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Indicate whether the statement is true or false.
1. Other things being equal, an expected decrease in interest rates will increase the demand for long-term funds by
borrowers.
a. True
b. False
2. The forward rate is commonly used to represent the market’s forecast of the future interest rate.
a. True
b. False
3. Yield curves are always upward sloping.
a. True
b. False
4. Treasury securities are exempt from federal and state income taxes.
a. True
b. False
5. Investment-grade bonds are bonds that are rated as Caa or better by Moody’s and as CCC or better by Standard &
Poor’s.
a. True
b. False
6. The graphic comparison of maturities and annualized yields is known as the interest rate curve.
a. True
b. False
7. Credit ratings are most commonly used to indicate which financial institutions have available funds that they can lend
to borrowers.
a. True
b. False
8. Investors will always prefer the purchase of risk-free Treasury securities, since other securities have a higher level of
risk.
a. True
b. False
9. Some types of debt securities always offer a higher yield than others.
a. True
b. False
10. The segmented markets theory suggests that although investors and borrowers may normally concentrate on a
particular natural maturity market, certain events may cause them to wander from it.
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b. False
11. The higher a bond rating, the lower the perceived credit risk.
a. True
b. False
12. The term structure of interest rates defines the relationship between maturity and annualized yield, holding other
factors such as risk constant.
a. True
b. False
13. The yields of securities commonly move in the same direction over time.
a. True
b. False
14. Based on the expectations theory of the term structure of interest rates, a flat or inverted yield curve is most commonly
interpreted to signal that that the economy will strengthen in the near future.
a. True
b. False
15. If liquidity influences the yield curve, the forward rate underestimates the market’s expectation of the future interest
rate.
a. True
b. False
16. According to the segmented markets theory, the term structure of interest rates is determined solely by expectations of
future interest rates.
a. True
b. False
17. Because interest rates may vary significantly across countries at a given point in time, investors do not monitor the
term structures of interest rates in foreign countries unless they are interested in investing in a particular foreign country.
a. True
b. False
18. Bonds issued at different times by the same corporation may not receive the same rating from a rating agency.
a. True
b. False
19. According to the text, research on the term structure of interest rates has found that maturity markets are not even
partially segmented, because investors view various maturities as adequate substitutes for each other.
a. True
b. False
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20. When expectations theory is combined with the liquidity theory, the yield on a security will always be equal to the
yield from consecutive investments in shorter-term securities over the same investment horizon.
a. True
b. False
21. If the yield curve is upward sloping, some investors may attempt to benefit from the higher yields on longer-term
securities, even when they have funds for only a short period of time. This strategy is known as riding the yield curve.
a. True
b. False
22. The preference for more liquid short-term securities places downward pressure on the slope of the yield curve.
a. True
b. False
Indicate the answer choice that best completes the statement or answers the question.
23. According to the segmented markets theory, if most investors suddenly preferred to invest in short-term securities and
most borrowers suddenly preferred to issue long-term securities, there would be
a. upward pressure on the yields of both short-term and long-term securities.
b. downward pressure on the yield of short-term securities.
c. downward pressure on the yield of long-term securities.
d. upward pressure on the yield of short-term securities.
24. If all other characteristics are similar, ____ would have to offer ____.
a. taxable securities; a higher after-tax yield than tax-exempt securities
b. taxable securities; a higher before-tax yield than tax-exempt securities
c. tax-exempt securities; a higher after-tax yield than taxable securities
d. tax-exempt securities; a higher before-tax yield than taxable securities
25. Within the category of capital market securities, municipal bonds have the before-tax yield, and their after-tax
yield is typically of Treasury bonds from the perspective of investors in high tax brackets.
a. highest; below that
b. lowest; above that
c. highest; above that
d. lowest; below that
26. Investors may attempt to benefit from the higher yields on longer-term securities even though they have only short-
term funds to invest by using a strategy called ________ the yield curve.
a. extending
b. holding
c. riding
d. exploiting
27. Assume investors are indifferent among security maturities. Today, the annualized two-year interest rate is 12 percent,
and the one-year interest rate is 9 percent. What is the forward rate according to the pure expectations theory?
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a. 15.08 percent
b. 3.00 percent
c. 12.00 percent
d. 12.62 percent
e. 11.41 percent
28. A theory states that while investors and borrowers may normally concentrate on a particular natural maturity market,
conditions may cause them to change maturity markets. This theory is called the
a. liquidity premium theory.
b. efficient markets theory.
c. pure expectations theory.
d. preferred habitat theory.
