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Chapter 07
The Risk and Term Structure of Interest Rates
Multiple Choice Questions
1. 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.
7-1
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2. 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.
3. 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.
4. Which 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
B. The Wall Street Journal
C. Moody's Investor Service
D. The Nasdaq
7-2
6. What is the highest bond rating assigned by Standard and Poor's?
A. AA
B. EEE
C. AAA
D. A
7. The lowest rating for an investment grade bond assigned by Moody's is:
A. Baa.
B. A.
C. BBB.
D. Aa.
8. 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.
9. Which 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
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10. 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.
11. Commercial paper refers to:
A. the financial publications read by the CEO's 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.
12. 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.
13. 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.
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14. 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.
15. 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.
16. 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.
17. 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.
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18. All of the following are true about the risk spread except 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.
19. 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.
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.
21. 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.
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22. 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.
23. 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.
24. 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.
25. Which 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.
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26. 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.
27. 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.
28. 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.
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29. 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.
30. 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.
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.
7-9
32. Municipal bonds are usually purchased by:
A. retired investors who have no other taxable income.
B. investors looking for securities to buy for their IRA accounts.
C. investors who live in cities with high municipal tax rates.
D. investors who are in high marginal tax brackets.
33. 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%
34. 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.
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35. 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.
36. If a local government eliminates the tax exemption on municipal bonds, we'd 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.
37. Which 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
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38. 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%
39. Suppose the economy has an inverted yield curve. According to the Expectations Hypothesis,
which 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.
40. 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.
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41. 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.
D. Why long-term bonds usually are less liquid than short-term bonds with the same default
risk.
42. 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 towards risk quickly.
43. 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.
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44. 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.
45. 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.
46. 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.
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47. 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.
48. Which of the following statements pertaining to the yield curve is not true?
A. Yield curves usually slope upwards.
B. The yield curve shows the difference in default risk between securities.
C. The yield curve shows the relationship among bonds with the same risk characteristics but
different maturities.
D. The yield curve can be flat or downward sloping depending on market conditions.
49. 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.
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50. 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.
51. 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.
52. Which 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.
53. The yield curve for U.S. Treasury securities allows us to draw the following conclusions,
except that:
A. long-term yields tend to higher than short term yields.
B. interest rates of different maturities tend to move.
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.
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54. 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.
55. 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.
56. 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.
57. 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.
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58. 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.
59. 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%. This 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.
60. 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%.
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61. Assume the Expectations Hypothesis regarding the term structure of interest rates is correct.
Then, 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%.
62. 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%.
63. Assume an investor has a choice of 3 consecutive one-year bonds or one 3-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 3-
year bond to reflect the risk premium.
B. interest rate of the 3-year bond should equal the average interest rate of the 3 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 3-year interest rate.
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64. 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.
65. 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.
66. 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.
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67. Under the Expectations Hypothesis, a downward-sloping yield curve suggests:
A. investors expect future short-term interest rates to fall.
B. investors expect future short-term interest rates to rise.
C. this is a trick question, the yield curve always slopes upward.
D. investors expect future short-term interest rates to remain constant.
68. 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.
69. 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.
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70. Suppose the economy has an inverted yield curve. According to the Liquidity Premium
Theory, which 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.
71. 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
72. 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%.
7-22
73. 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.
74. 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.
75. 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.
76. 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.
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77. 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.
78. 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.
79. 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.
7-24
80. A flight to quality refers to a move by investors:
A. away from bonds towards stocks.
B. towards securities of other countries and away from U.S. Treasuries.
C. towards precious metals and away from U.S. Treasury bonds.
D. away from low-quality bonds towards high-quality bonds.
81. 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.
82. 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.
83. 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.
7-25
84. 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.
85. 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.
86. The slope of the yield curve seems to predict the performance of the economy usually:
A. with a 3-month lag.
B. with a one-year lag.
C. within a few weeks.
D. with a two-year lag.
7-26
87. 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.
88. 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.
89. 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.
7-27
90. 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.
91. 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.
92. A permanent increase of borrowing by the U.S. Treasury to finance growing budget deficits
will:
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.
93. 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.
7-28
94. 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.
95. 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.
96. 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.
7-29
97. 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.
98. 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.
Short Answer Questions
99. What is the main purpose (function) of bond rating services?
7-30
100.What role did rating agencies play in the financial crisis of 2007-2009?
101.Briefly describe the two different types of junk bonds (high-yield bonds).
102.What is meant by a subprime mortgage?
7-31
103.If an investor wants to compare commercial paper to a corresponding default-free
investment, which security would he/she use and why?
104.How did asset backed commercial paper (ABCP) rollover risk contribute to the financial crisis
of 2007-2009?
7-32
105.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
his/her risk premium?
106.Why do economists pay particular attention to inverted yield curves?
7-33
107.If the yield curve is flat, using liquidity premium theory, what do you know about the expected
future short-term interest rate?
108.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.
109.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.
7-34
110.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 $1000 in a savings
account that he/she plans 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.
7-35
111.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 table below:
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?
7-36
112.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.
113.Assuming the Expectations Hypothesis is correct, and given the following information:
The current four-year interest rate is 5.0%

