Chapter 5
How Do Risk and Term Structure Affect Interest Rates?
◼ Multiple Choice Questions
1. The term structure of interest rates is
(a) the relationship among interest rates of different bonds with the same maturity.
(b) the structure of how interest rates move over time.
(c) the relationship among the terms to maturity of different bonds.
(d) the relationship among interest rates on bonds with different maturities.
2. The risk structure of interest rates is
(a) the structure of how interest rates move over time.
(b) the relationship among interest rates of different bonds with the same maturity.
(c) the relationship among the terms to maturity of different bonds.
(d) the relationship among interest rates on bonds with different maturities.
3. Which of the following long-term bonds should have the lowest interest rate?
(a) Corporate Baa bonds
(b) U.S. Treasury bonds
(c) Corporate Aaa bonds
(d) Municipal bonds
4. Which of the following long-term bonds should have the highest interest rate?
(a) Corporate Baa bonds
(b) U.S. Treasury bonds
(c) Corporate Aaa bonds
(d) Municipal bonds
5. The risk premium on corporate bonds becomes smaller if
(a) the riskiness of corporate bonds increases.
(b) the liquidity of corporate bonds increases.
(c) the liquidity of corporate bonds decreases.
(d) the riskiness of corporate bonds decreases.
(e) either (b) or (d) occur.
54 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
6. Bonds with relatively low risk of default are called
(a) zero coupon bonds.
(b) junk bonds.
(c) investment grade bonds.
(d) none of the above.
7. Bonds with relatively high risk of default are called
(a) Brady bonds.
(b) junk bonds.
(c) zero coupon bonds.
(d) investment grade bonds.
8. A corporation suffering big losses might be more likely to suspend interest payments on its bonds,
thereby
(a) raising the default risk and causing the demand for its bonds to rise.
(b) raising the default risk and causing the demand for its bonds to fall.
(c) lowering the default risk and causing the demand for its bonds to rise.
(d) lowering the default risk and causing the demand for its bonds to fall.
9. (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher
interest rates the firm must pay. (II) The spread between the interest rates on bonds with default risk
and default-free bonds is called the risk premium.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
10. Holding everything else constant, if a corporation begins to suffer large losses, then the default risk
on its bonds will _________ and the expected return on those bonds will _________.
(a) increase: increase
(b) decrease; increase
(c) increase; decrease
(d) decrease; decrease
11. Holding everything else the same, if a corporation’s earnings rise, then the default risk on its bonds
will _________ and the expected return on those bonds will _________.
(a) increase; decrease
(b) decrease; decrease
(c) increase; increase
(d) decrease; increase
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 55
12. If a corporation begins to suffer large losses, then the default risk on its bonds will _________ and
the equilibrium interest rate on these bonds will _________.
(a) increase; decrease
(b) decrease; increase
(c) increase; increase
(d) decrease; decrease
13. If a corporation’s earnings rise, then the default risk on its bonds will _________ and the
equilibrium interest rate on these bonds will _________.
(a) increase; decrease
(b) decrease; decrease
(c) increase; increase
(d) decrease; increase
14. When the default risk on corporate bonds decreases, other things equal, the demand curve for
corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the
_________.
(a) right; right
(b) right; left
(c) left; left
(d) left; right
15. (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the
right. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds
to the left.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
16. (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the
left. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds
to the right.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
56 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
17. When budget talks between congressional Republicans and President Clinton occurred in late 1995,
fear of a government default _________, Treasury bond values _________, and interest rates on
Treasury bonds _________.
(a) rose; fell; rose
(b) rose; rose; rose
(c) fell; rose; fell
(d) fell; fell; fell
18. The spread between interest rates on low quality corporate bonds and U.S. government bonds
_________ during the Great Depression.
(a) was reversed
(b) narrowed significantly
(c) widened significantly
(d) did not change
19. As a result of the Enron collapse and bankruptcy, the demand for low quality corporate bonds
_________, the demand for high quality corporate bonds _________, and the risk spread
_________.
(a) increased; decreased; was unchanged
(b) decreased; increased; increased
(c) increased; decreased; decreased
(d) decreased; increased; was unchanged
20. Moody’s and Standard and Poor’s are agencies that
(a) help investors collect when corporations default on their bonds.
