ECON 303 Chapter 4 Study Questions

ECON 303 Chapter 6 Study Questions

1) If a corporation begins to suffer large losses, then

(a) 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.

(b) the default risk on the corporate bond will increase and the bond’s return will become less uncertain, meaning the expected return on the corporate bond will fall.

(c) the default risk on the corporate bond will decrease and the bond’s return will become less uncertain, meaning the expected return on the corporate bond will fall.

(d) the default risk on the corporate bond will decrease and the bond’s return will become less uncertain, meaning the expected return on the corporate bond will rise.

2) 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

(d) left; left

3) A reduction in the riskiness of corporate bonds will _____ the price of corporate bonds and ____ the price of Treasury bonds.

(a) increase; increase

(b) reduce; reduce

(d) increase; reduce

(e) reduce; not affect

4) 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 _____.

(a) investment grade; lower grade

(b) investment grade; junk bonds

(d) high quality; junk bonds

5) 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.

(d) of all of the above.

(e) of only (a) and (b) of the above.

6) Which of the following statements are true?

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

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

(d) Only (a) and (b) of the above are true statements.

7) Which of the following long-term bonds currently has the lowest interest rate?

(a) Corporate Baa bonds

(b) U.S. Treasury bonds

(d) Municipal bonds

8) If income tax rates were lowered, then

(a) the interest rate on municipal bonds would rise.

(b) the interest rate on Treasury bonds would fall.

(d) both (a) and (b) would occur.

(e) both (b) and (c) would occur.

9) 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) 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.

10) 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

(a) 1 percent.

(b) 2 percent.

(d) none of the above.

11) 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

(a) 1 percent.

(b) 2 percent.

(d) 4 percent.

(e) 5 percent.

12) 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) one year.

(b) two years.

(d) four years.

(e) five years.

13) 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.

(d) four years.

14) 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.

(d) 4 percent.

(e) 5 percent.

15) 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.

(d) all of the above.

16) According to the segmented markets theory of the term structure

(a) the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

(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 preferences 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.

17) 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) all of the above.

18) According to the segmented markets theory of the term structure

(a) the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

(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 preferences for short-term relative to long-term bonds explains why yield curves typically slope downward.

(d) only (a) and (b) of the above.

19) According to the segmented markets theory of the term structure

(a) the interest rate for each maturity bond is determined by supply and demand for that maturity bond.

(b) investors’ strong preferences for short-term relative to long-term bonds explains why yield curves typically slope upward.

(c) bonds of one maturity are close substitutes for bonds of other maturities, therefore, interest rates on bonds of different maturities move together over time.

(d) all of the above.

(e) only (a) and (b) of the above.

20) 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 preferred habitats.

(d) does none of the above.

21) 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 term 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 term 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.

22) 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.

(d) all of the above.

(e) only (a) and (b) of the above.

23) 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, than the 3-year bond rate will be

(a) 1 percent.

(b) 2 percent.

(d) 4 percent.

(e) 5 percent.

24) According to the liquidity premium theory

(a) a steeply rising yield curve indicates that short-term interest rates are expected to rise in the future.

(b) a moderately rising yield curve indicates that short-term interest rates are not expected to change much in the future.

(d) all of the above are true.

(e) only (a) and (b) of the true.

25) Which of the following theories of the term structure are able to explain the fact that interest rates on bonds of different maturities move together over time?

(a) The preferred habitat theory

(b) The segmented market theory

(d) All of the above

(e) Both (a) and (c) of the above

26) 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.

(d) the inverted yield curve theory of the term structure.

(e) risk premium theory of the term structure

27) When the yield curve is upward sloping,

(a) the expectations theory suggests that short-term interest rates are expected to rise.

(b) the expectations theory suggests that short-term interest rates are expected to fall.

(d) the liquidity premium theory suggests that short-term interest rates are expected to fall.

28) 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

(d) Separable markets theory

Figure 6-1

29) The U-shaped yield curve in Figure 6-2 indicates that

(a) short-term interest rates are expected to rise in the near term and fall later on.

(b) short-term interest rates are expected to fall moderately in the near-term and rise later on.

(d) short-term interest rates are expected to remain unchanged in the near-term and rise later on.

Figure 6-2

30) The U-shaped yield curve in Figure 6-2 indicates that

(a) inflation is expected to remain constant in the near-term and fall later on.

(b) inflation is expected to fall sharply in the near-term and rise later on.

(d) inflation is expected to remain constant in the near-term and rise later on.

Figure 6-3

31) The inverted U-shaped yield curve in Figure 6-3 indicates that

(a) inflation is expected to remain constant in the near-term and fall later on.

(b) inflation is expected to fall moderately in the near-term and rise later on.

(d) inflation is expected to remain unchanged in the near-term and rise later on.

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

(a) slope up.

(b) be flat.

(d) be an inverted U shape.

(e) have a W shape.

Answers