Economics of Money, Banking, and Financial Markets, 11e (Mishkin)
Chapter 6 The Risk and Term Structure of Interest Rates
6.1 Risk Structure of Interest Rates
1) 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 term to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.
2) The risk that interest payments will not be made, or that the face value of a bond is not repaid
when a bond matures is
A) interest rate risk.
B) inflation risk.
C) liquidity risk.
D) default risk.
3) Bonds with no default risk are called
A) flower bonds.
B) no-risk bonds.
C) default-free bonds.
D) zero-risk bonds.
4) Which of the following bonds are considered to be default-risk free?
A) municipal bonds
B) investment-grade bonds
C) U.S. Treasury bonds
D) junk bonds
5) U.S. government bonds have no default risk because
A) they are issued in strictly limited quantities.
B) the federal government can increase taxes or print money to pay its obligations.
C) they are backed with gold reserves.
D) they can be exchanged for silver at any time.
6) The spread between the interest rates on bonds with default risk and default-free bonds is
called the
A) risk premium.
B) junk margin.
C) bond margin.
D) default premium.
7) If the probability of a bond default increases because corporations begin to suffer large losses,
then the default risk on corporate bonds will ________ and the expected return on these bonds
will ________, everything else held constant.
A) decrease; increase
B) decrease; decrease
C) increase; increase
D) increase; decrease
8) A bond with default risk will always have a ________ risk premium and an increase in its
default risk will ________ the risk premium.
A) positive; raise
B) positive; lower
C) negative; raise
D) negative; lower
9) If a corporation begins to suffer large losses, then the default risk on the corporate bond will
A) increase and the bond’s return will become more uncertain, meaning the expected return on
the corporate bond will fall.
B) increase and the bond’s return will become less uncertain, meaning the expected return on the
corporate bond will fall.
C) decrease and the bond’s return will become less uncertain, meaning the expected return on the
corporate bond will fall.
D) decrease and the bond’s return will become less uncertain, meaning the expected return on the
corporate bond will rise.
10) If the possibility of a default increases because corporations begin to suffer losses, then the
default risk on corporate bonds will ________, and the bonds’ returns will become ________
uncertain, meaning that the expected return on these bonds will decrease, everything else held
constant.
A) increase; less
B) increase; more
C) decrease; less
D) decrease; more
11) Other things being equal, an increase in the default risk of corporate bonds shifts the demand
curve for corporate bonds to the ________ and the demand curve for Treasury bonds to the
________.
A) right; right
B) right; left
C) left; right
D) left; left
12) Other things being equal, a decrease in the default risk of corporate bonds shifts the demand
curve for corporate bonds to the ________ and the demand curve for Treasury bonds to the
________.
A) right; right
B) right; left
C) left; right
D) left; left
13) A(n) ________ in the riskiness of corporate bonds will ________ the price of corporate
bonds and ________ the yield on corporate bonds, all else equal.
A) increase; increase; increase
B) increase; decrease; increase
C) decrease; increase; increase
D) decrease; decrease;decrease
14) An increase in the riskiness of corporate bonds will ________ the price of corporate bonds
and ________ the price of Treasury bonds, everything else held constant.
A) increase; increase
B) reduce; reduce
C) reduce; increase
D) increase; reduce
15) A decrease in the riskiness of corporate bonds will ________ the price of corporate bonds
and ________ the price of Treasury bonds, everything else held constant.
A) increase; increase
B) reduce; reduce
C) reduce; increase
D) increase; reduce
16) An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds
and ________ the yield on Treasury securities, everything else held constant.
A) increase; increase
B) reduce; reduce
C) increase; reduce
D) reduce; increase
17) A decrease in the riskiness of corporate bonds will ________ the yield on corporate bonds
and ________ the yield on Treasury securities, everything else held constant.
A) increase; increase
B) decrease; decrease
C) increase; decrease
D) decrease; increase
18) An increase in default risk on corporate bonds ________ the demand for these bonds, but
________ the demand for default-free bonds, everything else held constant.
A) increases; lowers
B) lowers; increases
C) does not change; greatly increases
D) moderately lowers; does not change
19) A decrease in default risk on corporate bonds ________ the demand for these bonds, and
________ the demand for default-free bonds, everything else held constant.
A) increases; lowers
B) lowers; increases
C) does not change; greatly increases
D) moderately lowers; does not change
20) As default risk increases, the expected return on corporate bonds ________, and the return
becomes ________ uncertain, everything else held constant.
