Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 5 The Risk Structure and Term Structure of Interest Rates
5.1 The Risk Structure of Interest Rates
1) The risk structure of interest rates refers to
A) the amount of additional interest necessary to compensate savers for the greater risk of default
on some bonds.
B) the relationship among the interest rates on similar bonds with different maturities.
C) the relationship among the interest rates on bonds with the same maturity.
D) the amount of additional yield necessary to compensate savers for the lesser liquidity of some
bonds.
2) Default risk arises from the fact that
A) borrowers differ in their ability to repay in full the principal and interest required by a loan
agreement.
B) the bond price drops when interest rates rise.
C) it is inherently riskier to wait for a capital gain than to receive an immediate interest payment.
D) interest rates are far more likely to go up than to go down.
3) The risk premium of corporate bonds typically increases
A) when the average price of corporate bonds increase.
B) during a recession.
C) when the interest rates on corporate bonds decreases.
D) when the risk premium on treasury bonds increases.
4) Currently, a three-month Treasury bill has a yield of 5% while the yield on a ten-year
Treasury bond is 4.7%. What is the risk premium of the typical A-rated ten-year corporate bond
with a yield of 5.5%?
A) 0.5%
B) 0.8%
C) 5.5%
D) 1.17%
5) Currently, a three-year Treasury note pays 4.75%. Assuming that your tax rate is 20%, what is
the minimum interest rate that you would you need to earn on a tax-free municipal bond in order
to buy it instead?
A) 0.95%
B) 3.8%
C) 5.7%
D) 15.25%
6) When a company whose ability to repay its obligations in full is uncertain,
A) it will have to issue debt with longer maturities than would a company with a lower
probability of default.
B) its bonds will sell for higher prices than would the bonds of a company with a lower
probability of default.
C) it must offer investors higher yields to compensate them for the risk they take in buying their
bonds or making loans.
D) it must do so through financial markets rather than through financial intermediaries.
7) Default risk
A) is the probability that a borrower will not pay in full the promised coupon or principal.
B) exists only for the bonds of small corporations.
C) is also known as market risk.
D) is zero for bonds issued by cities and states.
8) Which of the following is considered a default-risk-free instrument?
A) a three-month commercial paper issued by GE
B) a share of stock issued by Google
C) a three-month Treasury bill
D) a ten-year bond issued by Intel
9) U.S. Treasury securities
A) are considered risk free because their prices never change.
B) have been defaulted on several time in U.S. history.
C) are considered default-risk-free instruments.
D) have a large default risk premium.
10) The default risk premium is measured
A) by an index published monthly by the Securities and Exchange Commission.
B) by an index published monthly by The Wall Street Journal.
C) as the difference between the yield on a non-Treasury security and the yield on a U.S.
Treasury security of the same maturity.
D) as the difference between the nominal yield on the security and the real after-tax yield on the
security.
11) The default risk premium is
A) relevant only for securities issued by very small companies.
B) the additional yield a saver requires for holding a bond with some default risk.
C) zero for corporate bonds, but quite substantial for corporate stock.
D) constant across the business cycle.
12) Investors often pay professional analysts to gather and monitor information on the
creditworthiness of borrowers because
A) federal law requires it.
B) most investors are risk neutral.
C) the cost of acquiring information about a borrower’s creditworthiness can be high.
D) doing so increases the net-of-tax yield on most investments.
13) Which of the following assigns widely-followed bond ratings?
A) Standard & Poor’s Corporation
B) Securities and Exchange Commission
C) Federal Reserve
D) IBM
14) Bond ratings
A) are published annually by the federal government and are based largely on information
contained in corporate tax returns.
B) are published annually by the federal government and are based on publicly available
information.
C) are published monthly by the federal government and are based on publicly available
information.
D) are published by private bond-rating agencies.
15) Which of the following is the highest bond rating assigned by Moody’s Investors Service?
A) Aaa
B) A
C) B
D) Baa
16) Which of the following is the lowest rating given to an investment-grade bond by Moody’s?
