Chapter 07
The Risk and Term Structure of Interest Rates
Multiple-Choice Questions
1. The bond rating of a security reflects the:
a. size of the coupon payment relative to the face value.
b. likelihood the lender/borrower will be repaid by the borrower/issuer.
c. return a holder is likely to receive.
d. size of the coupon rate relative to other interest rates.
2. The two best known bond rating services are:
a. the Federal Reserve and Moody‘s Investment Services.
b. the Federal Reserve and the U.S. Treasury.
c. Standard & Poor’s and the Wall Street Journal.
d. Standard & Poor’s and Moody’s Investment Services.
3. Investors usually obtain bond ratings from:
a. private bond-rating agencies.
b. the annual tax returns of the issuer.
c. the U.S. government from publicly available information.
d. public Information made available by the bond issuers.
4. Which of the following assigns widely followed bond ratings?
a. The Federal Reserve
b. The U.S. Treasury
c. The New York Stock Exchange
d. Standard & Poor’s
5. Which of the following assigns widely followed bond ratings?
a. The Federal Reserve
b. The Wall Street Journal
c. Moody’s Investor Service
d. The Nasdaq
6. What is the highest bond rating assigned by Standard and Poor’s?
a. AA
b. EEE
c. AAA
d. A
7. The lowest rating for an investment grade bond assigned by Moody‘s is:
a. Baa.
b. A.
c. BBB.
d. Aa.
8. Bonds rated as “highly speculative” are:
a. rated so because they guarantee high returns for the buyer.
b. commonly referred to as junk bonds.
c. ranked just above investment grade by Standard & Poor’s.
d. rated so because they do not have any default risk.
9. Which of the following would be most likely to earn an AAA rating from Standard & Poor’s?
a. A 10-year bond issued by Canada
b. A bond issue by a new vegetarian fast-food chain
c. A 10-year bond issued by a state or municipality
d. Shares of stock in Coca-Cola
10. Once a bond rating is assigned, it:
a. never changes over the life of the bond.
b. can change as the financial position of the issuer changes.
c. can only change if the rating change is approved by the securities and exchange commission.
d. can change on the next bond from the issuer but is fixed for the current bond.
11. Commercial paper refers to:
a. the financial publications read by the CEO‘s of public corporations.
b. any debt security with a maturity exceeding one year.
c. short-term collateralized securities issued only by corporations.
d. unsecured short-term debt issued by corporations and governments.
12. Most commercial paper is:
a. issued with maturities exceeding one year.
b. issued with maturities between 50 and 75
da
ys.
c
. used exclusively for short-term financing needs.
d. issued by foreign companies doing business in the United States.
13. If a bond’s rating improves it should cause the bond’s price:
a. and yield to increase, all other factors constant.
b. and yield to decrease, all other factors constant.
c. to increase and its yield to decrease, all other factors constant.
d. to decrease and its yield to increase, all other factors constant.
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14. If a bond’s rating improves, we would expect:
a. the demand for this bond to increase, all other factors constant.
b. the demand for and the yield of this bond to increase, all other factors constant.
c. the demand for this bond to decrease, and its yield to increase, all other factors constant.
d. both the demand for and the price of the bond to decrease, all other factors constant.
15. Bonds issued by the U.S. Treasury are referred to as benchmark bonds because:
a. they are always purchased for a premium.
b. they are highly liquid and virtually free of default risk.
c. all bonds from national governments are labeled as benchmark bonds.
d. all bonds from the U.S. government have the same rate of interest.
16. The risk spread is:
a. the difference between a bond’s purchase price and selling price.
b. the difference between the bond’s yield and the yield on a U.S. Treasury bond of the same
maturity.
c. less than 0 (zero) for a U.S. Treasury bond.
d. assigned by a bond-rating agency.
17. The risk spread:
a. is also known as the default-risk premium.
b. should have a direct relationship with the bond’s price.
c. should have an inverse relationship with the bond’s yield.
d. is always constant.
18. All of the following are true about the risk spread except it should:
a. be higher for highly speculative bonds than investment grade bonds.
b. have a direct relationship with the bond’s yield.
c. have an inverse relationship with the bond‘s price.
d. have a direct relationship with the bond’s price.
