The Risk And Term Structure Of Ch7 Test Questions & Answers

Student name:__________

1) What is the main purpose (function) of bond rating services?

2) Briefly describe the two different types of junk bonds (high-yield bonds).

3) What is meant by a subprime mortgage?

4) If an investor wants to compare commercial paper to a corresponding default-free investment, which security would they use and why?

5) How did asset-backed commercial paper (ABCP) rollover risk contribute to the financial crisis of 2007–2009?

6) An investor sees the current twelve-month rate at 4% and expects the following future twelve-month rate for each of the subsequent years; 4.5%, 5.5% and 6.0%. If this investor views a four-year maturity at 5.65% as equal to four consecutive one-year securities, what is their risk premium?

7) Why do economists pay particular attention to inverted yield curves?

8) If the yield curve is flat, using liquidity premium theory, what do you know about the expected future short-term interest rate?

9) Explain why many mayors of cities facing the need to borrow for infrastructure improvements, may not look favorably on a large federal income tax rate reduction?

10) What is the effective after-tax yield to an investor from a bond paying $70 per $1,000 annually, if the investor is in a 25% marginal tax bracket? Explain.

11) Consider the following four investors. Rank each according to who has the most to gain from investing in 30-year tax-exempt municipal bonds. Each investor has $1,000 in a savings account that they plan to use to buy bonds. Explain briefly why you ranked the investors this way.

(a) A 20-year-old college student who earns low income through working over summers and breaks. The student plans to graduate next year.

(b) The CEO of a large company who is currently in the highest tax bracket.

(c) A middle-income household saving up to move into a larger home.

(d) A 60-year-old nurse who plans to retire at age 62. He uses a tax-exempt pension fund for all of his savings.

12) Using the information provided and the expectations hypothesis, compute the yields for a two-year, three-year, and four-year bonds.

Now, suppose there is a risk premium attached to each bond. These risk premiums are given in the following table.

Using the information above and the liquidity premium theory, compute the yields for a two- year, three-year, and four-year bonds. How does this yield curve compare to the one you computed using the expectations hypothesis?

13) What is the equivalent tax-exempt bond yield for a taxable bond with an 8% yield and a bondholder in a 35% marginal tax rate? Explain.

14) Assuming the expectations hypothesis is correct, use the information provided below to find the expected one-year interest rate for three years from now. Explain your answer.

15) Any theory of the yield curve must be able to explain what three general conditions?

16) The usually upward-sloping yield curve indicates that long-term bonds have higher yields than short-term bonds. Why is this?

17) Why can't the expectations hypothesis stand alone as an adequate theory to explain yield curves?

18) What impact should an economic slowdown have on the risk structure of interest rates?

19) During economic slowdowns why would you expect the risk premium to increase the most between U.S. Treasury bonds and junk bonds?

20) When we compare GDP growth over time to the risk spread on Baa bonds compared to 10-year U.S. Treasury bonds for the same time frame, what relationship can be inferred?

21) Describe the concept of “flight to quality” in terms of the Russian government default of August 1998.

22) Why do yield curves usually slope upward?

23) Explain why an inverted yield curve is a valuable forecasting tool.

24) Why might we expect to see a high correlation between increases in the risk structure of interest rates and the yield curve becoming inverted?

25) Does the expectations hypothesis allow for people to have a preference for longer-term investments? Explain

26) Explain why most retired individuals are not likely to be heavily invested in municipal bonds.

27) At the beginning of 2006 the yield curve was usually flat, and sometimes downward sloping (inverted). This raised concerns that a recession might be on the way. But the slope of the yield curve is only part of the story. What else is important?

28) Please use the graphs to show what happens to the risk (yield) differential in each situation and why.



Assume the corporate and Treasury bonds have the same maturity;

a) If the corporate bonds are default-risk free, what could you tell about the price and yields of each?

b) If the corporate bonds are now viewed as having the possibility of default, what happens in each market?

c) If the corporate bonds are granted tax-exempt status, what happens in each market?

d) If the corporate bonds have a longer maturity than the Treasury bonds what would happen?

29) Under the expectations hypothesis of the term structure of interest rates, explain the impact of a U.S. Treasury decision to phase out the 30-year bond and to only focus on 3-month, 1-year, 5-year, and 10-year bonds?

30) We have heard the predictions regarding the large number of people that will be retiring over the next 25–50 years and the strain this is going to place on the federal budget. Assuming that federal borrowing will have to increase, what is the likely impact going to be on the risk and term structure (if any) of interest rates and why?