The current one-year interest rate is 4.0%
The expected one-year rate for one year from now is 5.0%
The expected one-year rate for two years from now is 5.5%
What is the expected one-year rate for three years from now? Explain.
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114.Any theory of the yield curve must be able to explain what three general conditions?
115.The usually upward sloping yield curve indicates that long-term bonds have higher yields
than short-term bonds. Why is this?
116.Why can't the Expectations Hypothesis stand alone as an adequate theory to explain yield
curves?
7-38
117.What impact should an economic slowdown have on the risk structure of interest rates?
118.During economic slowdowns why would you expect the risk premium to increase the most
between U.S. Treasury bonds and junk bonds?
119.When we compare the graphs of GDP growth over time to the corresponding risk spread on
Baa bonds compared to 10-year U.S. Treasury bonds, what relationship can be inferred?
7-39
120.Describe the concept of flight to quality in terms of the Russian government default of
August 1998.
121.Why do yield curves usually slope upward?
122.Explain why an inverted yield curve is a valuable forecasting tool.
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123.Why might we expect to see a high correlation between increases in the risk structure of
interest rates and the yield curve becoming inverted?
124.Does the Expectations Hypothesis allow for people to have a preference for longer-term
investments? Explain.
125.Explain why most retired individuals are not likely to be heavily invested in municipal bonds.
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126.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?
Essay Questions
7-42
127.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?
7-43
128.In 2002 and 2003, the financial markets were hit by many corporate accounting scandals.
Discuss these scandals and the impact they would have not only in terms of a flight to
quality, but also in terms of the faith that people place in bond rating agencies.
129.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.
7-44
130.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?
131.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?
7-45
132.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.
7-46
Chapter 07 The Risk and Term Structure of Interest Rates Answer
Key
Multiple Choice Questions
1. 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.
AACSB: Reflective Thinking

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 07-01 Understand credit risk and bond ratings.
Topic: Ratings and the Risk Structure of Interest Rates
7-47
2. 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.

Blooms: Remember
Difficulty: 1 Easy
3. 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.

Blooms: Remember
Difficulty: 2 Medium
7-48
B. The U.S. Treasury
C. The New York Stock Exchange
D. Standard & Poor's

Blooms: Remember
B. The Wall Street Journal
C. Moody's Investor Service
D. The Nasdaq

Blooms: Remember
7-49
6. What is the highest bond rating assigned by Standard and Poor's?
A. AA
B. EEE
C. AAA
D. A

Blooms: Remember
Difficulty: 1 Easy
7. The lowest rating for an investment grade bond assigned by Moody's is:
A. Baa.
B. A.
C. BBB.
D. Aa.

Blooms: Remember
Difficulty: 1 Easy
7-50
8. 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.

Blooms: Remember
9. Which 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

Blooms: Understand
7-51
10. 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.

Blooms: Understand
11. Commercial paper refers to:
A. the financial publications read by the CEO's 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.

Blooms: Understand
Difficulty: 1 Easy
7-52
12. 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.

Blooms: Understand
Difficulty: 1 Easy
13. 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.

Blooms: Analyze
7-53
14. 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.
AACSB: Analytic
Blooms: Apply
15. 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.

Blooms: Understand
7-54
16. 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.

Blooms: Understand
Difficulty: 1 Easy
17. 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.

