65. According to the expectations hypothesis, if investors believed that, for a given holding
period, the average of the expected future short-term yields was greater than the long-term yield
for the holding period, they would act so as to drive:
a. down the price of the short-term bond and drive up the price of the long-term bond.
b. up the price of the short-term bond and drive down the price of the long-term bond.
c. up the prices of both the short- and long-term bonds.
d. down the prices of both the short- and long-term bonds.
66. The expectations hypothesis cannot explain why:
a. yields on securities of different maturities move together.
b. short-term yields are more volatile than long term yields.
c. yield curves usually slope upward.
d. long-term bonds usually are less liquid than short-term bonds with the same default risk.
67. Under the expectations hypothesis, a downward-sloping yield curve suggests:
a. investors expect future short-term interest rates to fall.
b. investors expect future short-term interest rates to rise.
c. this is a trick question, the yield curve always slopes upward.
d. investors expect future short-term interest rates to remain constant.
68. The expectations hypothesis assumes each of the following, except:
a. long-term bond rates are equal to the average of current and expected future short-term
interest rates.
b. bonds of different maturities are not perfect substitutes.
c. bonds of different maturities have the same risk characteristics.
d. bonds of different maturities are perfect substitutes.
69. Suppose that interest rates are expected to remain unchanged over the next few years.
However, there is a risk premium for longer-term bonds. According to the liquidity premium
theory, the yield curve should be:
a. upward sloping and very steep.
b. upward sloping and relatively flat.
c. inverted.
d. vertical.
70. Suppose the economy has an inverted yield curve. According to the liquidity premium
theory, which of the following interpretations could be used to explain this?
a. Interest rates are expected to rise in the future.
b. Investors expect an economic slowdown.
c. Investors are indifferent between bonds with different time horizons.
d. The term spread has increased.
71. The economy enters a period of robust economic growth that is expected to last for several
years. How would this be reflected in the risk structure of interest rates?
a. An inverted yield curve
b. A decrease in the term spread
c. A decrease in the interest rate spread
d. An increase in yields on tax–exempt bonds
72. If a one-year bond currently yields 4% and is expected to yield 6% next year, the liquidity
premium theory suggests the yield today on a two-year bond will be:
a. More than 4% but less than 5%.
b. 5%.
c. 4%.
d. More than 5%.
73. The addition of the liquidity premium theory to the expectations hypothesis allows us to
explain why:
a. yield curves usually slope upward.
b. interest rates on bonds of different maturities move together.
c. long-term interest rates are less volatile than short term interest rates.
d. yield curves are flat.
74. The reason for the increase in inflation risk over time is due to the fact that:
a. the inflation rate always increases over time.
b. we always have inflation.
c. it is more difficult to forecast inflation over longer periods of time.
d. investors are more focused on nominal returns than real returns.
75. The risk premium that investors associate with a bond increases with all of the following
except:
a. maturity.
b. inflation risk increases.
c. interest-rate risk.
d. an improved bond rating.
76. Under the liquidity premium theory a flat yield curve implies:
a. there is no risk premium for longer-term maturities.
b. short-term interest rates are expected to remain constant.
c. short-term interest rates are expected to decrease.
d. long-term interest rates are higher than short-term interest rates.
77. Under the liquidity premium theory, if investors expect short-term interest rates to remain
constant, the yield curve should:
a. have a positive slope.
b. have a negative slope.
c. be flat.
d. have an increasing slope.
78. Under the expectations hypothesis, if expectations are for lower inflation in the future than
what it currently is, the yield curve’s slope will:
a. become more upward sloping.
b. become flat.
c. be negative.
d. be vertical.
79. When the growth rate of the economy slows we would expect:
a. the risk to increase for U.S. Treasury securities.
b. the risk spread to increase more between U.S. Treasury Securities and Aaa securities than
between Aaa and Baa securities.
c. the risk spread to increase more between Aaa and Baa securities than U.S. Treasuries and Aaa
securities.
d. investors to purchase more junk bonds in search of a higher yield.