31) The paper-bill spread refers to the interest rate spread between commercial paper and Treasury bills with the same maturity. Is this a risk spread or a term spread? How do you expect the paper-bill spread is related to GDP growth? What is the intuition for this result? What does this imply about the yield curve?

32) Suppose that the Federal Reserve is concerned about rising inflation, so they increase short-term interest rates. How will this affect long-term rates and the yield curve? What does the slope of the yield curve reveal about the effectiveness of the Fed's policy? Explain in the context of the Liquidity Premium Theory.

33) In March of 2020, Argentina’s risk spread increased to levels not seen since 2005 as the coronavirus expanded globally. Why would the global pandemic be accompanied by an increase in the risk spread?

34) The bond rating of a security reflects the

A) size of the coupon payment relative to the face value.
B) likelihood the lender/borrower will be repaid by the borrower/issuer.
C) return a holder is likely to receive.
D) size of the coupon rate relative to other interest rates.

35) The two best known bond rating services are

A) the Federal Reserve and Moody's Investment Services.
B) the Federal Reserve and the U.S. Treasury.
C) Standard & Poor's and the Wall Street Journal.
D) Standard & Poor's and Moody's Investment Services.

36) Investors usually obtain bond ratings from

A) private bond-rating agencies.
B) the annual tax returns of the issuer.
C) the U.S. government from publicly available information.
D) public Information made available by the bond issuers.

37) Which one of the following assigns widely followed bond ratings?

A) the Federal Reserve
B) the U.S. Treasury
C) the New York Stock Exchange
D) Standard & Poor's

38) Which one of the following assigns widely followed bond ratings?

A) the Federal Reserve
B) the Wall Street Journal
C) Moody's Investor Service
D) NASDAQ

39) What is the highest bond rating assigned by Standard & Poor’s?

A) AA
B) EEE
C) AAA
D) A

40) The lowest rating for an investment grade bond assigned by Moody's is

A) Baa.
B) A.
C) BBB.
D) Aa.

41) Bonds rated as "highly speculative" are

A) rated so because they guarantee high returns for the buyer.
B) commonly referred to as junk bonds.
C) ranked just above investment grade by Standard & Poor's.
D) rated so because they do not have any default risk.

42) Which one of the following would be most likely to earn an AAA rating from Standard & Poor's?

A) a 10-year bond issued by Canada
B) a bond issue by a new vegetarian fast-food chain
C) a 10-year bond issued by a state or municipality
D) shares of stock in Coca-Cola

43) Once a bond rating is assigned, it

A) never changes over the life of the bond.
B) can change as the financial position of the issuer changes.
C) can only change if the rating change is approved by the Securities and Exchange Commission.
D) can change on the next bond from the issuer but is fixed for the current bond.

44) Commercial paper refers to

A) the financial publications read by the CEOs of public corporations.
B) any debt security with a maturity exceeding one year.
C) short-term collateralized securities issued only by corporations.
D) unsecured short-term debt issued by corporations and governments.

45) Most commercial paper is

A) issued with maturities exceeding one year.
B) issued with maturities between 50 and 75 days.
C) used exclusively for short-term financing needs.
D) issued by foreign companies doing business in the United States.

46) In 2011, several credit rating agencies around the world downgraded their credit ratings of the U.S. federal government, including S&P. This change in S&P’s rating, specifically, might be illustrated by which one of the following changes?

A) a change from a rating of C to Ca
B) a change from a rating of A to Baa
C) a change from a rating of BB to BBB
D) a change from a rating of AAA to AA+

47) If a bond's rating improves, it should cause the bond’s price

A) and yield to increase, all other factors constant.
B) and yield to decrease, all other factors constant.
C) to increase and its yield to decrease, all other factors constant.
D) to decrease and its yield to increase, all other factors constant.

48) If a bond's rating improves, we would expect

A) the demand for this bond to increase, all other factors constant.
B) the demand for and the yield of this bond to increase, all other factors constant.
C) the demand for this bond to decrease, and its yield to increase, all other factors constant.
D) both the demand for and the price of the bond to decrease, all other factors constant.

49) Bonds issued by the U.S. Treasury are referred to as benchmark bonds because

A) they are always purchased for a premium.
B) they are highly liquid and virtually free of default risk.
C) all bonds from national governments are labeled as benchmark bonds.
D) all bonds from the U.S. government have the same rate of interest.