Blooms: Understand
7-55
18. All of the following are true about the risk spread except 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.
AACSB: Analytic
Blooms: Apply
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.

Blooms: Remember
7-56
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.

Blooms: Understand
21. 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.

Blooms: Understand
7-57
22. 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.

Blooms: Understand
Difficulty: 1 Easy
23. 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.

Blooms: Understand
7-58
24. 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.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
25. Which 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.

Blooms: Understand
7-59
26. 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.

Blooms: Understand
Topic: Differences in Tax Status and Municipal Bonds
27. 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.

Blooms: Remember
Difficulty: 1 Easy
7-60
28. 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.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
29. 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.

Blooms: Understand
7-61
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.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
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.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
7-62
32. Municipal bonds are usually purchased by:
A. retired investors who have no other taxable income.
B. investors looking for securities to buy for their IRA accounts.
C. investors who live in cities with high municipal tax rates.
D. investors who are in high marginal tax brackets.

Blooms: Understand
33. 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%
AACSB: Analytic
Blooms: Apply
7-63
34. 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.

Blooms: Understand
35. 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.
AACSB: Analytic
Blooms: Analyze
7-64
36. If a local government eliminates the tax exemption on municipal bonds, we'd 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.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
37. Which 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

Blooms: Remember
Difficulty: 1 Easy
7-65
38. 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%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Learning Objective: 07-02 Understand the yield curve relating bond maturities to yields.
Topic: The Term Structure of Interest Rates
39. Suppose the economy has an inverted yield curve. According to the Expectations
Hypothesis, which 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.
AACSB: Analytic
Blooms: Evaluate
7-66
40. 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.
D. Why long-term bond yields are influenced by expected future short-term bond yields.

Blooms: Understand
41. 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.
D. Why long-term bonds usually are less liquid than short-term bonds with the same
default risk.

Blooms: Understand
7-67
42. 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 towards risk quickly.
AACSB: Analytic
Blooms: Analyze
43. 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.
AACSB: Analytic
Blooms: Analyze
7-68
44. 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.
AACSB: Analytic
Blooms: Apply
45. 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.
AACSB: Analytic
Blooms: Analyze
7-69
46. 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.

Blooms: Understand
Difficulty: 1 Easy
47. 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.
AACSB: Analytic
Blooms: Evaluate
7-70
48. Which of the following statements pertaining to the yield curve is not true?
A. Yield curves usually slope upwards.
B. The yield curve shows the difference in default risk between securities.
C. The yield curve shows the relationship among bonds with the same risk characteristics
but different maturities.
D. The yield curve can be flat or downward sloping depending on market conditions.
AACSB: Analytic
Blooms: Evaluate
49. 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.
AACSB: Analytic
Blooms: Analyze
7-71
50. 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.

Blooms: Remember
Difficulty: 1 Easy
51. 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.

Blooms: Understand
7-72
52. Which 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.

Blooms: Understand
53. The yield curve for U.S. Treasury securities allows us to draw the following conclusions,
except that:
A. long-term yields tend to higher than short term yields.
B. interest rates of different maturities tend to move.
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.

Blooms: Understand
7-73
54. 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.

Blooms: Understand
55. 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.
AACSB: Analytic
Blooms: Analyze
7-74
56. 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.

Blooms: Understand
57. 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.

Blooms: Remember
Difficulty: 1 Easy
7-75
58. 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.

Blooms: Understand
59. 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%. This 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.
AACSB: Analytic
Blooms: Apply
7-76
60. 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%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
61. Assume the Expectations Hypothesis regarding the term structure of interest rates is
correct. Then, 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%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
7-77
62. 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%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
63. Assume an investor has a choice of 3 consecutive one-year bonds or one 3-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
3-year bond to reflect the risk premium.
B. interest rate of the 3-year bond should equal the average interest rate of the 3 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 3-year interest rate.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
7-78
64. 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.

Blooms: Understand
65. 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.

Blooms: Understand
7-79
66. 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.

Blooms: Understand
Difficulty: 1 Easy
67. Under the Expectations Hypothesis, a downward-sloping yield curve suggests:
A. investors expect future short-term interest rates to fall.
B. investors expect future short-term interest rates to rise.
C. this is a trick question, the yield curve always slopes upward.
D. investors expect future short-term interest rates to remain constant.