(b) advise municipal bond issuers on the tax exempt status of their bonds.
(c) produce information about the probability of default on corporate bonds.
(d) maintain liquid markets for corporate bonds.
21. If Moody’s or Standard and Poor’s downgrades its rating on a corporate bond, the demand for the
bond _________ and its yield _________.
(a) increases; decreases
(b) decreases; increases
(c) increases; increases
(d) decreases; decreases
22. Corporate bonds are not as liquid as government bonds because
(a) fewer bonds for any one corporation are traded, making them more costly to sell.
(b) the corporate bond rating must be calculated each time they are traded.
(c) corporate bonds are not callable.
(d) all of the above.
(e) only (a) and (b) of the above.
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 57
23. (I) The risk premium widens as the default risk on corporate bonds increases. (II) The risk
premium widens as corporate bonds become less liquid.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
24. When the corporate bond market becomes less liquid, other things equal, the demand curve for
corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the
_________.
(a) right; right
(b) right; left
(c) left; left
(d) left; right.
25. When the corporate bond market becomes more liquid, other things equal, the demand curve for
corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the
_________.
(a) right; right
(b) right; left
(c) left; left
(d) left; right
26. (I) If a corporate bond becomes less liquid, the demand for the bond will fall, causing the interest
rate to rise. (II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not
change.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
27. (I) If a corporate bond becomes less liquid, the interest rate on the bond will fall. (II) If a corporate
bond becomes less liquid, the interest rate on Treasury bonds will fall.
(a) (I) is true, (II) false.
(b) (I) is false, (II) true.
(c) Both are true.
(d) Both are false.
58 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
28. Which of the following bonds generally has the lowest interest rate?
(a) Treasury bonds
(b) Corporate Baa bonds
(c) Municipal bonds
(d) Corporate Aaa bonds
29. If income tax rates were lowered, then
(a) the interest rate on municipal bonds would fall.
(b) the interest rate on Treasury bonds would rise.
(c) the interest rate on municipal bonds would rise.
(d) the price of Treasury bonds would fall.
30. If income tax rates rise, then
(a) the prices of municipal bonds will fall.
(b) the prices of Treasury bonds will rise.
(c) the interest rate on Treasury bonds will rise.
(d) the interest rate on municipal bonds will rise.
31. An increase in marginal tax rates would likely have the effect of _________ the demand for
municipal bonds and _________ the demand for U.S. government bonds.
(a) increasing; increasing
(b) increasing; decreasing
(c) decreasing; increasing
(d) decreasing; decreasing
32. A decrease in marginal tax rates would likely have the effect of _________ the demand for
municipal bonds and _________ the demand for U.S. government bonds.
(a) increasing; increasing
(b) increasing; decreasing
(c) decreasing; increasing
(d) decreasing; decreasing
33. Which of the following statements are true?
(a) Because coupon payments on municipal bonds are exempt from federal income tax, the
expected after-tax return on them will be higher for individuals in higher income tax brackets.
(b) An increase in tax rates will increase the demand for municipal bonds, lowering their interest
rates.
(c) Interest rates on municipal bonds will be lower than on comparable bonds without the tax
exemption.
(d) All of the above are true statements.
(e) Only (a) and (b) are true statements.
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 59
34. Which of the following statements are true?
(a) Because coupon payments on municipal bonds are exempt from federal income tax, the
expected after-tax return on them will be higher for individuals in higher income tax brackets.
(b) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest
rates.
(c) Interest rates on municipal bonds will be higher than on comparable bonds without the tax
exemption.
(d) Only (a) and (b) are true statements.
35. When a municipal bond is given tax-free status, the demand for municipal bonds shifts _________,
causing the interest rate on the bond to _________
(a) leftward; rise.