50) The risk spread is

A) the difference between a bond's purchase price and selling price.
B) the difference between the bond's yield and the yield on a U.S. Treasury bond of the same maturity.
C) less than 0 (zero) for a U.S. Treasury bond.
D) assigned by a bond-rating agency.

51) The risk spread

A) is also known as the default-risk premium.
B) should have a direct relationship with the bond's price.
C) should have an inverse relationship with the bond's yield.
D) is always constant.

52) In a March, 2020, Moody’s Analytics Report, chief economist Mark Zandi reported that credit spreads in the bond market have sharply widened. This is a signal of

A) heightened investor angst.
B) positive investor expectations for the future.
C) future ratings upgrades for speculative bonds.
D) decreasing rates for speculative-grade commercial paper.

53) All of the following are true about the risk spread except that it should

A) be higher for highly speculative bonds than investment grade bonds.
B) have a direct relationship with the bond's yield.
C) have an inverse relationship with the bond's price.
D) have a direct relationship with the bond's price.

54) The default-risk premium

A) is negative for a U.S. Treasury bond.
B) is also known as the risk spread.
C) must always be greater than 0 (zero).
D) is assigned by a bond-rating agency.

55) The default-risk premium

A) should vary directly with the bond's yield and inversely with its price.
B) is less than 0 (zero) for a U.S. Treasury bond.
C) should be lower for a highly speculative bond than for an investment-grade bond.
D) should vary directly with the bond's yield and the bond's price.

56) The risk structure of interest rates says

A) the interest rates on a variety of bonds will move independently of each other.
B) lower rated bonds will have higher yields.
C) U.S. Treasury bond yields always change by more than other bonds.
D) interest rates only compensate for risk during recessions.

57) Comparing Moody’s Aaa corporate bond yield to the yield on 10-year U.S. Treasury bonds, the spread increased from 1.14 on January 3, 2020, to 2.81 on March 23, 2020. What does this type of increase signal?

A) There is an increase in confidence in the U.S. economy.
B) Consumers are less willing to take on riskier investments.
C) The economy is heading for an expansion in economic activity.
D) Borrowers can pay lower interest rates to get investors to take risks.

58) U.S. Treasury securities are considered to carry no risk spread because

A) they are the closest thing to default-risk free that an investor can obtain.
B) the prices of U.S. Treasury bonds never change.
C) the yields on U.S. Treasury bonds never change.
D) the yields on U.S. Treasury bonds are always low.

59) The risk structure of interest rates refers to the

A) relationship among the interest rates of bonds with different maturities.
B) relationship among the interest rates of bonds from different issuers with the same maturities.
C) relationship among the interest rates of bonds from the same issuer but different maturities.
D) additional interest required to compensate the buyer for the longer maturity of the bond.

60) A borrower who has to pay an interest rate of 8% rather than 6% due to risk spread will pay

A) $20 more in interest annually for every $100 borrowed.
B) 33.3% higher interest in dollar terms.
C) 2% in net interest.
D) less interest in total over the life of the loan.

61) Which one of the following is true?

A) Long-term bond yields move together but short-term yields do not.
B) Short-term bond yields move together but long-term yields do not.
C) U.S. Treasury Bill yields are lower than the yields on commercial paper.
D) Long-term bond yields are usually the same as short-term yields.

62) Taxes play an important role in bond returns because

A) all interest from owning bonds is taxed.
B) all governments (federal, state, municipal) tax bonds similarly.
C) some bond interest is exempt from some government taxation, so after tax returns across bonds can vary considerably.
D) only U.S. Treasury bonds are tax-exempt, so investors should always seek higher returns from other bonds.

63) Municipal bonds are issued by

A) cities only.
B) the U.S. Treasury, but the proceeds can only be used by cities.
C) states and cities, but their interest is taxable only at the federal level.
D) states and cities and their interest is exempt from U.S. government taxation.

64) Fatima holds a one-year $200 face value, taxable bond with a coupon rate of 5%. Suppose she faces a tax rate of 20%. How much tax will she pay for income earned on the investment? And, what is the return on the investment when taxes are taken into account?

A) She will pay $2 in taxes and earn a return of 4%.
B) She will pay $2 in taxes and earn a return of 5%.
C) She will pay $10 in taxes and earn a return of 4%.
D) She will pay $10 in taxes and earn a return of 5%.