29. The ____ theory suggests that although investors and borrowers may normally concentrate on a particular natural
maturity market, certain events may cause them to wander from it.
a. pure expectations
b. liquidity premium
c. segmented markets
d. preferred habitat
30. All other characteristics being equal, securities with ____ liquidity would have to offer a ____ yield to be preferred.
a. lower; higher
b. higher; higher
c. lower; lower
d. None of these are correct.
31. The term structure of interest rates defines the relationship
a. between risk and return.
b. between risk and maturity.
c. between maturity and yield.
d. between default risk ratings and maturity.
32. A downward-sloping yield curve indicates that Treasury securities with ____ maturities offer ____ annualized yields.
a. longer; lower
b. longer; higher
c. shorter; lower
d. shorter; the same (short-term and long-term annualized yields are the same)
33. The theory of the term structure of interest rates, which states that investors and borrowers choose securities with
maturities that satisfy their forecasted cash needs, is the
a. pure expectations theory.
b. liquidity premium theory.
c. segmented markets theory.
d. liquidity habitat theory.
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34. In some time periods, there is evidence that corporations initially financed long-term projects with short-term funds.
They planned to borrow long-term funds once interest rates were lower. This specifically supports the ____ for explaining
the term structure of interest rates.
a. liquidity premium theory
b. expectations theory
c. segmented markets theory
d. liquidity premium theory AND segmented markets theory
35. According to segmented markets theory, if investors have mostly long-term funds available and borrowers want short-
term funds, this will place ____ pressure on the demand for short-term funds by borrowers and the yield curve will be
____ sloping.
a. upward; downward
b. downward; upward
c. upward; upward
d. downward; downward
36. Assume that the Treasury experiences a large increase in the budget deficit and issues a large number of short-term
securities (Treasury bills or T-bills). This action will ____ the supply of T-bills in the market and place ____ pressure on
the yield of T-bills.
a. decrease; downward
b. decrease; upward
c. increase; upward
d. increase; downward
37. Assume that today, the annualized two-year interest rate is 12 percent, and the one-year interest rate is 9 percent. A
three-year security has an annualized interest rate of 14 percent. What is the one-year forward rate two years from now?
a. 12.67 percent
b. 113 percent
c. 195 percent
d. 15.67 percent
e. None of these are correct.
38. If issuers of securities (borrowers) and investors suddenly expect interest rates to decrease, their actions to benefit
from their expectations should cause
a. long-term yields to rise.
b. short-term yields to decrease.
c. prices of long-term securities to decrease.
d. long-term yields to rise AND short-term yields to decrease.
e. None of these are correct.
39. According to segmented markets theory, if investors have mostly short-term funds available and borrowers want long-
term funds, there would be ____ pressure on the supply of short-term funds provided by investors and ____ pressure on
the yield of long-term securities.
a. upward; upward
b. downward; downward
c. upward; downward
d. downward; upward
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40. Credit (default) risk is likely to be highest for
a. short-term Treasury securities.
b. AAA corporate securities.
c. long-term Treasury securities.
d. BBB corporate securities.
41. The annualized yield on a three-year security is 13 percent; the annualized two-year interest rate is 12 percent, while
the one-year interest rate is 9 percent. The forward rate one year ahead is ____ percent.
a. 2.8
b. 115
c. 103
d. 15.1
42. Assume an investor’s tax rate is 25 percent. The before-tax yield on a security is 12 percent. What is the after-tax
yield?
a. 16.00 percent
b. 9.25 percent
c. 9.00 percent
d. 3.00 percent
e. None of these are correct.
43. The annualized yield on a two-year security is below the annualized one-year interest rate. The one-year forward rate
as of one year ahead is ______________.
a. zero
b. negative
c. positive, but below the annualized one-year interest rate
d. None of these are correct
44. If research showed that anticipation about future interest rates was the only important factor for all investors in
choosing short-term or long-term securities, this would support the argument made by the
a. liquidity premium theory.
b. expectations theory.
c. segmented markets theory.
d. liquidity premium theory AND expectations theory.
45. Assume that the current yield on one-year securities is 6 percent, and that the yield on a two-year security is 7 percent.
If the liquidity premium on a two-year security is 0.4 percent, then the one-year forward rate is
a. 8.0 percent.
b. 7.6 percent.
c. 3.0 percent.
d. 7.0 percent.