(b) leftward; fall.
(c) rightward; rise.
(d) rightward; fall.
36. When a municipal bond is given tax-free status, the demand for Treasury bonds shifts _________,
and the interest rate on Treasury bonds _________
(a) leftward; rises.
(b) leftward; falls.
(c) rightward; rises.
(d) rightward; falls.
37. If municipal bonds were to lose their tax-free status, then the demand for Treasury bonds would shift
_________, and the interest rate on Treasury bonds would _________
(a) rightward; fall.
(b) rightward; rise.
(c) leftward; fall.
(d) leftward; rise.
38. The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent
over the next ten years. As a result of this tax cut, the demand for municipal bonds should shift to
the _________ and the interest rate on municipal bonds should _________.
(a) right; decline
(b) right; increase
(c) left; decline
(d) left; increase
39. The relationship among interest rates on bonds with identical default risk, but different maturities, is
called the
(a) time-risk structure of interest rates.
(b) liquidity structure of interest rates.
(c) yield curve.
(d) bond demand curve.
40. Yield curves can be classified as
(a) upward-sloping.
(b) downward-sloping.
(c) flat.
(d) all of the above.
(e) only (a) and (b) of the above.
41. Typically, yield curves are
(a) gently upward-sloping.
(b) gently downward-sloping.
(c) flat.
(d) bowl shaped.
(e) mound shaped.
42. When yield curves are steeply upward-sloping,
(a) long-term interest rates are above short-term interest rates.
(b) short-term interest rates are above long-term interest rates.
(c) short-term interest rates are about the same as long-term interest rates.
(d) medium-term interest rates are above both short-term and long-term interest rates.
(e) medium-term interest rates are below both short-term and long-term interest rates.
43. Economists’ attempts to explain the term structure of interest rates
(a) illustrate how economists modify theories to improve them when they are inconsistent with the
empirical evidence.
(b) illustrate how economists continue to accept theories that fail to explain observed behavior of
interest rate movements.
(c) prove that the real world is a special case that tends to get short shrift in theoretical models.
(d) have proved entirely unsatisfactory to date.
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 61
44. According to the pure expectations theory of the term structure,
(a) the interest rate on long-term bonds will exceed the average of expected future short-term
interest rates.
(b) interest rates on bonds of different maturities move together over time.
(c) buyers of bonds prefer short-term to long-term bonds.
(d) all of the above.
(e) only (a) and (b) of the above.
45. According to the pure expectations theory of the term structure,
(a) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in
the future.
(b) when the yield curve is downward-sloping, short-term interest rates are expected to decline in
the future.
(c) buyers of bonds prefer short-term to long-term bonds.
(d) all of the above.
(e) only (a) and (b) of the above.
46. According to the pure expectations theory of the term structure,
(a) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in
the future.
(b) when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
(c) investors have strong preferences for short-term relative to long-term bonds, explaining why
yield curves typically slope upward.
(d) all of the above.
(e) only (a) and (b) of the above.
47. According to the pure expectations theory of the term structure,
(a) yield curves should be equally likely to slope downward as to slope upward.
(b) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in
the future.
(c) when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
(d) all of the above.
(e) only (a) and (b) of the above.
48. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent,
2 percent, and 1 percent, then the pure expectations theory predicts that today’s interest rate on the
four-year bond is
(a) 1 percent.
(b) 2 percent.
(c) 4 percent.
(d) none of the above.
62 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
49. If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent,
3 percent, 4 percent, and 5 percent, the pure expectations theory predicts that the bond with the highest
interest rate today is the one with a maturity of
(a) one year.
(b) two years.
(c) three years.
(d) four years.
(e) five years.
50. If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent,
1 percent, 4 percent, and 3 percent, the pure expectations theory predicts that the bond with the
lowest interest rate today is the one with a maturity of
(a) one year.
(b) two years.
(c) three years.
(d) four years.