65) An investor in a 30% marginal tax bracket, earning $10 in interest annually for a $100 U.S. Treasury bond

A) earns a 10% after-tax return because interest on U.S. Treasury bonds is tax exempt at the federal level.
B) earns a 3% return after-tax.
C) would be indifferent between this bond and a municipal bond offering $7 annually per $100 of face value, assuming the same default risk and liquidity characteristics.
D) earns a 1% return after-tax.

66) The yield on a tax-exempt bond

A) equals the taxable bond yield times one minus the tax rate.
B) is equal to the yield on a U.S. 30-year bond.
C) is called the risk-free yield.
D) only applies to foreign bonds because they are exempt from U.S. income taxes.

67) Holding liquidity and default risk constant, an investor earning 6% from a tax-exempt bond who is in a 25% tax bracket would be indifferent between that bond and a taxable bond with a(n)

A) 8% yield.
B) 4.5% yield.
C) 6.25% yield.
D) 7.5% yield.

68) Holding liquidity and default risk constant, an investor earning 4% from a tax-exempt bond who is in a 20% tax bracket would be indifferent between that bond and a taxable bone with a(n)

A) 7.5% yield.
B) 8.0% yield.
C) 5% yield.
D) 6% yield.

69) Municipal bonds are usually purchased by investors

A) who are retired and have no other taxable income.
B) looking for securities to buy for their IRA accounts.
C) who live in cities with high municipal tax rates.
D) who are in high marginal tax brackets.

70) Suppose the tax rate is 25% and the taxable bond yield is 8%. What is the equivalent tax-exempt bond yield?

A) 2%
B) 2.3%
C) 6%
D) 6.9%

71) In 2003, ratings agencies downgraded bonds issued by the State of California several times. How will this affect the market for these bonds?

A) Yields on these bonds will decrease and the yield on Treasury bonds will increase.
B) The yield on these bonds will not change, nor will the yield on Treasury bonds.
C) The yield on these bonds and on Treasury bonds will both decrease.
D) Yields on these bonds will increase.

72) Tax-exempt bonds

A) generate higher returns for the bondholder when purchased through a tax-exempt retirement account.
B) are not affected by changes in yields on taxable bonds.
C) are most beneficial to those who pay higher income tax rates.
D) include U.S. Treasury securities because the Internal Revenue Service does not charge income tax on interest earned from these bonds.

73) If a local government eliminates the tax exemption on municipal bonds, we would expect to see

A) an increase in the yield on taxable bonds.
B) a decrease in the gap in yields on taxable and tax-exempt bonds.
C) a decrease in the yield on municipal bonds.
D) municipal bonds will become more attractive to investors.

74) Which one of the following is not typically used for qualifying mortgages as prime or subprime?

A) the borrower’s income
B) the borrower’s credit score
C) the borrower’s ethnicity
D) the loan to value ratio

75) According to the Expectations Theory of the term structure, if interest rates are expected to be 2%, 2%, 4%, and 5% over the next four years, which yield is the closest to the yield on a three-year bond today?

A) 2.7%
B) 4%
C) 4.3%
D) 8%

76) Suppose the economy has an inverted yield curve. According to the expectations hypothesis, which one of the following interpretations could be used to explain this?

A) Interest rates are expected to fall in the future.
B) Investors prefer bonds with less default risk.
C) Investors prefer bonds with less interest-rate risk.
D) The term spread is positive.

77) The following figures illustrate which theory concerning interest rates?

A) term structure of interest rates
B) risk structure of interest rates
C) liquidity premium theory
D) expectations hypothesis

78) Which fact about the term structure is the expectations theory unable to explain?

A) why interest rates on bonds with different terms to maturity tend to move together over time
B) why yields on short-term bonds are more volatile than yields on long-term bonds
C) why longer-term yields tend to be higher than shorter-term yields
D) why long-term bond yields are influenced by expected future short-term bond yields

79) Which fact about the term structure is the expectations theory able to explain?

A) why interest rates on bonds with different terms to maturity tend to move together over time
B) why yields on short-term bonds are more volatile than yields on long-term bonds
C) why longer-term yields tend to be higher than shorter-term yields
D) why long-term bonds usually are less liquid than short-term bonds with the same default risk

80) The risk spread on bonds fluctuates mainly because

A) taxes tend to increase over time.
B) bond rating agencies are often inconsistent.
C) new information about a borrower’s financial condition becomes available.
D) people do not change their attitudes toward risk quickly.