46. The yield curve in a foreign country is
a. always downward sloping.
b. nonexistent.
c. the same as in the United States at any point in time.
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d. None of these are correct.
47. Other things being equal, the yield required on A-rated bonds should be ____ the yield required on B-rated bonds
whose other characteristics are exactly the same.
a. greater than
b. equal to
c. less than
d. All of these are possible, depending on the size of the bond offering.
48. The yield offered on a debt security is related to the prevailing risk-free rate and related
to the security’s risk premium.
a. negatively; negatively
b. positively; positively
c. negatively; positively
d. positively; negatively
49. Assume the yield curve is flat. If investors flood the short-term market and avoid the long-term market, they may
cause the yield curve to
a. remain flat.
b. become upward sloping.
c. become downward sloping.
d. None of these are correct.
50. If liquidity influences the yield curve, but is not considered when deriving the forward interest rate, the forward
interest rate ____ the market’s expectation of the future interest rate.
a. overestimates
b. accurately estimates
c. underestimates
d. is an unbiased forecast of (it has an equal chance of overestimating or underestimating)
51. Assume that annualized yields of short-term and long-term securities are equal. If investors suddenly believe interest
rates will increase, their actions may cause the yield curve to
a. become inverted.
b. become flat.
c. become upward sloping.
d. be unaffected.
52. Assume that the Treasury bond yield today is 2 percentage points higher than it was one year ago. Also assume that
the credit (default) risk premium of an A-rated bond declined by 0.4 percentage point since one year ago. A newly issued
A-rated bond will likely offer a yield today that is ____ the yield that was offered on an A-rated bond issued one year ago.
a. greater than
b. equal to
c. less than
d. A or B are both common
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53. A firm in the 20 percent tax bracket is aware of a tax-exempt security that is paying a yield of 7 percent. To match this
yield, taxable securities must offer a before-tax yield of
a. 8.75 percent.
b. 10.8 percent.
c. 20.0 percent.
d. None of these are correct.
54. If shorter-term securities have higher annualized yields than longer-term securities, the yield curve
a. is horizontal.
b. is upward sloping.
c. is downward sloping.
d. cannot be determined unless we know additional information (such as the level of market interest rates).
55. According to the pure expectations theory of the term structure of interest rates, the ____ the difference between the
implied one-year forward rate and today’s one-year interest rate, the ____ is the expected change in the one-year interest
rate.
a. greater; less
b. less; greater
c. greater; greater
d. less; less
56. The theory for the term structure of interest rates that says the shape of the yield curve is determined solely by
expectations of future interest rates is called the
a. segmented markets theory.
b. liquidity premium theory.
c. pure expectations theory.
d. theory of rational expectations.
57. If a security can easily be converted to cash without a loss in value, it
a. is liquid.
b. has a high after-tax yield.
c. has high credit risk.
d. is illiquid.
58. If a yield curve is upward sloping, the investment strategy of buying long-term securities, then selling them after a
short period (say, one year) is called
a. riding the yield curve.
b. liquidating the yield curve.
c. segmenting the yield curve.
d. a forward roll.
e. None of these are correct.
59. According to the segmented markets theory, if most investors suddenly preferred to invest in long-term securities and
most borrowers suddenly preferred to issue short-term securities, there would be
a. upward pressure on the yield of long-term securities.
b. downward pressure on the yield of short-term securities.
c. downward pressure on the yield of long-term securities.
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d. no change in the yield of short-term securities.
60. You are considering the purchase of a tax-exempt security that is paying a yield of 10.08 percent. You are in the 28
percent tax bracket. To match this after-tax yield, you would consider taxable securities that pay
a. 31.1 percent.
b. 19 percent.
c. 12.5 percent.
d. 14 percent.
61. If the liquidity premium exists, a flat yield curve would be interpreted as the market expecting ____ in interest rates.
a. no changes
b. a slight decrease
c. a slight increase
d. a large increase
62. According to segmented markets theory, if investors have mostly long-term funds available and borrowers want short-
term funds, this will place ____ pressure on the demand for long-term funds issued by borrowers and the yield curve will
be ____ sloping.
a. upward; downward
b. downward; upward
c. upward; upward
d. downward; downward
63. Which of the following is NOT a characteristic affecting the yields on debt securities?
a. credit (default) risk
b. liquidity
c. tax status
d. term to maturity
e. All of these are correct and affect yields on debt securities.
