal government's budget deficit decreases, the ________ curve for bonds shifts to the ________.

supply; left

When the federal governments budget deficit increases, the ________ curve for bonds shifts to the ________.

supply; right

If income tax rates rise, then

the interest rate on Treasury bonds will rise.

An increase in the expected rate of inflation causes the demand for bonds to ________ and the supply for bonds to ________.

fall; rise

In a recession when income and wealth are falling, the demand for bonds ________ and the demand curve shifts to the ________.

falls; left

As the price of a bond ________ and the expected return ________, bonds become more attractive to investors and the quantity demanded rises.

falls; rises

Corporate bonds are not as liquid as government bonds because

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

The higher the standard deviation of returns on an asset, the ________ the asset's ________.

greater; risk

Holding everything else constant, if a corporation begins to suffer large losses, then the default risk on its bonds will ________ and the expected return on those bonds will ________.

increase; decrease

A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby

raising the default risk and causing the demand for its bonds to fall.

An increase in the expected rate of inflation will ________ the expected return on bonds relative to that on ________ assets, and shift the ________ curve to the left.

reduce; real; demand

When bonds become more widely traded, and as a consequence the market becomes more liquid, the demand curve for bonds shifts to the ________ and the interest rate ________.

right; falls

When people begin to expect a large stock market decline, the demand curve for bonds shifts to the ________ and the interest rate ________.

right; falls

When prices in the stock market become more uncertain, the demand curve for bonds shifts to the ________ and the interest rate ________.

right; falls

When the corporate 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 ________.

right; left

When the default risk on corporate bonds decreases, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________.

right; left

If municipal bonds were to lose their tax-free status, then the demand for Treasury bonds would shift ________, and the interest rate on Treasury bonds would ________.

rightward; fall

The spread between the interest rates on bonds with default risk and default-free bonds, both of the same maturity, is called the

risk premium.

A ________ prefers stock in a less risky asset than in a riskier asset.

risk-averse person

When the interest rate on a bond is below the equilibrium interest rate, there is excess ________ in the bond market and the interest rate will ________.

supply; rise

(I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II) The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium.

(I) is false, (II) true.

(I) If a corporate bond becomes less liquid, the interest rate on the bond will fall. (II) If a corporate bond becomes less liquid, the interest rate on Treasury bonds will fall.

(I) is false, (II) true. `

(I) If a corporate bond becomes less liquid, the demand for the bond will fall, causing the interest rate to rise. (II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.

(I) is true, (II) false.

As of 2016, the debt of Microsoft and Johnson & Johnson both had ________ ratings from Standard and Poor's.

AAA

Which of the following long-term bonds should have the highest interest rate?

Corporate Baa bonds

________ are investment advisory firms that rate the quality of corporate and municipal bonds in terms of probability of default.

Credit-rating agencies

________ bonds are exempt from federal income taxes.

Municipal

Which of the following long-term bonds should have the lowest interest rate?

Municipal bonds

Which of the following statements are true? 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 higher income tax brackets and An increase in tax rates will increase the demand for municipal bonds, lowering their interest rates are true statements. Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption.

all true

Between 1919 and 1990, when did long-term bond yields reach a low point?

around 1945

The risk premium on corporate bonds becomes smaller if

either the liquidity of corporate bonds increases or the riskiness of corporate bonds decreases occur.

When the price of a bond is ________ the equilibrium price, there is an excess supply of bonds and the price will ________.

above; fall

Factors that can cause the supply curve for bonds to shift to the right include

an expansion in overall economic activity.