81) In the fall of 1998 we saw an increase in the risk spread because

A) the risk spread always increases as we approach the end of the year.
B) the Russian government defaulted on some of its bonds.
C) there was an extraordinarily large amount of corporate fraud being reported in 1998.
D) there was a significant increase in U.S. income tax rates.

82) As a global pandemic erupted in early 2020, lenders began to reevaluate the relative risk of holding various types of bonds. An important early signal in this type of crisis-induced analysis is

A) interest rate spreads.
B) tax implications of holding bonds.
C) availability of public information about bonds.
D) the size of coupon payments relative to the face value of bonds.

83) A company that continues to have strong profit performance during an economic downturn when many other companies are suffering losses or failing should see

A) an increase in the yield of their bonds and the price of the bond increases.
B) their bond rating maintained or actually increase.
C) the demand for their bonds decrease and their yields decrease.
D) the demand and price for their bonds decrease.

84) Bonds with the same tax status and ratings

A) always have the same yield.
B) can have different yields due to different maturities.
C) should sell for the same price.
D) will still have different yields depending on their face values.

85) The U.S. Treasury yield curve

A) shows the relationship among bonds with the same risk characteristics but different maturities.
B) assumes maturities are constant, and reflects the difference in risk.
C) always has a positive slope.
D) always has a negative slope.

86) During a recession you would expect the difference between the commercial paper rate and the yield on U.S. T-bills of the same maturity to

A) be the same since their maturities are the same.
B) increase, reflecting the possibility of higher default risk for commercial paper.
C) decrease.
D) fluctuate rarely.

87) Which one of the following statements pertaining to the yield curve is false? The yield curve

A) usually slopes upwards.
B) shows the difference in default risk between securities.
C) shows the relationship among bonds with the same risk characteristics but different maturities.
D) can be flat or downward sloping depending on market conditions.

88) If the federal government replaced the current income tax with a national sales tax, the price of

A) corporate bonds and municipal bonds would rise.
B) municipal bonds would rise and corporate bonds would not change.
C) corporate bonds would fall while the price of municipal bonds would rise.
D) municipal bonds would fall while the price of corporate bonds would rise.

89) Interest on most bonds issued by states is usually exempt from

A) state income tax but not federal.
B) from federal income tax but not state.
C) both state and federal income taxes.
D) from city income taxes.

90) The term structure of interest rates

A) always results in an upward sloping yield curve.
B) represents the variation in yields for securities differing in maturities.
C) usually results in a flat yield curve.
D) usually results in a downward sloping yield curve.

91) Which one of the following statements is not true of the yield curve for U.S. Treasury securities?

A) The yield curve usually slopes upward.
B) The yield curve usually is inverted.
C) The yield curve shows the relationship among securities of different maturities.
D) The yield curve can shift over time.

92) In examining the yield curve for U.S. Treasury securities, we find all of the following except which one?

A) Long-term yields tend to be higher than short-term yields.
B) Interest rates of different maturities tend to move together.
C) Long-term rates tend to equal short-term rates.
D) Yields on short-term securities are more volatile than yields on long-term bonds.

93) When the yield curve slope is more upward sloping than usual, people are expecting

A) an economic slowdown.
B) the U.S. Treasury may default on its obligations.
C) the Federal Reserve is going to ease monetary policy.
D) a future rise in short-term interest rates.

94) When the yield curve is downward sloping,

A) people are expecting an economic slowdown.
B) short-term yields are lower than long-term yields.
C) people are expecting higher inflation in the future.
D) people could be expecting a tightening in monetary policy.

95) Any theory of the term structure of interest rates needs to explain each of the following, except why

A) short-term yields are more volatile than long-term yields.
B) the yields of different maturities tend to move together.
C) short-term yields are usually higher than long-term yields.
D) long-term yields are usually higher than short-term yields.

96) The expectations hypothesis assumes

A) a high level of uncertainty regarding the future of long-term yields.
B) investors know the yields on bonds today and form expectations of the yields on short-term bonds in future time periods.
C) securities of different maturities are not perfect substitutes for each other.
D) the risk premium increases with longer maturities.

97) The expectations hypothesis suggests the

A) yield curve should usually be downward-sloping.
B) yield curve should usually be upward-sloping.
C) slope of the yield curve reflects the risk premium associated with longer-term bonds.
D) slope of the yield curve depends on the expectations for future short-term rates.