19. The default–risk premium:
a. is negative for a U.S. Treasury bond.
b. is also known as the risk spread.
c. must always be greater than 0 (zero).
d. is assigned by a bond-rating agency.
20. The default–risk premium:
a. should vary directly with the bond‘s yield and inversely with its price.
b. is less than 0 (zero) for a U.S. Treasury bond.
c. should be lower for a highly speculative bond than for an investment-grade bond.
d. should vary directly with the bond’s yield and the bond’s price.
21. The risk structure of interest rates says:
a. the interest rates on a variety of bonds will move independently of each other.
b. lower rated bonds will have higher yields.
c. U.S. Treasury bond yields always change by more than other bonds.
d. interest rates only compensate for risk during recessions.
22. U.S. Treasury securities are considered to carry no risk spread because:
a. they are the closest thing to default-risk free that an investor can obtain.
b. the prices of U.S. Treasury bonds never change.
c. the yields on U.S. Treasury bonds never change.
d. the yields on U.S. Treasury bonds are always low.
23. The risk structure of interest rates refers to the:
a. relationship among the interest rates of bonds with different maturities.
b. relationship among the interest rates of bonds from different issuers with the same
maturities.
c. relationship among the interest rates of bonds from the same issuer but different maturities.
d. additional interest required to compensate the buyer for the longer maturity of the bond.
24. A borrower who has to pay an interest rate of 8% rather than 6% due to risk spread will pay:
a. $20 more in interest annually for every $100 borrowed.
b. 33.3% higher interest in dollar terms.
c. 2% in net interest.
d. less interest in total over the life of the loan.
25. Which of the following is true?
a. Long-term bond yields move together but short-term yields do not.
b. Short-term bond yields move together but long-term yields do not.
c. U.S. Treasury Bill yields are lower than the yields on commercial paper.
d. Long-term bond yields are usually the same as short-term yields.
26. Taxes play an important role in bond returns because:
a. all interest from owning bonds is taxed.
b. all governments (federal, state, municipal) tax bonds similarly.
c. some bond interest is exempt from some government taxation, so after tax returns
across bonds can vary considerably.
d. only U.S. Treasury bonds are tax-exempt, so investors should always seek higher returns
from other bonds.
27. Municipal bonds are issued by:
a. cities only.
b. the U.S. Treasury, but the proceeds can only be used by cities.
c. states and cities, but their interest is taxable only at the federal level.
d. states and cities and their interest is exempt from U.S. government taxation.
28. An investor in a 30% marginal tax bracket, earning $10 in interest annually for a $100 U.S.
Treasury bond:
a. earns a 10% after-tax return because interest on U.S. Treasury bonds is tax exempt at the
federal level.
b. earns a 3% return after-tax.
c. would be indifferent between this bond and a municipal bond offering $7 annually per $100
of face value, assuming the same default risk and liquidity characteristics.
d. earns a 1% return after-tax.
29. The yield on a tax-exempt bond:
a. equals the taxable bond yield times one minus the tax rate.
b. is equal to the yield on a U.S. 30-year bond.
c. is called the risk-free yield.
d. only applies to foreign bonds because they are exempt from U.S. income taxes.
30. Holding liquidity and default risk constant, an investor earning 6% from a tax–exempt bond
who is in a 25% tax bracket would be indifferent between that bond and a taxable bond with
a(n):
a. 8% yield.
b. 4.5% yield.
c. 6.25% yield.
d. 7.5% yield.
31. Holding liquidity and default risk constant, an investor earning 4% from a tax–exempt bond who
is in a 20% tax bracket would be indifferent between that bond and a taxable bone with a(n):
a. 7.5% yield.
b. 8.0% yield.
c. 5% yield.
d. 6% yield.
32. Municipal bonds are usually purchased by:
a. retired investors who have no other taxable income.
b. investors looking for securities to buy for their IRA accounts.
c. investors who live in cities with high municipal tax rates.
d. investors who are in high marginal tax brackets.