64. According to pure expectations theory, if interest rates are expected to decrease, there will be ____ pressure on the
demand for short-term funds by borrowers and ____ pressure on the demand for long-term funds issued by borrowers.
a. upward; upward
b. downward; downward
c. upward; downward
d. downward; upward
65. Interest rate movements across countries tend to be _________ correlated as a result of ____________ financial
markets.
a. positively; internationally integrated
b. positively; fully segmented
c. negatively; partially segmented
d. negatively; internationally integrated
66. Assume that maturity markets are completely segmented. If the Treasury issues a large amount of long-term Treasury
bonds to finance the budget deficit, this would place ____ pressure on _________-term yields.
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a. upward; short
b. downward; short
c. upward; long
d. downward; long
67. If research showed that all investors attempt to purchase securities that perfectly match the time for which they will
have available funds, this would specifically support the argument made by the
a. liquidity premium theory.
b. real interest rate theory.
c. expectations theory.
d. segmented markets theory.
68. Assume that the Treasury experiences a large decrease in the budget deficit and purchases a large number of short-
term Treasury securities (Treasury bills or T-bills). This action will ____ the supply of T-bills in the market and place
____ pressure on the yield of T-bills.
a. decrease; downward
b. decrease; upward
c. increase; upward
d. increase; downward
69. In general, securities with ____ characteristics will offer ____ yields.
a. favorable; higher
b. favorable; lower
c. unfavorable; lower
d. None of these are correct.
70. If the liquidity premium theory completely describes the term structure of interest rates, then, on the average, the yield
curve should be
a. flat.
b. downward sloping.
c. upward sloping.
d. None of these are correct.
71. Which of the following established the Office of Credit Ratings and mandated that credit rating agencies establish
internal controls to make their ratings process more transparent?
a. Financial Reform Act of 2010
b. Consumer Protection Act of 2008
c. Federal Ratings Commission Act of 2014
d. None of the above is correct.
72. Vaughn Corporation is considering the issue of commercial paper and would like to know the yield it should offer on
its commercial paper. The corporation believes that a 0.2 percent credit risk premium, a 0.1 percent liquidity premium,
and a 0.3 percent tax adjustment are necessary to sell its commercial paper to investors. Furthermore, annualized rates on
short-term Treasury securities (T–bills) are 7 percent. Based on this information, Vaughn should offer ____ percent on its
commercial paper.
a. 8.0
b. 7.6
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c. 7.5
d. 7.9
e. None of these are correct.
73. If interest rates are expected to decrease, the yield on new short-term securities may be expected to ____, and the yield
curve should be ____ sloping.
a. increase; upward
b. increase; downward
c. decrease; upward
d. decrease; downward
74. An upward-sloping yield curve indicates that Treasury securities with ____ maturities offer ____ annualized yields.
a. longer; lower
b. longer; higher
c. shorter; similar (short-term and long-term annualized yields are the same)
d. shorter; higher
75. According to the liquidity premium theory, the expected yield on a two-year security will ____ the expected yield
from consecutive investments in one-year securities.
a. equal
b. be less than
c. be greater than
d. be less than or greater than, depending on the size of the liquidity premium
76. Holding other factors such as risk constant, the relationship between the maturity and the annualized yield of debt
securities is called the
a. term structure of interest rates.
b. default structure of interest rates.
c. liquidity structure of interest rates.
d. tax structure of interest rates.
e. None of these are correct.
77. According to expectations theory, the sudden expectation of lower interest rates in the future will cause investors to
provide a ____ supply of short-term funds and a ____ supply of long-term funds.
a. large; large
b. large; small
c. small; small
d. small; large
78. Which of the following statements is NOT true with respect to debt securities?
a. Some types of debt securities always offer a higher yield than others.
b. Debt securities offer different yields because they exhibit different characteristics that influence the offered yield.
c. In general, securities with favorable characteristics will offer higher yields to entice investors.
d. All of these are correct with respect to debt securities.
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79. Assume that a yield curve is influenced by interest rate expectations and a liquidity premium. Assume the yield curve
is initially flat. If liquidity suddenly was no longer important, the yield curve would now have a ____ (assuming no other
changes).
a. slight downward slope
b. slight upward slope
c. steep upward slope
d. steep downward slope
80. Some financial institutions such as commercial banks typically invest only in
a. junk bonds.
b. corporate bonds rated B or higher.
c. Treasury securities.
d. investment-grade bonds.
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Answer Key
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