51. According to the market segmentation theory of the term structure,
(a) the interest rate for bonds of one maturity is determined by supply and demand for bonds of that
maturity.
(b) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates
on bonds of different maturities do not move together over time.
(c) investors’ strong preference for short-term relative to long-term bonds explains why yield
curves typically slope upward.
(d) all of the above.
(e) none of the above.
52. According to the market segmentation theory of the term structure,
(a) the interest rate for bonds of one maturity is determined by supply and demand for bonds of that
maturity.
(b) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates
on bonds of different maturities do not move together over time.
(c) investors’ strong preference for short-term relative to long-term bonds explains why yield
curves typically slope downward.
(d) only (a) and (b) of the above.
53. The liquidity premium theory of the term structure
(a) indicates that today’s long-term interest rate equals the average of short-term interest rates that
people expect to occur over the life of the long-term bond.
(b) assumes that bonds of different maturities are perfect substitutes.
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 63
(c) suggests that markets for bonds of different maturities are completely separate because people
have preferred habitats.
(d) does none of the above.
54. The liquidity premium theory of the term structure
(a) assumes investors tend to prefer short-term bonds because they have less interest-rate risk.
(b) assumes that interest rates on the long-term bond respond to demand and supply conditions for
that bond.
(c) assumes that an average of expected short-term rates is an important component of interest rates
on long-term bonds.
(d) assumes all of the above.
(e) assumes none of the above.
55. According to the liquidity premium theory of the term structure,
(a) the interest rate on long-term bonds will equal an average of short-term interest rates that people
expect to occur over the life of the long-term bonds plus a liquidity premium.
(b) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of
different maturities move together over time.
(c) even with a positive liquidity premium, if future short-term interest rates are expected to fall
significantly, then the yield curve will be downward-sloping.
(d) all of the above.
(e) only (a) and (b) of the above.
56. According to the liquidity premium theory of the term structure,
(a) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds
of different maturities do not move together over time.
(b) the interest rate on long-term bonds will equal an average of short-term interest rates that people
expect to occur over the life of the long-term bonds plus a term premium.
(c) because of the positive term premium, the yield curve cannot be downward-sloping.
(d) all of the above.
(e) only (a) and (b) of the above.
57. If the yield curve slope is flat, the liquidity premium theory indicates that the market is predicting
(a) a mild rise in short-term interest rates in the near future and a mild decline further out in the
future.
(b) constant short-term interest rates in the near future and further out in the future.
(c) a mild decline in short-term interest rates in the near future and a continuing mild decline further
out in the future.
(d) constant short-term interest rates in the near future and a mild decline further out in the future.
64 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
58. If the yield curve has a mild upward slope, the liquidity premium theory indicates that the market is
predicting
(a) a rise in short-term interest rates in the near future and a decline further out in the future.
(b) constant short-term interest rates in the near future and further out in the future.
(c) a decline in short-term interest rates in the near future and a rise further out in the future.
(d) a decline in short-term interest rates in the near future and an even steeper decline further out in
the future.
59. According to the liquidity premium theory of the term structure, a downward-sloping yield curve
indicates that short-term interest rates are expected to
(a) rise in the future.
(b) remain unchanged in the future.
(c) decline moderately in the future.
(d) decline sharply in the future.
60. According to the liquidity premium theory of the term structure, when the yield curve has its usual
slope, the market expects
(a) short-term interest rates to rise sharply.
(b) short-term interest rates to drop sharply.
(c) short-term interest rates to stay near their current levels.
(d) none of the above.
61. In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major
shortcoming of the
(a) market segmentation theory.
(b) pure expectations theory.
(c) liquidity premium theory.
(d) separable markets theory.
62. Which theory of the term structure proposes that bonds of different maturities are not substitutes for
one another?
(a) market segmentation theory
(b) pure expectations theory
(c) liquidity premium theory
(d) separable markets theory
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 65
63. Since yield curves are usually upward sloping, the _________ indicates that, on average, people
tend to prefer holding short-term bonds to long-term bonds.