33. Suppose the tax rate is 25% and the taxable bond yield is 8%. What is the equivalent tax–
exempt bond yield?
a. 2%
b. 2.3%
c. 6%
d. 6.9%
34. In 2003, ratings agencies downgraded bonds issued by the State of California several
times. How will this affect the market for these bonds?
a. Yields on these bonds will decrease and the yield on Treasury bonds will
increase.
b. The yield on these bonds will not change, nor will the yield on Treasury bonds.
c. The yield on these bonds and on Treasury bonds will both
decrease.
d. Yields on these bonds will increase.
35. Tax-exempt bonds:
a. generate higher returns for the bondholder when purchased through a tax–exempt retirement
account.
b. are not affected by changes in yields on taxable bonds.
c. are most beneficial to those who pay higher income tax rates.
d. include U.S. Treasury securities because the Internal Revenue Service does not charge
income tax on interest earned from these bonds.
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36. If a local government eliminates the tax exemption on municipal bonds, we‘d expect to see:
a. an increase in the yield on taxable bonds.
b. a decrease in the gap in yields on taxable and tax–exempt bonds.
c. a decrease in the yield on municipal bonds.
d. municipal bonds will become more attractive to investors.
37. Which of the following is not typically used for qualifying mortgages as prime or subprime?
a. The borrower’s income
b. The borrower’s credit score
c. The borrower’s ethnicity
d. The loan to value ratio
38. According to the Expectations Theory of the term structure, if interest rates are expected to
be 2%, 2%, 4%, and 5% over the next four years, which yield is the closest to the yield on a
three-year bond today?
a. 2.7%
b. 4%
c. 4.3%
d. 8%
39. Suppose the economy has an inverted yield curve. According to the expectations
hypothesis, which of the following interpretations could be used to explain this?
a. Interest rates are expected to fall in the future
b. Investors prefer bonds with less default risk.
c. Investors prefer bonds with less interest-rate risk.
d. The term spread is positive.
40. Which fact about the term structure is the expectations theory unable to explain?
a. Why interest rates on bonds with different terms to maturity tend to move together over time.
b. Why yields on short-term bonds are more volatile than yields on long-term bonds.
c. Why longer-term yields tend to be higher than shorter-term yields.
d. Why long-term bond yields are influenced by expected future short-term bond yields.
41. Which fact about the term structure is the expectations theory able to explain?
a. Why interest rates on bonds with different terms to maturity tend to move together over time.
b. Why yields on short-term bonds are more volatile than yields on long-term bonds.
c. Why longer-term yields tend to be higher than shorter-term yields.
d. Why long-term bonds usually are less liquid than short-term bonds with the same default risk.
42. The risk spread on bonds fluctuates mainly because:
a. taxes tend to increase over time.
b. bond rating agencies are often inconsistent.
c. new information about a borrower’s financial condition becomes available.
d. people do not change their attitudes towards risk quickly.
43. In the fall of 1998 we saw an increase in the risk spread
beca
us
e:
a
. the risk spread always increases as we approach the end of the year.
b. the Russian government defaulted on some of its bonds.
c. there was an extraordinarily large amount of corporate fraud being reported in 1998.
d. there was a significant increase in U.S. income tax rates.
44. A company that continues to have strong profit performance during an economic downturn
when many other companies are suffering losses or failing should see:
a. an increase in the yield of their bonds and the price of the bond increases.
b. their bond rating maintained or actually increase.
c. the demand for their bonds decrease and their yields decrease.
d. the demand and price for their bonds decrease.
45. Bonds with the same tax status and ratings:
a. always have the same yield.
b. can have different yields due to different
maturities. c. should sell for the same price.
d. will still have different yields depending on their face values.
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46. The U.S. Treasury yield curve:
a. shows the relationship among bonds with the same risk characteristics but different
maturities. b. assumes maturities are constant, and reflects the difference in risk.
c. always has a positive
slope. d. always has a
negative slope. Ans: A
47. During a recession you would expect the difference between the commercial paper rate
and the yield on U.S. T-bills of the same maturity to:
a. be the same since their maturities are the same.
b. increase reflecting the possibility of higher default risk for commercial
paper. c. decrease.
d. fluctuate rarely.