Blooms: Understand
Difficulty: 1 Easy
7-80
68. 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.

Blooms: Understand
69. 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.
AACSB: Analytic
Blooms: Apply
7-81
70. Suppose the economy has an inverted yield curve. According to the Liquidity Premium
Theory, which 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.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
71. 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
AACSB: Analytic
Blooms: Analyze
7-82
72. 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%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
73. 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.
AACSB: Analytic
Blooms: Analyze
7-83
74. 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.
AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
75. 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.

Blooms: Remember
Difficulty: 1 Easy
7-84
76. 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.

Blooms: Understand
77. 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.

Blooms: Understand
7-85
78. 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.

Blooms: Understand
79. 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.
AACSB: Analytic
Blooms: Analyze
7-86
80. A flight to quality refers to a move by investors:
A. away from bonds towards stocks.
B. towards securities of other countries and away from U.S. Treasuries.
C. towards precious metals and away from U.S. Treasury bonds.
D. away from low-quality bonds towards high-quality bonds.

Blooms: Understand
Difficulty: 1 Easy
81. 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.
AACSB: Analytic
Blooms: Analyze
7-87
82. 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.
AACSB: Analytic
Blooms: Analyze
83. 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.
AACSB: Analytic
Blooms: Analyze
7-88
84. 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.
AACSB: Analytic
Blooms: Apply
85. 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.
AACSB: Analytic
Blooms: Analyze
7-89
86. The slope of the yield curve seems to predict the performance of the economy usually:
A. with a 3-month lag.
B. with a one-year lag.
C. within a few weeks.
D. with a two-year lag.

Blooms: Understand
Difficulty: 1 Easy
87. 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.
AACSB: Analytic
Blooms: Analyze
7-90
88. 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.
AACSB: Analytic
Blooms: Analyze
89. 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.

Blooms: Understand
Topic: The Information Content of Interest Rates
7-91
90. 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.
AACSB: Analytic
Blooms: Apply
Learning Objective: 07-03 Understand how yields anticipate and signal the future.
91. 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.
AACSB: Analytic
Blooms: Analyze
7-92
92. A permanent increase of borrowing by the U.S. Treasury to finance growing budget deficits
will:
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.
AACSB: Analytic
Blooms: Analyze
93. 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.

Blooms: Understand
7-93
94. 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.

Blooms: Understand
Difficulty: 1 Easy
95. 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.
AACSB: Analytic
Blooms: Evaluate
7-94
96. 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.

Blooms: Understand
97. 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.
AACSB: Analytic
Blooms: Analyze
7-95
98. 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.

Blooms: Understand
Short Answer Questions
99. What is the main purpose (function) of bond rating services?
These companies monitor the status of individual bond issuers and assess the likelihood
that a lender/bondholder will be repaid by a borrower/issuer.

Blooms: Understand
Difficulty: 1 Easy
7-96
100. What role did rating agencies play in the financial crisis of 2007-2009?
Rating errors on mortgage-backed securities triggered sharp downgrades as U.S. housing

prices began to fall. This diminished the resources available in the financial system which
helped trigger and then intensify the crisis.

Blooms: Understand
Difficulty: 1 Easy
101. Briefly describe the two different types of junk bonds (high-yield bonds).
There are two types of junk bonds; there are the fallen angels, which were at one time
investment grade bonds, but their issuer fell on hard times. The second type results
because little is known about the issuer. These bonds originate as junk bonds.

Blooms: Remember
7-97
102. What is meant by a subprime mortgage?
A subprime mortgage does not meet key standards of credit worthiness. And, there are
original issue junk bonds, where little is known about the riskiness of the issuer.

Blooms: Remember
103. If an investor wants to compare commercial paper to a corresponding default-free

investment, which security would he/she use and why?
He or she should use the U.S. Treasury bill. The reason is U.S. Treasuries are the closest
thing to risk free and the reason for the Treasury bill is that T-Bills, like commercial paper
have very short maturities, usually less than 360 days.

