Chapter 5

13) An increase in the marginal tax rate would likely increase the demand for municipal bonds, and decrease the demand for U.S. government bonds.

Answer: TRUE

18) Risk, liquidity, and income tax rules all play a role in determining the risk structure of interest rates.

Answer: TRUE

19) During the budget negotiations in Congress in 1995-1996, and then again in 2011-2013, the Republicans threatened to let Treasury bonds default, and this had an impact on the bond market.

Answer: TRUE

2) The risk structure of interest rates describes the relationship between the interest rates of different bonds with the same maturities.

Answer: TRUE

3) Following the subprime collapse, the spread (difference) between the interest rates on Baa bonds and Treasury bonds widened.

Answer: TRUE

5) An increase in income tax rates will cause the interest rates on tax-exempt municipal bonds to fall relative to the interest rate on taxable corporate securities.

Answer: TRUE

6) The interest rates on bonds of different maturities tend to move together over time.

Answer: TRUE

8) According to the expectations theory, the interest rate on a long-term bond is the average of the short-term interest rates expected over the life of the long-term bond.

Answer: TRUE

5) What is meant by the risk structure of interest rates?

the relationship of interest rates on bonds with the SAME term to maturity.

25) (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. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

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

32) Which of the following statements are true? A) 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. B) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates. C) Interest rates on municipal bonds will be higher than on comparable bonds without the tax exemption. D) Only A and B are true statements.

A) 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.

Which of the following long-term bonds should have the highest interest rate? A) Corporate Baa bonds B) U.S. Treasury bonds C) Corporate Aaa bonds D) Municipal bonds

A) Corporate Baa bonds

60) Which theory of the term structure proposes that bonds of different maturities are not substitutes for one another? A) Market segmentation theory B) Expectations theory C) Liquidity premium theory D) Separable markets theory

A) Market segmentation theory

62) ________ cannot explain the empirical fact that interest rates on bonds of different maturities tend to move together. A) The market segmentation theory B) The expectations theory C) The liquidity premium theory D) Both A and B of the above E) Both A and C of the above

A) The market segmentation theory

74) Based on the expectations hypothesis, the steep upward sloping yield curve in June of 2013 indicted that short-term rates would ________ in the future. A) climb B) fall C) remain the same D) change in a random fashion

A) climb

21) Corporate bonds are not as liquid as government bonds because A) fewer 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) all of the above. E) only A and B of the above.

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

39) Typically, yield curves are A) gently upward-sloping. B) gently downward-sloping. C) flat. D) bowl shaped. E) mound shaped.

A) gently upward-sloping.

41) 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.

34) When a municipal bond is given tax-free status, the demand for Treasury bonds shifts ________, and the interest rate on Treasury bonds ________. A) leftward; rises B) leftward; falls C) rightward; rises D) rightward; falls

A) leftward; rises

71) The ________ theory is the most widely accepted theory of the term structure of interest rates because it explains the major empirical facts about the term structure so well. A) liquidity premium B) market segmentation C) expectations D) none of the above

A) liquidity premium

76) Closely related to the ________ is the preferred habitat theory, which takes a somewhat less direct approach to modifying the expectations hypothesis but comes to a similar conclusion. A) liquidity premium theory B) expectations theory C) market segmentation theory D) supply theory

A) liquidity premium theory

40) 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. E) medium-term interest rates are below both short-term and long-term interest rates.

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

65) A moderately upward-sloping yield curve indicates that short-term interest rates are expected to A) neither rise nor fall in the near future. B) remain relatively unchanged, but that long-term rates are expected to fall. C) neither rise nor fall, but that long-term rates are expected to rise moderately. D) rise moderately in the near future.

A) neither rise nor fall in the near future.

48) If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, then the pure 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.

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

A) positive

63) Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that views long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond is the A) pure expectations theory. B) preferred habitat theory. C) liquidity premium theory. D) segmented markets theory

A) pure expectations theory.