When the price of a bond is ________ the equilibrium price, there is an excess demand for bonds and the price will ________.

below; rise

When the interest rate on a bond is ________ the equilibrium interest rate, there is excess ________ in the bond market and the interest rate will ________.

below; supply; rise

Based on the expectations hypothesis, the steep upward sloping yield curve in June of 2013 indicted that short-term rates would ________ in the future.

climb

A lower level of income causes the demand for money to ________ and the interest rate to ________.

decrease; decrease

If a corporation's earnings rise, then the default risk on its bonds will ________ and the equilibrium interest rate on these bonds will ________.

decrease; decrease

Holding everything else the same, if a corporation's earnings rise, then the default risk on its bonds will ________ and the expected return on those bonds will ________.

decrease; increase

A decline in the expected inflation rate causes the demand for money to ________ and the demand curve to shift to the ________.

decrease; left

A decline in the price level causes the demand for money to ________ and the demand curve to shift to the ________.

decrease; left

Higher expected interest rates in the future ________ the demand for long-term bonds and shift the demand curve to the ________.

decrease; left

As a result of the subprime collapse, the demand for low -quality corporate bonds ________, the demand for high-quality Treasury bonds ________, and the risk spread ________. Correct!

decreased; increased; increased

If Moody's or Standard and Poor's downgrades its rating on a corporate bond, the demand for the bond ________ and its yield ________.

decreases; decreases

When the demand for bonds ________ or the supply of bonds ________, bond prices fall.

decreases; increases

When the demand for bonds ________ or the supply of bonds ________, interest rates rise.

decreases; increases

When the expected inflation rate increases, the demand for bonds ________, the supply of bonds ________, and the interest rate ________.

decreases; increases; rises

During a recession, the supply of bonds ________ and the supply curve shifts to the ________.

decreases; left

When bond prices become more volatile, the demand for bonds ________ and the interest rate ________.

decreases; rises

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 structure of interest rates is explained by

default risk. tax considerations. liquidity.

When the inflation rate is expected to increase, the expected return on bonds relative to real assets falls for any given interest rate; as a result, the ________ bonds falls and the ________ curve shifts to the left.

demand for; demand

When the interest rate on a bond is above the equilibrium interest rate, there is excess ________ in the bond market and the interest rate will ________.

demand; fall

When the price of a bond is below the equilibrium price, there is excess ________ in the bond market and the price will ________.

demand; rise

Between 1919 and 2016, when did long-term bond yields peak?

early 1980s

If a corporation begins to suffer large losses, then the default risk on its bonds will ________ and the equilibrium interest rate on these bonds will ________.

increase; increase

A rise in the price level causes the demand for money to ________ and the demand curve to shift to the ________.

increase; right

An increase in expected inflation causes the supply of bonds to ________ and the supply curve to shift to the ________.

increase; right

An increase in marginal tax rates would likely have the effect of ________ the demand for municipal bonds and ________ the demand for U.S. government bond

increasing; decreasing

Bonds with relatively low risk of default are called

investment-grade bonds.

Bonds with relatively high risk of default are called

junk bonds.

The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent over the next ten years. As a result of this tax cut, the demand for municipal bonds should shift to the ________ and the interest rate on municipal bonds should ________.

left; increase

When the corporate 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 ________.

left; right

When people begin to expect a large run up in stock prices, the demand curve for bonds shifts to the ________ and the interest rate ________.

left; rises

When stock prices become less volatile, the demand curve for bonds shifts to the ________ and the interest rate ________.

left; rises

When a municipal bond is given tax-free status, the demand for Treasury bonds shifts ________, and the interest rate on Treasury bonds ________.

leftward; rises

Moody's and Standard and Poor's are agencies that

produce information about the probability of default on corporate bonds.

A decrease in the expected rate of inflation will ________ the expected return on bonds relative to that on ________ assets.

raise; real

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.

Factors that determine the demand for an asset include changes in the

wealth of investors; liquidity of bonds relative to alternative assets; risk of bonds relative to alternative assets; expected returns on bonds relative to alternative assets.

The spread between interest rates on low-quality corporate bonds and U.S. government bonds ________ during the Great Depression.

widened significantly

If a bond has a favorable tax treatment, its required interest rate (all else equal)

will be lower.

The relationship among interest rates on bonds with identical default risk but different maturities is called the

yield curve.