98) The yield on a 30-year U.S. Treasury security is 6.5%; the yield on a 2-year U.S. Treasury bond is 4.0%. These data indicate

A) the yield curve is downward-sloping.
B) the yield curve is flat since the risk premium needs to be added for longer maturities.
C) the yield curve is upward sloping.
D) that people expect inflation to decrease in the future.

99) Assume the expectation hypothesis regarding the term structure of interest rates is correct. Then, if the current one-year interest rate is 4% and the two-year interest rate is 6%, then investors are expecting the future one-year rate to be

A) 4%.
B) 8%.
C) 6%.
D) 5%.

100) Assume the expectations hypothesis regarding the term structure of interest rates is correct. If the current two-year interest rate is 5% and the current one-year rate is 6%, then investors expect the future one-year rate to be

A) 4%.
B) 5%.
C) 6%.
D) 1%.

101) Assume the expectations hypothesis regarding the term structure of interest rates is correct. If the current one-year interest rate is 3% and the one-year-ahead expected one-year interest rate is 5%, then the current two-year interest rate should be

A) 3%.
B) 5%.
C) 4%.
D) 8%.

102) Assume an investor has a choice of three consecutive one-year bonds or one three-year bond. Assuming the expectations hypothesis of the term structure of interest rates is correct, the

A) average interest rate of the three consecutive one-year bonds should be less than the three-year bond to reflect the risk premium.
B) interest rate of the three-year bond should equal the average interest rate of the three one-year bonds.
C) three consecutive one-year bonds must have the same interest rate.
D) current one-year interest rate must equal the current three-year interest rate.

103) According to the expectations hypothesis,

A) when short-term interest rates are expected to rise in the future, the long-term interest rates are equal to current short-term interest rates.
B) when short-term rates are expected to remain constant in the future, the long-term interest rates are higher than current short-term interest rates.
C) short-term bonds are perfect substitutes for long-term bonds.
D) expectations of future short-term rates equal estimates of current short-term rates.

104) According to the expectations hypothesis, if investors believed that, for a given holding period, the average of the expected future short-term yields was greater than the long-term yield for the holding period, they would act so as to drive

A) down the price of the short-term bond and drive up the price of the long-term bond.
B) up the price of the short-term bond and drive down the price of the long-term bond.
C) up the prices of both the short- and long-term bonds.
D) down the prices of both the short- and long-term bonds.

105) The expectations hypothesis cannot explain why

A) yields on securities of different maturities move together.
B) short-term yields are more volatile than long term yields.
C) yield curves usually slope upward.
D) long-term bonds usually are less liquid than short-term bonds with the same default risk.

106) Under the expectations hypothesis, a downward-sloping yield curve suggests that investors expect future

A) short-term interest rates to fall.
B) short-term interest rates to rise.
C) long-term interest rates to remain constant.
D) short-term interest rates to remain constant.

107) The expectations hypothesis assumes each of the following, except

A) long-term bond rates are equal to the average of current and expected future short-term interest rates.
B) bonds of different maturities are not perfect substitutes.
C) bonds of different maturities have the same risk characteristics.
D) bonds of different maturities are perfect substitutes.

108) Suppose that interest rates are expected to remain unchanged over the next few years. However, there is a risk premium for longer-term bonds. According to the liquidity premium theory, the yield curve should be

A) upward-sloping and very steep.
B) upward-sloping and relatively flat.
C) inverted.
D) vertical.

109) Suppose the economy has an inverted yield curve. According to the liquidity premium theory, which one of the following interpretations could be used to explain this?

A) Interest rates are expected to rise in the future.
B) Investors expect an economic slowdown.
C) Investors are indifferent between bonds with different time horizons.
D) The term spread has increased.

110) The economy enters a period of robust economic growth that is expected to last for several years. How would this be reflected in the risk structure of interest rates?

A) an inverted yield curve
B) a decrease in the term spread
C) a decrease in the interest rate spread
D) an increase in yields on tax-exempt bonds

111) If a one-year bond currently yields 4% and is expected to yield 6% next year, the liquidity premium theory suggests the yield today on a two-year bond will be

A) more than 4% but less than 5%.
B) 5%.
C) 4%.
D) more than 5%.

112) The addition of the liquidity premium theory to the expectations hypothesis allows us to explain why

A) yield curves usually slope upward.
B) interest rates on bonds of different maturities move together.
C) long-term interest rates are less volatile than short-term interest rates.
D) yield curves are flat.