A) increases; less
B) increases; more
C) decreases; less
D) decreases; more
21) As default risk decreases, the expected return on corporate bonds ________, and the return
becomes ________ uncertain, everything else held constant.
A) increases; less
B) increases; more
C) decreases; less
D) decreases; more
22) As their relative riskiness ________, the expected return on corporate bonds ________
relative to the expected return on default-free bonds, everything else held constant.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; does not change
23) Which of the following statements are TRUE?
A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but
increases the demand for default-free bonds.
B) The expected return on corporate bonds decreases as default risk increases.
C) A corporate bond’s return becomes less uncertain as default risk increases.
D) As their relative riskiness increases, the expected return on corporate bonds increases relative
to the expected return on default-free bonds.
24) Everything else held constant, if the federal government were to guarantee today that it will
pay creditors if a corporation goes bankrupt in the future, the interest rate on corporate bonds
will ________ and the interest rate on Treasury securities will ________.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
25) Bonds with relatively high risk of default are called
A) Brady bonds.
B) junk bonds.
C) zero coupon bonds.
D) investment grade bonds.
26) Junk bonds, bonds with a low bond rating, are also known as
A) high-yield bonds.
B) investment grade bonds.
C) high quality bonds.
D) zero-coupon bonds.
27) Bonds with relatively low risk of default are called ________ securities and have a rating of
Baa (or BBB) and above; bonds with ratings below Baa (or BBB) have a higher default risk and
are called ________.
A) investment grade; lower grade
B) investment grade; junk bonds
C) high quality; lower grade
D) high quality; junk bonds
28) Which of the following bonds would have the highest default risk?
A) municipal bonds
B) investment-grade bonds
C) U.S. Treasury bonds
D) junk bonds
29) Which of the following long-term bonds has the highest interest rate?
A) corporate Baa bonds
B) U.S. Treasury bonds
C) corporate Aaa bonds
D) municipal bonds
30) Which of the following securities has the lowest interest rate?
A) junk bonds
B) U.S. Treasury bonds
C) investment-grade bonds
D) corporate Baa bonds
31) The spread between interest rates on low quality corporate bonds and U.S. government bonds
A) widened significantly during the Great Depression.
B) narrowed significantly during the Great Depression.
C) narrowed moderately during the Great Depression.
D) did not change during the Great Depression.
32) During the Great Depression years 1930-1933 there was a very high rate of business failures
and defaults, we would expect the risk premium for ________ bonds to be very high.
A) U.S. Treasury
B) corporate Aaa
C) municipal
D) corporate Baa
33) Risk premiums on corporate bonds tend to ________ during business cycle expansions and
________ during recessions, everything else held constant.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
34) The collapse of the subprime mortgage market
A) did not affect the corporate bond market.
B) increased the perceived riskiness of Treasury securities.
C) reduced the Baa-Aaa spread.
D) increased the Baa-Aaa spread.
35) The collapse of the subprime mortgage market increased the spread between Baa and
default-free U.S. Treasury bonds. This is due to
A) a reduction in risk.
B) a reduction in maturity.
C) a flight to quality.
D) a flight to liquidity.
36) During a “flight to quality”
A) the spread between Treasury bonds and Baa bonds increases.
B) the spread between Treasury bonds and Baa bonds decreases.
C) the spread between Treasury bonds and Baa bonds is not affected.
D) the change in the spread between Treasury bonds and Baa bonds cannot be predicted.
37) If you have a very low tolerance for risk, which of the following bonds would you be least
likely to hold in your portfolio?
A) a U.S. Treasury bond
B) a municipal bond
C) a corporate bond with a rating of Aaa
D) a corporate bond with a rating of Baa
38) Which of the following statements is TRUE?
A) A liquid asset is one that can be quickly and cheaply converted into cash.
B) The demand for a bond declines when it becomes less liquid, decreasing the interest rate
spread between it and relatively more liquid bonds.
C) The differences in bond interest rates reflect differences in default risk only.
D) The corporate bond market is the most liquid bond market.
39) Corporate bonds are not as liquid as government bonds because
A) fewer corporate 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) corporate bonds cannot be resold.