A) AA
B) A
C) Baa
D) B
17) Which of the following bond ratings by Moody’s Investors Service would NOT be
considered to be below investment grade?
A) Baa
B) Ba
C) B
D) All of these ratings are considered below investment grade.
18) Which of the following statements about junk (high-risk) bonds is true?
A) They never outperform treasury bonds since they’re too risky.
B) The price of junk bonds increase as their perceived risk increases.
C) They tend to perform best during recessions.
D) One can profit by owning them if market perceptions of their risk decline.
19) The default risk premium fluctuates mainly
A) because bond rating agencies tend to be inconsistent in their ratings of bonds.
B) because risk-neutral investors will often become risk-averse as time passes.
C) because taxes tend to rise over the long run.
D) as new information about a borrower’s creditworthiness becomes available.
20) If lenders anticipate no changes in liquidity, information costs, and tax differences, the yield
on a risky security should be
A) greater than that on a safe security and the price of a risky security should also be greater than
that of a safe security.
B) less than that on a safe security and the price of a risky security should also be less than that
of a safe security.
C) greater than that on a safe security and the price of a risky security should be lower than that
of a safe security.
D) less than that on a safe security and the price of a risky security should be greater than that on
a safe security.
21) A flight to quality refers to a shift by savers from
A) bonds and into stocks.
B) stocks and into gold or other precious metals.
C) bonds and into real assets, such as real estate.
D) low-quality bonds and into high-quality bonds.
22) During the financial crisis of 2008, the prices of U.S. Treasury securities
A) rose and the price of corporate bonds declined.
B) fell relative to the prices of corporate bonds.
C) remained in the same relative position to the prices of corporate bonds.
D) were frozen by order of the federal government.
23) In late 2008, the average risk premium rose because
A) investors feared a revival of inflation.
B) large tax increases in the United States reduced corporate profits and led to fears of increased
defaults.
C) of the financial crisis.
D) of fraud in the market for municipal bonds.
24) A company that retains a high bond rating during a recession in which many other companies
see their bond ratings cut will experience
A) an increased flow of funds into the market for its securities.
B) an increased demand for its securities, resulting in a higher expected return.
C) a decreased demand for its securities, resulting in a lower expected return.
D) a decreased flow of funds into the market for its securities.
25) The greatest appeal of U.S. Treasury securities is that
A) they have high yields.
B) they have no default risk.
C) the U.S. Treasury will repurchase them at any time.
D) their market prices fluctuate very little.
26) Suppose that savers become much more willing to purchase a certain type of municipal bond.
The result will be that the bond’s price will
A) fall relative to the price of U.S. Treasury securities but rise relative to the price of corporate
bonds.
B) rise relative to the price of U.S. Treasury securities but fall relative to the price of corporate
bonds.
C) rise relative to the prices of U.S. Treasury securities and corporate bonds.
D) fall relative to the prices of U.S. Treasury securities and corporate bonds.
27) Suppose that savers become less willing to purchase medium-quality corporate bonds. The
result will be that the prices of medium-quality corporate bonds will
A) fall relative to the price of U.S. Treasury securities, but rise relative to the price of high-
quality corporate bonds.
B) rise relative to the price of U.S. Treasury securities, but fall relative to the price of high-
quality corporate bonds.
C) rise relative to the prices of U.S. Treasury securities and high-quality corporate bonds.
D) fall relative to the prices of U.S. Treasury securities and high-quality corporate bonds.
28) Financial instruments with high information costs
A) will usually be more liquid than similar instruments with low information costs.
B) will have lower yields than U.S. Treasury securities.
C) may not be offered for sale in some states.
D) will have lower prices than similar instruments with low information costs.
29) The existence of rating agencies has
A) lowered returns on corporate bonds.
B) raised returns on corporate bonds.
C) left returns on corporate bonds largely unaffected.
D) raised returns on both corporate bonds and Treasury securities.
30) Government obligations, such as Treasury bills and bonds, have
A) high liquidity and high information costs.