113) The reason for the increase in inflation risk over time is due to the fact that

A) the inflation rate always increases over time.
B) we always have inflation.
C) it is more difficult to forecast inflation over longer periods of time.
D) investors are more focused on nominal returns than real returns.

114) The risk premium that investors associate with a bond increases with all of the following except

A) maturity.
B) inflation risk increases.
C) interest-rate risk.
D) an improved bond rating.

115) Under the liquidity premium theory, a flat yield curve implies

A) there is no risk premium for longer-term maturities.
B) short-term interest rates are expected to remain constant.
C) short-term interest rates are expected to decrease.
D) long-term interest rates are higher than short-term interest rates.

116) Under the liquidity premium theory, if investors expect short-term interest rates to remain constant, the yield curve should

A) have a positive slope.
B) have a negative slope.
C) be flat.
D) have an increasing slope.

117) Under the expectations hypothesis, if expectations are for lower inflation in the future than what it currently is, the yield curve's slope will

A) become more upward-sloping.
B) become flat.
C) be negative.
D) be vertical.

118) When the growth rate of the economy slows, we would expect

A) the risk to increase for U.S. Treasury securities.
B) the risk spread to increase more between U.S. Treasury Securities and Aaa securities than between Aaa and Baa securities.
C) the risk spread to increase more between Aaa and Baa securities than U.S. Treasuries and Aaa securities.
D) investors to purchase more junk bonds in search of a higher yield.

119) A flight to quality refers to a move by investors

A) away from bonds toward stocks.
B) toward securities of other countries and away from U.S. Treasuries.
C) toward precious metals and away from U.S. Treasury bonds.
D) away from low-quality bonds toward high-quality bonds.

120) As a global pandemic erupts and consumers isolate at home, we would expect the risk spread between Baa bonds and U.S. Treasury securities of the same maturities to

A) widen.
B) narrow.
C) disappear.
D) remain relatively constant.

121) We would expect the risk spread between Baa bonds and U.S. Treasury securities of the same maturities to

A) widen during periods of economic recession.
B) remain relatively constant over the business cycle.
C) decrease during economic slowdowns.
D) increase during economic growth periods.

122) We would expect the relationship between the risk spread on Baa bonds and U.S. Treasury securities of similar maturities to

A) vary directly with economic growth.
B) show no variation over the business cycle.
C) vary inversely with economic growth.
D) be uncorrelated with economic growth.

123) A flight to quality should result in the

A) price of U.S. Treasury Securities rising and the price of corporate bonds rising.
B) yield on U.S. Treasury Securities falling and the price of corporate bonds rising.
C) yield on corporate bonds falling and the price of U.S. Treasury Securities rising.
D) yield on U.S. Treasury securities falling and the price of corporate bonds falling.

124) When the Russian government defaulted on its bonds in August 1998,

A) risk spreads decreased significantly.
B) yields on U.S. Treasury securities fell while yields on corporate bonds rose.
C) yields on U.S. Treasury securities rose while prices of corporate bonds rose.
D) risk spreads did not change.

125) An inverted yield curve is a valuable forecasting tool because

A) the yield curve usually is inverted so it reflects a growing economy.
B) the yield curve seldom is inverted and can signal an economic slowdown.
C) investors are expecting higher short-term rates in the future, and this usually signals an economic slowdown.
D) inverted yield curves signal better economic times are expected.

126) The slope of the yield curve seems to predict the performance of the economy usually

A) with a three-month lag.
B) with a one-year lag.
C) within a few weeks.
D) with a two-year lag.

127) A proposed increase in the federal income tax rate should

A) have no impact on the slope of the yield curve since the tax laws impact all maturities the same.
B) cause the slope of the yield curve to become negative.
C) increase the slope of the yield curve since it increases the risk premium of longer maturities.
D) flatten the yield curve.

128) If their only concern were the cost of issuing municipal debt, how would you expect the mayors of most U.S. cities to respond to a revenue-neutral change in the federal income tax that sharply lowered the top marginal tax rate?

A) Favorably, since this will significantly increase the demand for municipal bonds.
B) Unfavorably, the demand for municipal bonds will fall and their yields will increase.
C) Favorably, the price of municipal bonds should increase and their yields fall.
D) No reaction, this should have no impact on municipal bonds at all.