40) When the Treasury 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; right
D) left; left
41) When the Treasury 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; right
D) left; left
42) A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand
curve for corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right
43) An increase in the liquidity of corporate bonds, other things being equal, shifts the demand
curve for corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right
44) A(n) ________ in the liquidity of corporate bonds will ________ the price of corporate
bonds and ________ the yield on corporate bonds, all else equal.
A) increase; increase; decrease
B) increase; decrease; decrease
C) decrease; increase; increase
D) decrease; decrease; decrease
45) An increase in the liquidity of corporate bonds will ________ the price of corporate bonds
and ________ the yield of Treasury bonds, everything else held constant.
A) increase; increase
B) reduce; reduce
C) increase; reduce
D) reduce; increase
46) A decrease in the liquidity of corporate bonds will ________ the yield of corporate bonds
and ________ the yield of Treasury bonds, everything else held constant.
A) increase; increase
B) decrease; decrease
C) increase; decrease
D) decrease; increase
47) The risk premium on corporate bonds reflects the fact that corporate bonds have a higher
default risk and are ________ U.S. Treasury bonds.
A) less liquid than
B) less speculative than
C) tax-exempt unlike
D) lower-yielding than
48) Which of the following statements is TRUE?
A) State and local governments cannot default on their bonds.
B) Bonds issued by state and local governments are called municipal bonds.
C) All government issued bonds—local, state, and federal—are federal income tax exempt.
D) The coupon payment on municipal bonds is usually higher than the coupon payment on
Treasury bonds.
49) Everything else held constant, if the tax-exempt status of municipal bonds were eliminated,
then
A) the interest rates on municipal bonds would still be less than the interest rate on Treasury
bonds.
B) the interest rate on municipal bonds would equal the rate on Treasury bonds.
C) the interest rate on municipal bonds would exceed the rate on Treasury bonds.
D) the interest rates on municipal, Treasury, and corporate bonds would all increase.
50) Municipal bonds have default risk, yet their interest rates are lower than the rates on default-
free Treasury bonds. This suggests that
A) the benefit from the tax-exempt status of municipal bonds is less than their default risk.
B) the benefit from the tax-exempt status of municipal bonds equals their default risk.
C) the benefit from the tax-exempt status of municipal bonds exceeds their default risk.
D) Treasury bonds are not default-free.
51) Everything else held constant, 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
52) Everything else held constant, 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
53) Everything else held constant, the interest rate on municipal bonds rises relative to the
interest rate on Treasury securities when
A) income tax rates are lowered.
B) income tax rates are raised.
C) municipal bonds become more widely traded.
D) corporate bonds become riskier.
54) Everything else held constant, 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.
55) Everything else held constant, abolishing the individual income tax will
A) increase the interest rate on corporate bonds.
B) reduce the interest rate on municipal bonds.
C) increase the interest rate on municipal bonds.
D) increase the interest rate on Treasury bonds.
56) Which of the following statements are TRUE?
A) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest
rates.
B) Because the tax-exempt status of municipal bonds was of little benefit to bond holders when
tax rates were low, they had higher interest rates than U.S. government bonds before World War
II.
C) Interest rates on municipal bonds will be higher than comparable bonds without the tax
exemption.
D) 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 lower income tax brackets.
57) The Obama administration increased the tax on the top income tax bracket from 35% to
39%. Supply and demand analysis predicts the impact of this change was a ________ interest
rate on municipal bonds and a ________ interest rate on Treasury bonds, all else the same.
A) higher; lower
B) lower; lower
C) higher; higher
D) lower; higher
58) Three factors explain the risk structure of interest rates
A) liquidity, default risk, and the income tax treatment of a security.
B) maturity, default risk, and the income tax treatment of a security.
C) maturity, liquidity, and the income tax treatment of a security.
D) maturity, default risk, and the liquidity of a security.
59) The spread between the interest rates on Baa corporate bonds and U.S. government bonds is
very large during the Great Depression years 1930-1933. Explain this difference using the bond
supply and demand analysis.
60) If the federal government where to raise the income tax rates, would this have any impact on
a state’s cost of borrowing funds? Explain.
AACSB: Reflective Thinking
6.2 Term Structure of Interest Rates
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 term to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.
2) A plot of the interest rates on default-free government bonds with different terms to maturity
is called
A) a risk-structure curve.
B) a default-free curve.
C) a yield curve.
D) an interest-rate curve.
3) Differences in ________ explain why interest rates on Treasury securities are not all the same.
A) risk
B) liquidity
C) time to maturity
D) tax characteristics