35) 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 ________. A) rightward; fall B) rightward; rise C) leftward; fall D) leftward; rise

A) rightward; fall

44) 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 rise 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) all of the above. E) only A and B of the above.

A) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future.

1) The term structure of interest rates describes how interest rates move over time.

Answer: FALSE

10) Bonds with the lowest risk of default are often referred to as junk bonds.

Answer: FALSE

11) A positive liquidity premium indicates that investors prefer long-term bonds over short-term bonds.

Answer: FALSE

14) When yield curves are downward-sloping, long-term interest rates are above short-term interest rates.

Answer: FALSE

15) Risk occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures.

Answer: FALSE

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

Answer: FALSE

17) With the Obama tax increase that repealed the Bush tax cuts for high-income tax payers in 2013, the after-tax expected return on tax-free municipal bonds relative to Treasury bonds decreases.

Answer: FALSE

4) The risk premium on corporate bonds becomes smaller as the liquidity of the bonds falls.

Answer: FALSE

7) The expectations theory is able to explain why yield curves are usually upward-sloping.

Answer: FALSE

9) The market segmentation theory is able to explain why interest rates on bonds of different maturities move together over time.

Answer: FALSE

12) A mildly upward-sloping yield curve suggests that the market is predicting constant short-term interest rates.

Answer: TRUE

26) (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. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

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

9) (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. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

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

72) ________ are investment advisory firms that rate the quality of corporate and municipal bonds in terms of probability of default. A) Financial institutions B) Credit-rating agencies C) Securities companies D) none of the above

B) Credit-rating agencies

56) If the yield curve has a mild upward slope, the liquidity premium theory 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.

13) If a corporation's earnings rise, then the default risk on its bonds will ________ and the equilibrium interest rate on these bonds will ________. A) increase; decrease B) decrease; decrease C) increase; increase D) decrease; increase

B) decrease; decrease

18) 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 ________. A) increased; decreased; was unchanged B) decreased; increased; increased C) increased; decreased; decreased D) decreased; increased; was unchanged

B) decreased; increased; increased

20) If Moody's or Standard and Poor's downgrades its rating on a corporate bond, the demand for the bond ________ and its yield ________. A) increases; decreases B) decreases; increases C) increases; increases D) decreases; decreases

B) decreases; increases

59) In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major shortcoming of the A) market segmentation theory. B) expectations theory. C) liquidity premium theory. D) separable markets theory

B) expectations theory.

67) A bond rating of Aa or AA would mean that the quality of the bond is A) the highest. B) high. C) medium grade. D) speculative.

B) high.

29) 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. A) increasing; increasing B) increasing; decreasing C) decreasing; increasing D) decreasing; decreasing

B) increasing; decreasing

42) According to the expectations theory of the term structure, A) the interest rate on long-term bonds will exceed the average of expected future short-term interest rates. B) interest rates on bonds of different maturities move together over time. C) buyers of bonds prefer short-term to long-term bonds. D) all of the above. E) only A and B of the above.

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

7) Bonds with relatively high risk of default are called A) Brady bonds. B) junk bonds. C) zero coupon bonds. D) investment-grade bonds

B) junk bonds.

8) A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby A) raising the default risk and causing the demand for its bonds to rise. B) raising the default risk and causing the demand for its bonds to fall. C) lowering the default risk and causing the demand for its bonds to rise. D) lowering the default risk and causing the demand for its bonds to fall.

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

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

B) right; left

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

B) right; left

64) Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that assumes that bonds of different maturities are not substitutes for one another is the A) expectations theory. B) segmented markets theory. C) liquidity premium theory. D) preferred habitat theory.

B) segmented markets theory.

2) Why would an increase in the income tax rate reduce borrowing costs to municipalities?

Increase in income tax rate would reduce borrowing cost to municipalities because increase tax rate would allow them to reduce interest rate on muni b0nds.

54) 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 cannot be downward-sloping. D) all of the above. E) only A and B of the above.

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.

2) 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 terms 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.