B) low liquidity and low information costs.
C) low liquidity and high information costs.
D) high liquidity and low information costs.
31) During the financial crisis of 2007-2009,
A) mortgage-backed securities became more liquid.
B) information costs of mortgage-backed securities rose.
C) information costs of mortgage-backed securities declined.
D) the tax treatment of mortgage-backed securities was changed.
32) Differences in the taxation of returns
A) only affect the yields of illiquid credit market instruments.
B) have a negligible effect on the yields of credit market instruments.
C) only affect the yields of high-information cost credit market instruments.
D) create differences in yields among credit market instruments.
33) Municipal bonds are issued
A) only by local governments.
B) only by state governments.
C) by both state and local governments.
D) by the federal government, and by state and local governments.
34) For state residents, interest on most bonds issued by their state government is
A) exempt from state and federal income taxes.
B) exempt from state, but not from federal, income taxes.
C) exempt from federal, but not from state, income taxes.
D) subject to both state and federal income taxes.
35) Many savers are willing to accept a lower interest rate on municipal bonds than on
comparable instruments because
A) the after-tax yield on municipal bonds is greater.
B) municipal bonds invariably have lower default risk.
C) municipal bonds are more liquid than most other instruments.
D) the yield on municipal bonds is considered inflation proof.
36) Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state
and local tax rates is 5%, and the yield on thirty-year U.S. Treasury bonds is 10%. You would be
indifferent between buying a thirty-year Treasury bond and buying a thirty-year municipal bond
issued within your state (ignoring differences in liquidity, risk, and costs of information) if the
municipal bond has a yield of
A) 6.5%.
B) 7.0%.
C) 9.5%.
D) 10.0%.
37) Suppose that your marginal federal income tax rate is 30%, the sum of your marginal state
and local tax rates is 5%, and the yield on a thirty-year corporate bond is 10%. You would be
indifferent between buying this corporate bond and buying a thirty-year municipal bond issued
within your state (ignoring differences in liquidity, risk, and costs of information) if the
municipal bond has a yield of
A) 6.5%.
B) 7.0%.
C) 9.5%.
D) 10.0%.
38) Interest and capital gains are taxed differently in the United States in that
A) interest is exempt from state and local taxes.
B) interest is taxed as ordinary income, but capital gains are taxed only when realized.
C) interest is taxed as ordinary income, but capital gains are taxed as accrued.
D) capital gains when realized are exempt from state and local taxes.
39) If the federal government replaced the current income tax with a value-added tax
A) the prices of Treasury and municipal bonds would rise.
B) the prices of Treasury and municipal bonds would fall.
C) the prices of Treasury bonds would rise, while the prices of municipal bonds would fall.
D) the prices of Treasury bonds would fall, while the prices of municipal bonds would rise.
40) Which of the following statements is true?
A) The more liquid the bond, the lower the yield.
B) Tax-free bonds normally have a higher interest rate than other types of bonds.
C) The price of a bond increases as it becomes more risky.
D) The yield curve illustrates the relative default risks of alternative types of bonds.
41) Steve Forbes has run for president twice on a program of a “flat tax.” Under a flat tax, there
would be only one tax bracket for the federal income tax and most tax deductions and tax
exemptions would be eliminated. Suppose that Forbes wins the 2012 presidential election. What
would be the likely impact on the market for municipal bonds?
42) Suppose the private bond rating agencies ceased to exist. What would be the impact on the
bond market?
43) Discuss what happened to the market prices on corporate securities relative to government
securities during the Great Depression.
44) If the three-month Treasury bill has an interest rate of 0.2%, the ten-tear Treasury bond has
an interest rate of 2.75%, and a ten-year bond issued by Time Warner has an interest rate of 6%,
what is the risk premium on Time Warner’s bond?
45) How do ratings agencies earn income?
46) Why did some economists and policymakers think ratings agencies had a conflict of interest
leading up to the Financial Crisis of 2007-2009?