Blooms: Understand
7-98
104. How did asset backed commercial paper (ABCP) rollover risk contribute to the financial
crisis of 2007-2009?
ABCP creates a mismatch between the long-term maturity of the asset (mortgage) and
the short-term maturity of the liability (ABCP). When the ABCP matures the issuers may
have to borrow to meet their payment obligations which creates rollover risk because of
the possibility that the market for borrowing may have dried up. This is exactly what
happened in the early days of the financial crisis of 2007-2009.
AACSB: Analytic
Blooms: Apply
105. 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 his/her risk premium?
0.65%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
7-99
106. Why do economists pay particular attention to inverted yield curves?
Inverted yield curves can be highly useful for forecasting economic slowdowns. Usually the
yield curve turning inverted predicts an economic slowdown, usually with a one-year lag.
AACSB: Analytic
Blooms: Analyze
107. If the yield curve is flat, using liquidity premium theory, what do you know about the
expected future short-term interest rate?
If the yield curve is flat, the expected future short-term interest rate(s) must be lower than
the current short-term rate because liquidity premium theory assigns a positive risk
premium to longer maturities, which is why the yield curve usually slopes upward.

Blooms: Understand
7-100
108. 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.
The interest earned on municipal bonds is exempt from federal income taxes. A reduction
in the federal income tax rate decreases the attractiveness of these bonds. As a result of
the decrease in demand, their prices will fall and their yields will need to increase to
attract investors.
AACSB: Analytic
Blooms: Analyze
109. 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.
5.25%. The $70 is taxed at 25%; leaving the bondholder with $52.50; which when divided
by the $1,000 provides an effective yield of 5.25%.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
7-101
110. 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 $1000 in a
savings account that he/she plans 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.
(b), (c), (a), (d)

The CEO has the most to gain because she is in the highest marginal tax break. Therefore,
she would receive the largest benefit from investing in tax-exempt bonds. Similarly, the
middle-income family will benefit, but their savings will not be as significant as those of
the CEO. The 20-year old college student earns low income, so her tax savings are
relatively low. Finally, the nurse will receive no benefit from purchasing a tax-exempt bond
because he uses a tax-exempt pension to purchase his assets. Therefore, he saves
nothing from buying a tax-exempt bond in lieu of a taxable bond.
AACSB: Analytic
Blooms: Create
7-102
7-103
111. 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 table below:
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?
Using the Expectations Hypothesis, the interest rates are as follows:
1-year: 2.5% (given)

2-year: 3%
3-year: 3.33%
4-year: 3.625%
Using the Liquidity Premium Theory, the interest rates are as follows:
1-year: 2.5% (given)
7-104
2-year: 3.5%
3-year: 4.33%
4-year: 5.625%
Using the Liquidity Premium Theory, the yield curve has a steeper positive slope. This is
caused by the presence of a risk premium attached to the longer-term bonds.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
112. 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.
5.20%. The tax-exempt bond yield = (Taxable bond yield) × (1 - tax rate).
Substituting; The tax exempt bond yield = (8%) × (1 - 0.35) = 5.20%
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
7-105
113. Assuming the Expectations Hypothesis is correct, and given the following information:
The current four-year interest rate is 5.0%

The current one-year interest rate is 4.0%
The expected one-year rate for one year from now is 5.0%
The expected one-year rate for two years from now is 5.5%
What is the expected one-year rate for three years from now? Explain.
The general statement of the Expectations Hypothesis is that the interest rate on a bond
with n years to maturity is the average of n expected future one year interest rates, which
is:
In this case n = 4 and we know int = 5.0%, using a little algebra allows us to solve for ie1t + 3.
In this case 4 × 5 = 20 and subtract the sum of the first three short-term rates, which is
14.5; this leaves us 5.5% as the expected one year rate or three years from now.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
7-106
114. Any theory of the yield curve must be able to explain what three general conditions?
#1) The interest rates of different maturities will move together; #2) Yields on short-term
bonds will be more volatile than yields on long-term bonds; and #3) Long-term yields are
usually higher than short-term yields, (the yield curve usually slopes upward).

Blooms: Understand
Difficulty: 1 Easy
115. The usually upward sloping yield curve indicates that long-term bonds have higher yields
than short-term bonds. Why is this?
Bondholders face both inflation- and interest-rate risk. The longer the term of the bond,
the greater both types of risk. This implies that the risk premium increases with maturity.