22) (I) The risk premium widens as the default risk on corporate bonds increases. (II) The risk premium widens as corporate bonds become less liquid. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

C) Both are true

16) (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. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

C) Both are true.

55) If the yield curve slope is flat, the liquidity premium theory indicates that the market is predicting A) a mild rise in short-term interest rates in the near future and a mild decline further out in the future. B) constant short-term interest rates in the near future and further out in the future. C) a mild decline in short-term interest rates in the near future and a continuing mild decline further out in the future. D) constant short-term interest rates in the near future and a mild decline further out in the future.

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

30) 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. A) increasing; increasing B) increasing; decreasing C) decreasing; increasing D) decreasing; decreasing

C) decreasing; increasing

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

C) increase; decrease

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

C) increase; increase

6) Bonds with relatively low risk of default are called A) zero coupon bonds. B) junk bonds. C) investment-grade bonds. D) none of the above.

C) investment-grade bonds.

19) Moody's and Standard and Poor's are agencies that A) help investors collect when corporations default on their bonds. B) advise municipal bond issuers on the tax exempt status of their bonds. C) produce information about the probability of default on corporate bonds. D) maintain liquid markets for corporate bonds.

C) produce information about the probability of default on corporate bonds.

28) If income tax rates rise, then A) the prices of municipal bonds will fall. B) the prices of Treasury bonds will rise. C) the interest rate on Treasury bonds will rise. D) the interest rate on municipal bonds will rise.

C) the interest rate on Treasury bonds will rise.

27) If income tax rates were lowered, then A) the interest rate on municipal bonds would fall. B) the interest rate on Treasury bonds would rise. C) the interest rate on municipal bonds would rise. D) the price of Treasury bonds would fall.

C) the interest rate on municipal bonds would rise.

17) The spread between interest rates on low-quality corporate bonds and U.S. government bonds ________ during the Great Depression. A) was reversed B) narrowed significantly C) widened significantly D) did not change

C) widened significantly

73) If a bond has a favorable tax treatment, its required interest rate (all else equal) A) will be higher. B) will not be affected. C) will be lower. D) all of the above could happen

C) will be lower.

37) The relationship among interest rates on bonds with identical default risk but different maturities is called the A) time-risk structure of interest rates. B) liquidity structure of interest rates. C) yield curve. D) bond demand curve.

C) yield curve.

31) Which of the following statements are true? A) 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. B) An increase in tax rates will increase the demand for municipal bonds, lowering their interest rates. C) Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption. D) All of the above are true statements. E) Only A and B are true statements.

D) All of the above are true statements.

15) (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. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.

D) Both are false.

69) ________ bonds are exempt from federal income taxes. A) Corporate Aaa B) U.S. Treasury C) Corporate Baa D) Municipal

D) Municipal

3) Which of the following long-term bonds should have the lowest interest rate? A) Corporate Baa bonds B) U.S. Treasury bonds C) Corporate Aaa bonds D) Municipal bonds

D) Municipal bonds

68) ________ bonds are the most liquid of all long-term bonds. A) Callable B) Municipal C) Corporate Aaa D) U.S. Treasury

D) U.S. Treasury

38) Yield curves can be classified as A) upward-sloping. B) downward-sloping. C) flat. D) all of the above. E) only A and B of the above

D) all of the above.

49) According to the market segmentation theory of the term structure, A) the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity. B) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time. C) investors' strong preference for short-term relative to long-term bonds explains why yield curves typically slope upward. D) all of the above. E) none of the above.

D) all of the above.

53) According to the liquidity premium 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 plus a liquidity premium. B) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of different maturities move together over time. C) even with a positive liquidity premium, if future short-term interest rates are expected to fall significantly, then the yield curve will be downward-sloping. D) all of the above. E) only A and B of the above.

D) all of the above.

70) The risk structure of interest rates is explained by A) default risk. B) liquidity. C) tax considerations. D) all of the above.

D) all of the above.

