Chapter 07 – The Risk and Term Structure of Interest Rates
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:
D. The future one-year rate to be 5%
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%,
D. The future one-year rate to be 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 expected one-year interest rate is
5%, then the current two-year interest rate should be:
A. 3%
Chapter 07 – The Risk and Term Structure of Interest Rates
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:
D. The current one-year interest rate must equal the current 3-year interest rate
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
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:
D. Drive down the prices of both the short- and long-term bonds
Chapter 07 – The Risk and Term Structure of Interest Rates
66. The Expectations Hypothesis cannot explain:
67. Under the Expectations Hypothesis, a downward-sloping yield curve suggests:
D. Investors expect future short-term interest rates to remain constant
D. Bonds of different maturities are perfect substitutes
Chapter 07 – The Risk and Term Structure of Interest Rates
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:
D. Vertical
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?
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 and term structures of interest rates?
A. An inverted yield curve
Chapter 07 – The Risk and Term Structure of Interest Rates
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%
73. The addition of the Liquidity Premium Theory to the Expectations Hypothesis allows us
to explain why:
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 increase over time
Chapter 07 – The Risk and Term Structure of Interest Rates
75. The risk premium that investors associate with a bond increases with all of the following
except:
A. Maturity
76. Under the Liquidity Premium Theory a flat yield curve implies:
A. There is no risk premium for longer-term maturities
77. Under the Liquidity Premium Theory, if investors expect short-term interest rates to
D. Have an increasing slope
Chapter 07 – The Risk and Term Structure of Interest Rates
78. Under the expectations hypothesis, if expectations are for lower inflation in the future than
what it currently is, the yield curve’s slope:
A. Will become more upward sloping
79. As GDP rises the:
A. Risk spread and term spread decrease
80. Under the liquidity premium theory, if investors become less certain about future
monetary policy, the yield curve should:
D. Be vertical
Chapter 07 – The Risk and Term Structure of Interest Rates
81. When the growth rate of the economy slows we would expect:
A. The risk to increase for U.S. Treasury securities
82. A flight to quality refers to a move by investors:
A. Away from bonds towards stocks
83. We would expect the risk spread between Baa bonds and U.S. Treasury securities of the
same maturities to:
D. Increase during economic growth periods
Chapter 07 – The Risk and Term Structure of Interest Rates
84. 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
85. A flight to quality should result in:
A. The price of U.S. Treasury Securities rising and the price of corporate bonds rising
86. When the Russian government defaulted on its bonds in August 1998:
D. Risk spreads increased significantly
Chapter 07 – The Risk and Term Structure of Interest Rates
87. An inverted yield curve is a valuable forecasting tool because:
D. Inverted yield curves signal better economic times are expected
88. The slope of the yield curve seems to predict the performance of the economy:
D. Usually with a two-year lag
89. A proposed increase in the federal income tax rate should:
D. Flatten the yield curve
Chapter 07 – The Risk and Term Structure of Interest Rates
90. How would you expect the mayors of most U.S. cities to respond to a proposed significant
reduction in U.S. income taxes?
D. No reaction, this should have no impact on municipal bonds at all
91. The terrorist attack on the World Trade Center on September 11, 2001:
D. Did not have any significant impact since the risk on all bonds increased
92. If the Federal Reserve announces an easing of monetary policy and this move was not
expected:
D. We should expect the yield curve to steepen
Chapter 07 – The Risk and Term Structure of Interest Rates
93. Increasing tensions in many parts of the world should:
A. Cause the demand for all government securities including U.S. Treasury securities to
decrease
94. Increased 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
95. The presence of a term spread that is usually positive indicates that:
D. We should expect the yield curve to usually slope downward
Chapter 07 – The Risk and Term Structure of Interest Rates
96. The interest-rate risk that is associated with bond investing:
D. Can be eliminated by holding only short-term bonds
97. 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
D. Long-term interest rates are higher than current short-term rates
Chapter 07 – The Risk and Term Structure of Interest Rates
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99. Under the Expectations Hypothesis, bonds of different maturities are assumed to be
perfect substitutes because:
D. Bond markets are very liquid
100. 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
101. As technology allows information regarding the financial health of corporations to
D. The risk spread to increase
Short Answer Questions
Chapter 07 – The Risk and Term Structure of Interest Rates
102. What is the main purpose (function) of bond rating services?
103. What role did rating agencies play in the financial crisis of 2007-2009?
104. Briefly describe the two different types of junk bonds (high-yield bonds).
104. What is meant by a subprime mortgage?
Chapter 07 – The Risk and Term Structure of Interest Rates
105. If an investor wants to compare commercial paper to a corresponding risk-free
investment, which security would he/she use and why?
106. How did asset backed commercial paper (ABCP) rollover risk contribute to the financial
crisis of 2007-2009?
107. 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?