Blooms: Understand
Difficulty: 1 Easy
7-107
116. Why can't the Expectations Hypothesis stand alone as an adequate theory to explain yield
curves?
The Expectations Hypothesis does a good job of explaining why interest rates of different
maturities move together and for explaining why short-term rates are more volatile than
long-term rates. What it cannot do is explain why yield curves usually are upward sloping.
To use only expectations hypothesis implies that investors usually expect short-term
interest rates to rise, which certainly is not the case.

Blooms: Understand
117. What impact should an economic slowdown have on the risk structure of interest rates?
An economic slowdown should increase the risk premium on privately issued bonds since
some firms may find it increasingly difficult to meet their financial obligations. It is
important to note, however, that a slowdown or recession does not affect the risk of
holding government bonds, which is why the risk spread increases for private bonds.
AACSB: Analytic
Blooms: Analyze
7-108
118. During economic slowdowns why would you expect the risk premium to increase the most
between U.S. Treasury bonds and junk bonds?
While it is true that during economic slowdowns most private bond issuers may feel
increased difficulty, it is highly likely that firms that were already in a precarious position
regarding their finances (junk bonds) would feel the most difficulty, thus significantly
increasing the risk premium on those issues the most.
AACSB: Analytic
Blooms: Analyze
119. When we compare the graphs of GDP growth over time to the corresponding risk spread
on Baa bonds compared to 10-year U.S. Treasury bonds, what relationship can be
inferred?
There seems to be an inverse relationship between GDP growth and the size of the risk
spread. As GDP growth slows, the risk spread increases and vice versa.
AACSB: Analytic
Blooms: Analyze
7-109
120. Describe the concept of flight to quality in terms of the Russian government default of
August 1998.
The concept of flight to quality implies that during any economic downturn or turmoil in
financial markets, investors (savers) will seek out high quality bonds and shun low quality
bonds. This can have very significant impacts on the prices and yields of high and low
quality bonds, adding to the volatility of financial markets. This was certainly what was
observed when the Russia government defaulted.
AACSB: Analytic
Blooms: Analyze
Difficulty: 1 Easy
121. Why do yield curves usually slope upward?
The upward sloping yield curve is the most common since it includes the risk premium for
longer maturities, and the risk premium increases with maturities. So even if investors
expected short term rates to remain constant, we would still observe an upward sloping
yield curve.

Blooms: Understand
Difficulty: 1 Easy
7-110
122. Explain why an inverted yield curve is a valuable forecasting tool.
An inverted yield curve is a valuable forecasting tool because it predicts a general

economic slowdown. Even if short-term rates were expected to remain constant, the yield
curve would slope upward. So an inverted yield curve signals an expected decrease in
short-term interest rates.
AACSB: Analytic
Blooms: Analyze
123. Why might we expect to see a high correlation between increases in the risk structure of
interest rates and the yield curve becoming inverted?
Both situations, the risk structure of interest rates increasing and the inverted yield curve,
usually occur when a tight monetary policy is expected to lead to an economic slowdown.
As a result, we would expect to see the risk spread increase in anticipation of economic
slowdowns as we would view the inverted yield curve as an omen of an economic
slowdown.
AACSB: Analytic
Blooms: Evaluate
7-111
124. Does the Expectations Hypothesis allow for people to have a preference for longer-term
investments? Explain.
Not really, a key assumption of the Expectations Hypothesis is that bonds of different
maturities are perfect substitutes, which basically implies that investors are indifferent
between different maturities and that the yield of consecutive short-term investments will
equal the yield of a long-term investment over the same investment horizon.

Blooms: Understand
125. Explain why most retired individuals are not likely to be heavily invested in municipal
bonds.
Most retired individuals are not working and as a result, they may find themselves in a
relatively low marginal tax bracket. As a result, the tax-exempt status of municipal bond
interest is less beneficial and hence, less attractive to them.

Blooms: Apply
7-112
126. 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?
A recession is associated both with an inverted yield curve and with an increase in the risk
spread. As illustrated in the text, in 2006 Baa bond yields were less than two percentage
points above U.S. Treasury yields, well below levels associated with recessions.