52) The liquidity premium theory of the term structure A) assumes investors tend to prefer short-term bonds because they have less interest-rate risk. B) assumes that interest rates on the long-term bond respond to demand and supply conditions for that bond. C) assumes that an average of expected short-term rates is an important component of interest rates on long-term bonds. D) assumes all of the above. E) assumes none of the above.

D) assumes all of the above.

57) 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.

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

D) decrease; increase

51) The liquidity premium theory of the term structure A) indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond. B) assumes that bonds of different maturities are perfect substitutes. C) suggests that markets for bonds of different maturities are completely separate because people have different preferences. D) does none of the above.

D) does none of the above.

36) 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 ________. A) right; decline B) right; increase C) left; decline D) left; increase

D) left; increase

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

D) left; right

46) If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the pure expectations theory predicts that today's interest rate on the four-year bond is A) 1 percent. B) 2 percent. C) 4 percent. D) none of the above.

D) none of the above.

58) According to the liquidity premium theory of the term structure, when the yield curve has its usual slope, the market expects A) short-term interest rates to rise sharply. B) short-term interest rates to drop sharply. C) short-term interest rates to stay near their current levels. D) none of the above.

D) none of the above.

50) According to the market segmentation theory of the term structure, A) the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity. B) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time. C) investors' strong preference for short-term relative to long-term bonds explains why yield curves typically slope downward. D) only A and B of the above.

D) only A and B of the above.

33) When a municipal bond is given tax-free status, the demand for municipal bonds shifts ________, causing the interest rate on the bond to ________. A) leftward; rise B) leftward; fall C) rightward; rise D) rightward; fall

D) rightward; fall

66) A steep upward-sloping yield curve indicates that short-term interest rates are expected to A) neither rise nor fall in the near future. B) remain relatively unchanged, but that long-term rates are expected to fall. C) neither rise nor fall, but that long-term rates are expected to rise moderately. D) rise moderately in the near future

D) rise moderately in the near future

1) The term structure of interest rates is A) the relationship among interest rates of different bonds with the same risk and maturity. B) the structure of how interest rates move over time. C) the relationship among the terms to maturity of different bonds from different issuers. D) the relationship among interest rates on bonds with different maturities but similar risk.

D) the relationship among interest rates on bonds with different maturities but similar risk.

61) Since yield curves are usually upward sloping, the ________ indicates that, on average, people tend to prefer holding short-term bonds to long-term bonds. A) market segmentation theory B) expectations theory C) liquidity premium theory D) both A and B of the above E) both A and C of the above

E) both A and C of the above

5) The risk premium on corporate bonds becomes smaller if A) the riskiness of corporate bonds increases. B) the liquidity of corporate bonds increases. C) the liquidity of corporate bonds decreases. D) the riskiness of corporate bonds decreases. E) either B or D of the above occur.

E) either B or D of the above occur.

47) If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, then the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of A) one year. B) two years. C) three years. D) four years. E) five years.

E) five years.

43) 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 rise in the future. B) when the yield curve is downward-sloping, short-term interest rates are expected to decline in the future. C) buyers of bonds prefer short-term to long-term bonds. D) all of the above. E) only A and B of the above.

E) only A and B of the above.

45) According to the expectations theory of the term structure, A) yield curves should be equally likely to slope downward as to slope upward. B) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future. C) when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future. D) all of the above. E) only A and B of the above.

E) only A and B of the above.

1) Contrast the liquidity premium theory to the market segmentation theory of the term structure of interest rates.

Market segmentation theory states that bonds of different maturities are not substitutes at all. Liquidity theory says they are substitutes, but allows that investors prefer one maturity over another, and prefer shorter maturities because they have less interest rate risk. Modify expectations with liquidity premium.

3) Discuss what is shown by a yield curve.

a yield curve has interest rate on Y axis and term to maturity on X show the path of interest rates over different maturity times.

4) Why is it unlikely that the expectations theory alone is the correct theory for explaining the yield curve?

expectation theory alone cannot explain why yield curves usually slope upward. Expectation theory suggest curve is just as likely to slope downward.