48. Which of the following statements pertaining to the yield curve is not true?
a. Yield curves usually slope upwards.
b. The yield curve shows the difference in default risk between securities.
c. The yield curve shows the relationship among bonds with the same risk characteristics
but different maturities.
d. The yield curve can be flat or downward sloping depending on market conditions.
49. If the federal government replaced the current income tax with a national sales tax, the price of:
a. corporate bonds and municipal bonds would rise.
b. municipal bonds would rise and corporate bonds would not
change.
c. corporate bonds would fall while the price of municipal bonds would
rise. d. municipal bonds would fall while the price of corporate bonds
50. Interest on most bonds issued by states is usually exempt from:
a. state income tax but not federal.
b. from federal income tax but not
state. c. both state and federal income
taxes.
d. from city income taxes.
51. The term structure of interest rates:
a. always results in an upward sloping yield curve.
b. represents the variation in yields for securities differing in
maturities. c. usually results in a flat yield curve.
d. usually results in a downward sloping yield curve.
52. Which of the following statements is not true of the yield curve for U.S. Treasury
securities?
a. The yield curve usually slopes upward.
b. The yield curve usually is inverted.
c. The yield curve shows the relationship among securities of different maturities.
d. The yield curve can shift over time.
53. The yield curve for U.S. Treasury securities allows us to draw the following conclusions,
except that:
a. long-term yields tend to higher than short term yields.
b. interest rates of different maturities tend to move.
c. long-term rates tend to equal short-term rates.
d. yields on short-term securities are more volatile than yields on long-term bonds.
54. When the yield curve slope is more upward sloping than usual, people are expecting:
a. an economic slowdown.
b. the U.S. Treasury may default on its obligations.
c. the Federal Reserve is going to ease monetary policy.
d. a future rise in short-term interest rates.
55. When the yield curve is downward sloping:
a. people are expecting an economic slowdown.
b. short-term yields are lower than long term yields.
c. people are expecting higher inflation in the future.
d. people could be expecting a tightening in monetary policy.
56. Any theory of the term structure of interest rates needs to explain each of the following,
except why:
a. short-term yields are more volatile than long-term yields.
b. the yields of different maturities tend to move together.
c. short-term yields are usually higher than long-term yields.
d. long-term yields are usually higher than short-term yields.
57. The expectations hypothesis assumes:
a. a high level of uncertainty regarding the future of long-term yields.
b. investors know the yields on bonds today and form expectations of the yields on short-term
bonds in future time periods.
c. securities of different maturities are not perfect substitutes for each other.
d. the risk premium increases with longer maturities.
58. The expectations hypothesis suggests the:
a. yield curve should usually be downward sloping.
b. yield curve should usually be upward sloping.
c. slope of the yield curve reflects the risk premium associated with longer-term bonds.
d. slope of the yield curve depends on the expectations for future short-term rates.
59. The yield on a 30-year U.S. Treasury security is 6.5%; the yield on a 2-year U.S. Treasury
bond is 4.0%. This data indicate:
a. the yield curve is downward sloping.
b. the yield curve is flat since the risk premium needs to be added for longer maturities.
c. the yield curve is upward sloping.
d. that people expect inflation to decrease in the future.
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 the future one-year rate to be:
a. 4%.
b. 8%.
c. 6%.
d. 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%, then investors
expect the future one-year rate to be:
a. 4%.
b. 5%.
c. 6%.
d. 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 one-year-ahead expected one-year interest rate is
5%, then the current two-year interest rate should be:
a. 3%.
b. 5%.
c. 4%.
d. 8%.
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 the:
a. average interest rate of the three consecutive one-year bonds should be less than the 3- year
bond to reflect the risk premium.
b. interest rate of the 3-year bond should equal the average interest rate of the 3 one-year bonds.
c. three consecutive one-year bonds must have the same interest rate.
d. 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.
b. when short-term rates are expected to remain constant in the future, the long-term interest
rates are higher than current short-term interest rates.
c. short-term bonds are perfect substitutes for long-term bonds.
d. expectations of future short-term rates equal estimates of current short-term rates.