129) The terrorist attack on the World Trade Center on September 11, 2001,

A) triggered a flight to quality in the bond market.
B) caused the demand for U.S. Treasury securities to fall and the demand for corporate bonds to rise.
C) caused the price of U.S. Treasury securities to fall and the yields on corporate bonds to fall.
D) did not have any significant impact since the risk on all bonds increased.

130) Interest rates on short-term U.S. Treasury bills turned negative on March 25, 2020. They inched back up into positive values shortly after, but they remained very low. In the case of negative interest rates, cash deposited at a bank yields a storage charge rather than an opportunity to earn interest income. If the central bank charges banks to store their reserves at the central bank, they are providing an incentive for banks to

A) lend more money.
B) charge higher interest rates.
C) provide less liquidity in the economy.
D) restrict loans to preferred customers only.

131) As the COVID-19 pandemic spread in 2020, many countries’ economies headed toward recession. Economic activity ground to a halt in many countries as people stayed home to slow the spread of the virus. What is the expected change in the risk spread when there is an impending recession? The risk spread

A) narrows.
B) widens.
C) is unchanged.
D) is not correlated to economic activity.

132) As the COVID-19 pandemic spread in 2020, many countries’ economies headed toward recession. Economic activity ground to a halt in many countries as people stayed home to slow the spread of the virus. Using the term spread as an economic indicator, economists would expect the yield curve to

A) become inverted as recession hit.
B) have inverted approximately a year earlier.
C) have become flat as recession hit.
D) become inverted approximately a year after recession hit.

133) Which one of the following suggests troubled economic times ahead?

A) increases in the risk spread and an inverted yield curve
B) decreases in the risk spread and an inverted yield curve
C) increases in the risk spread and an upward-sloping yield curve
D) decreases in the risk spread and an upward-sloping yield curve

134) If the Federal Reserve surprises investors by announcing an easing of monetary policy

A) it should have no impact on the slope of the yield curve.
B) we should expect the yield curve to possibly become inverted.
C) the yield curve would flatten.
D) we should expect the yield curve to steepen.

135) An increased risk of a financial crisis in the euro area should cause the

A) demand for all government securities including U.S. Treasury securities to decrease.
B) risk spread between U.S. Treasury bonds and other bonds to decrease.
C) price of U.S. Treasury bonds to increase and the yield on other bonds to increase.
D) price of U.S. Treasury bonds to increase and the yield on other bonds to decrease.

136) A permanent increase of borrowing by the U.S. Treasury to finance growing budget deficits would

A) result in U.S. Treasury yields being higher than high-grade corporate bonds.
B) result in the price of U.S. Treasury bonds rising.
C) cause the yield on U.S. Treasury bonds to increase, but still be lower than corporate bonds.
D) result in lower yields on corporate bonds.

137) The presence of a term spread that is usually positive indicates that

A) the yield curve always slopes upward.
B) bonds of similar risk but with different maturities are not perfect substitutes.
C) we should expect the yield curve to usually be flat.
D) we should expect the yield curve to usually slope downward.

138) The interest-rate risk that is associated with bond investing

A) exists even if an investor plans on holding the bond to maturity.
B) arises because of a mismatch between the investor's investment horizon and the maturity of the bond.
C) is not reflected in the risk premium.
D) can be eliminated by holding only consols.

139) Imagine a scandal that finds the officers of bond rating agencies have been taking bribes to inflate the rating of specific bonds. This should

A) have no impact on the bond market since bond markets are highly efficient.
B) decrease the demand for all bonds.
C) increase the demand for U.S. Treasury securities and decrease the demand for corporate bonds.
D) decrease the risk spread.

140) Under the expectations hypothesis, bonds of different maturities are assumed to be perfect substitutes because

A) the risk premium is assumed to be negative.
B) market forces would always have long-term interest rates equal the average of the current and expected short-term rate.
C) expectations of future interest rates are uncertain and therefore cannot be included in the analysis.
D) bond markets are very liquid.

141) A proposed increase in the federal income tax rates may actually be viewed favorably by many mayors of cities because

A) it will allow them to also raise their tax rates.
B) it will cause the demand for municipal bonds to increase and their yields to increase.
C) people will pay less attention to local taxes.
D) it will cause the price of municipal bonds to increase and their yields to decrease.

142) As technology allows information regarding the financial health of corporations to become easier to obtain, we should expect

A) the risk spread to decrease.
B) the role of bond rating agencies to become more important.
C) a decrease in the number of participants in the bond market.
D) the risk spread to increase.