(a) market segmentation theory
(b) pure expectations theory
(c) liquidity premium theory
(d) both (a) and (b) of the above
(e) both (a) and (c) of the above
64. _________ cannot explain the empirical fact that interest rates on bonds of different maturities tend
to move together.
(a) The market segmentation theory
(b) The pure expectations theory
(c) The liquidity premium theory
(d) Both (a) and (b) of the above
(e) Both (a) and (c) of the above
65. Which of the following theories of the term structure is (are) able to explain the fact that interest
rates on bonds of different maturities tend to move together over time?
(a) The expectations hypothesis
(b) The segmented markets theory
(c) The preferred habitat theory
(d) Both (a) and (b) of the above
(e) Both (a) and (c) of the above
66. Of the four theories that explain how interest rates on bonds with different terms to maturity are
related, the one that views long-term interest rates as equaling the average of future short-term rates
expected to occur over the life of the bond is the
(a) pure expectations theory.
(b) preferred habitat theory.
(c) liquidity premium theory.
(d) segmented markets theory.
67. Of the four theories that explain how interest rates on bonds with different terms to maturity are
related, the one that assumes that bonds of different maturities are not substitutes for one another
is the
(a) pure expectations theory.
(b) segmented markets theory.
(c) liquidity premium theory.
(d) preferred habitat theory.
66 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
68. A moderately upward-sloping yield curve indicates that short-term interest rates are expected to
(a) neither rise nor fall in the near future.
(b) remain relatively unchanged, but that long-term rates are expected to fall.
(c) neither rise nor fall, but that long-term rates are expected to rise moderately.
(d) rise moderately in the near future.
69. A steep upward sloping yield curve indicates that short-term interest rates are expected to
(a) neither rise nor fall in the near future.
(b) remain relatively unchanged, but that long-term rates are expected to fall.
(c) neither rise nor fall, but that long-term rates are expected to rise moderately.
(d) rise moderately in the near future.
Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 67
◼ True/False
1. The term structure of interest rates describes how interest rates move over time.
2. The risk structure of interest rates describes the relationship between the interest rates of different
bonds with the same maturity.
3. Following the Enron bankruptcy, the spread between the interest rates on Baa bonds and Aaa bonds
widened.
4. The risk premium on corporate bonds becomes smaller as the liquidity of the bonds falls.
5. An increase in income tax rates will cause the interest rates on tax exempt municipal bonds to fall
relative to the interest rate on taxable corporate securities.
6. The interest rates on bonds of different maturities tend to move together over time.
7. The pure expectations theory is able to explain why yield curves are usually upward-sloping.
8. According to the pure expectations theory, the interest rate on a long-term bond is the average of the
short-term interest rates expected over the life of the long-term bond.
9. The market segmentation theory is able to explain why interest rates on bonds of different maturities
move together over time.
10. Bonds with the lowest risk of default are often referred to as junk bonds.
11. A positive liquidity premium indicates that investors prefer long-term bonds over short-term bonds.
12. A mildly upward sloping yield curve suggests that the market is predicting constant short-term
interest rates.
13. An increase in the marginal tax rate would likely increase the demand for municipal bonds, and
decrease the demand for U.S. government bonds.
14. When yield curves are downward sloping, long-term interest rates are above short-term
interest rates.
68 Mishkin/Eakins • Financial Markets and Institutions, Fifth Edition
◼ Essay
1. Contrast the liquidity premium theory to the market segmentation theory of the term structure of
interest rates.
2. Why would an increase in the income tax rate reduce borrowing costs to municipalities?
3. Discuss what is shown by a yield curve.
4. Why is it unlikely that the pure expectations theory alone is the correct theory for explaining the
yield curve?
5. What is meant by the risk structure of interest rates?
6. How would a severe recession affect the risk premium on corporate bonds?
7. Explain why a flight to quality occurred following the Enron bankruptcy and how this affected the
interest rates on lower quality and higher quality corporate bonds.
8. What do credit-rating agencies do and why is this work important?