TUTORIAL 4

RISK AND TERM STRUCTURE OF INTEREST RATES

Part 1: Review questions

1. What is the risk structure of the interest rate? What factors explain the risk structure
2. What is the term structure of the interest rate? Yield curve? What theories are used to
explain the shape of the yield curve? What are three main facts of the yield curve?

Part 2: Multiple-choice questions

1. Generally, which bond has the highest interest rate?
A. Corporate Baa Bonds
B. Long-term Government Bonds
C. Municipal Bonds
D. Corporate Aaa Bonds

2. Default risk is:

A. the chance the issuer will be unable to make interest payments or repay principal.
B. the chance the issuer will retire the debt early.
C. the chance the issuer will sell more debt.
D. the chance the issuing firm will be sold to another firm.

3. Suppose that there are two bonds, A and B. Suppose also the default risk on
bond A increases. As a result of this we would expect to see:
A. the demand for A to decrease and the demand for B to increase.
B. the demand for A to increase and the demand for B to decrease.
C. the demand for A to decrease and the demand for B to decrease.
D. the demand for A to increase and the demand for B to increase.

4. The risk premium on a bond is:

A. the difference in interest rate between that bond and a US Treasury bond.
B. the difference in interest rate between that bond and a municipal bond.
C. the difference in interest rate between that bond and a bank CD.
D. the difference in interest rates between that bond and a S&P 500 firm bond.

5. An increase in the level of risk for bond A will:

A. increase the risk premium on bond A and reduce the risk premium on bond B.
B. increase the risk premium on bond B and reduce the risk premium on bond A.
C. increase the risk premium on bond A and increase the risk premium on bond B.
D. reduce the risk premium on bond A and reduce the risk premium on bond B.

6. Municipal bonds generally have lower interest rates than U.S. Government
bonds because:
A. they have less risk.
B. they never mature.
C. they are exempt from Federal taxes.
D. they are more liquid.
7. Yield curves show:
A. the relationship between time to maturity and bond interest rates (yields).
B. the relationship between bond interest rates (yields) and bond prices.
C. the relationship between risk and bond interest rates (yields).
D. the relationship between liquidity and bond interest rates (yields).

8. The liquidity premium theory explains an inverted yield curve by

A. Assuming that interest rated move together over time
B. Assuming that the liquidity premium is always positive
C. Assuming that short-term rates are expected to fall to a great degree in the future
D. Assuming that investors prefer shorter-term bonds over longer maturity bonds

9. The liquidity premium theory suggests that yield curves should usually be:
A. inverted.
B. up-sloping through year 1, then flat thereafter.
C. up-sloping.
D. flat.

10. The liquidity premium theory is based upon the idea that, other things
remaining equal,
A. investors are indifferent between short-term and long-term bonds.
B. investors prefer long-term bonds.
C. investors prefer short-term bonds.
D. investors prefer intermediate-term bonds.

11. The shape of the yield curve is usually:

A. flat.
B. downward sloping.
C. upward sloping for shorter maturities and downward sloping for longer maturities.
D. upward sloping.

12. The expectations theory of the term structure assumes:

A. buyers of bonds consider bonds of different maturities to be perfect substitutes.
B. buyers of bonds prefer bonds with shorter maturities.K
C. buyers of bonds prefer bonds with longer maturities.
D. markets for different maturity bonds are completely separate

13. What will the yield curve look like if future short-term interest rates are
expected to rise sharply?
A. It will steeply slope upward.
B. It will slightly slope upward.
C. It will be horizontal.
D. It will slope downward.

14. Reduced liquidity of a bond causes the interest rate on that bond
A. To be higher because it is more widely traded.
B. To be higher because it is less widely traded.
C. To be lower because it is less widely traded
D. To be lower because it is more widely traded

15. The Segmented Markets theory of term structure suggests that

A. Interest rates on long-term bonds strongly influence the demand for short-term bonds.
B. Bonds of different maturities are perfect substitutes for each other.
C. Investors have no preference for short-term bonds over long-term bonds, or vice
versa.
D. Investors have strong preferences for bonds of a particular maturity

Part 3: Applications
Chapter 6: Questions and Problems 2, 5, 7, 8, 17, 23, 25
2. Which should have the higher risk premium on its interest rates, a corporate bond with
a Moody’s Baa rating or a corporate bond with a C rating? Why?

5. Risk premiums on corporate bonds are usually anticyclical; that is, they decrease
during business cycle expansions and increase during recessions. Why is this so?

7. What is a key function of credit-rating agencies? Do credit-rating agencies always

provide reliable information? What was the role of credit-rating agencies in the sub-prime
crisis of 2008?

8. Predict what will happen to interest rates on a corporation’s bonds if the federal
government guarantees today that it will pay creditors if the corporation goes
bankrupt in the future. What will happen to the interest rates on Treasury securities?

17. If a yield curve looks like the one shown in the figure below, what is the market
predicting about the movement of future short-term interest rates? What might the yield
curve indicate about the market’s predictions for the inflation rate in the future?

23. Assuming the expectations theory is the correct theory of the term structure, calculate
the interest rates in the term structure for maturities of one to four years, and plot the
resulting yield curves for the following paths of one-year interest rates over the next four
years:
a. 4%, 6%, 11%, 15%
b. 3%, 5%, 13%, 15%
How would your yield curves change if people preferred shorter-term bonds to longer-
term bonds?

25. The table below shows current and expected future one-year interest rates, as well as
current interest rates on multiyear bonds. Use the table to calculate the liquidity premium
for each multiyear bond.

Part 4: Additional problems:

In the bond market, ABC Corp. issues multiple maturities bonds, all selling at the face
value of $1000 as follow:
1-year bond 3% coupon
2-year bond 5% coupon
3-year bond 7% coupon
5-year bond 8% coupon
a. Calculate the YTM of all ABC’s bonds above.
b. Based on the expectation theory, what are expected future short term (1-year) interest
rates in 1 year and in the next 2 years?