Blooms: Understand
Essay Questions
7-113
127. 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?
a) If corporate bonds are default-risk free, the risk premium would be 0 (zero) so the price
and yield should be the same across both bonds.
b) If the corporate bonds are viewed as having the possibility of default, then the demand
for corporate bonds will decrease, and the demand for Treasury bonds will rise; this will
result in the price of Treasury bonds increasing while their yields fall, where in the
corporate bond market, the price decreases and the yields increase.
c) If corporate bonds are granted tax-exempt status, the demand for these bonds will
increase, their price will rise and the yield will fall. In the Treasury bond market, the
demand will decrease, so the price will fall and the yield will increase.
d) If corporate bonds have longer maturity than the Treasury bonds, the demand for the
corporate bonds will decrease since longer maturity bonds carry more risk. This will cause
7-114
their price to fall and the yield to rise. In the Treasury bond market, the demand will
increase, thus the price of the bond will rise and the yield will decrease.
AACSB: Analytic
Blooms: Analyze
128. In 2002 and 2003, the financial markets were hit by many corporate accounting scandals.
Discuss these scandals and the impact they would have not only in terms of a flight to
quality, but also in terms of the faith that people place in bond rating agencies.
The corporate accounting scandals certainly will fuel a flight to quality, which should
cause the risk premium to increase as the demand for Treasury bonds increases and the
demand for corporate bonds decreases. The failure of bond rating agencies to anticipate
the accounting scandals reduced confidence in ratings more generally.

Blooms: Analyze
7-115
129. 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.
This decision should not have any impact in terms of the Expectations Hypothesis. A key
assumption of the Expectations Hypothesis is savers look at all maturities as perfect
substitutes because they have certainty regarding the future of interest rates. Thus, the
phasing out of the 30-year bond would have no impact on the decisions made by savers.
AACSB: Analytic
Blooms: Analyze
7-116
130. 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?
Increased borrowing by the U.S. Treasury may certainly cause interest rates to increase,
however the U.S. Treasury will still be the benchmark bond or the default-free bond. Other
bonds will still have their yield calculated by taking the default-free rate (now perhaps
higher) and adding the appropriate risk premium to this rate. As a result, greater borrowing
by the U.S. Treasury would likely result in an increase in all yields. Regarding the term
structure, this may depend on the selection of instruments used by the Treasury. For
example, if the Treasury decides to finance the deficit by issuing only long-term (30 year)
bonds, the price of these bonds will adjust to market forces. In order to attract buyers their
price may fall and their yields increase causing the slope of the yield curve to increase. A
similar argument could be offered if the Treasury decided to finance the deficit with
mainly short-term instruments, in this case the subsequent market forces may cause the
slope of the yield curve to decrease.
AACSB: Analytic
Blooms: Analyze
Difficulty: 3 Hard
7-117
131. 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?
This is a risk spread because it compares the commercial paper yield to a benchmark
bond, a U.S. Treasury bill. Since the terms are the same, this is not a term spread. Risk
spreads generally increase when GDP growth decreases. This happens because the
default risk premium associated with commercial paper increases when economic
conditions worsen. This doesn't imply anything about the yield curve per se, because the
two bonds have the same terms to maturity.

Blooms: Analyze
7-118
132. 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.
The increase in the short-term rate may cause the yield curve to flatten. In addition to
raising short-term rates, the policy will reduce expected inflation, reducing the risk
premium associated with longer-term bonds. The more the curve flattens, the greater the
confidence of investors that the central bank will limit future inflation.
AACSB: Analytic
Blooms: Evaluate
Difficulty: 3 Hard
7-119

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Money Banking and Financial

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The Risk and Term Structure of Interest Rates

Multiple Choice Questions

1. 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.

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.

3. 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.

4. Which 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

5. Which of the following assigns widely followed bond ratings?

A. The Federal Reserve

B. The Wall Street Journal

C. Moody's Investor Service

8. 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.

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

A. never changes over the life of the bond.

B. can change as the financial position of the issuer changes.

11. Commercial paper refers to:

A. the financial publications read by the CEO's 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.

12. 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.

13. 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.

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.

16. The risk spread is:

A. the difference between a bond's purchase price and selling price.

C. less than 0 (zero) for a U.S. Treasury bond.

D. assigned by a bond-rating agency.

17. The risk spread:

A. is also known as the default-risk premium.