80. A flight to quality refers to a move by investors:
a. away from bonds towards stocks.
b. towards securities of other countries and away from U.S. Treasuries.
c. towards precious metals and away from U.S. Treasury bonds.
d. away from low-quality bonds towards high-quality bonds.
81. We would expect the risk spread between Baa bonds and U.S. Treasury securities of the
same maturities to:
a. widen during periods of economic recession.
b. remain relatively constant over the business cycle.
c. decrease during economic slowdowns.
d. increase during economic growth periods.
82. We would expect the relationship between the risk spread on Baa bonds and U.S. Treasury
securities of similar maturities to:
a. vary directly with economic growth.
b. show no variation over the business cycle.
c. vary inversely with economic growth.
d. be uncorrelated with economic growth.
83. A flight to quality should result in the:
a. price of U.S. Treasury Securities rising and the price of corporate bonds rising.
b. yield on U.S. Treasury Securities falling and the price of corporate bonds rising.
c. yield on corporate bonds falling and the price of U.S. Treasury Securities rising.
d. yield on U.S. Treasury securities falling and the price of corporate bonds falling.
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84. When the Russian government defaulted on its bonds in August 1998:
a. risk spreads decreased significantly.
b. yields on U.S. Treasury securities fell while yields on corporate bonds rose.
c. yields on U.S. Treasury securities rose while prices of corporate bonds rose. d.
risk spreads did not change.
85. An inverted yield curve is a valuable forecasting tool because:
a. the yield curve usually is inverted so it reflects a growing economy.
b. the yield curve seldom is inverted and can signal an economic slowdown.
c. investors are expecting higher short-term rates in the future, and this usually signals an
economic slowdown.
d. inverted yield curves signal better economic times are expected.
86. The slope of the yield curve seems to predict the performance of the economy usually:
a. with a 3-month lag.
b. with a one-year lag.
c. within a few weeks.
d. with a two-year lag.
87. A proposed increase in the federal income tax rate should:
a. have no impact on the slope of the yield curve since the tax laws impact all maturities the same.
b. cause the slope of the yield curve to become negative.
c. increase the slope of the yield curve since it increases the risk premium of longer maturities.
d. flatten the yield curve.
88. If their only concern were the cost of issuing municipal debt, how would you expect the
mayors of most U.S. cities to respond to a revenue-neutral change in the federal income tax that
sharply lowered the top marginal tax rate?
a. Favorably, since this will significantly increase the demand for municipal bonds.
b. Unfavorably, the demand for municipal bonds will fall and their yields will increase.
c. Favorably, the price of municipal bonds should increase and their yields fall.
d. No reaction, this should have no impact on municipal bonds at all.
89. The terrorist attack on the World Trade Center on September 11, 2001:
a. triggered a flight to quality in the bond market.
b. caused the demand for U.S. Treasury securities to fall and the demand for corporate bonds to rise.
c. caused the price of U.S. Treasury securities to fall and the yields on corporate bonds to fall.
d. did not have any significant impact since the risk on all bonds increased.
90. If the Federal Reserve surprises investors by announcing an easing of monetary policy:
a. it should have no impact on the slope of the yield curve.
b. we should expect the yield curve to possibly become inverted.
c. the yield curve would flatten.
d. we should expect the yield curve to steepen.
91. An increased risk of a financial crisis in the euro area should cause the:
a. demand for all government securities including U.S. Treasury securities to decrease.
b. risk spread between U.S. Treasury bonds and other bonds to decrease.
c. price of U.S. Treasury bonds to increase and the yield on other bonds to increase.
d. price of U.S. Treasury bonds to increase and the yield on other bonds to decrease.
92. A permanent increase of borrowing by the U.S. Treasury to finance growing
budget deficits will:
a. result in U.S. Treasury yields being higher than high-grade corporate bonds.
b. result in the price of U.S. Treasury bonds rising.
c. cause the yield on U.S. Treasury bonds to increase, but still be lower than corporate bonds.
d. result in lower yields on corporate bonds.
93. The presence of a term spread that is usually positive indicates that:
a. the yield curve always slopes upward.
b. bonds of similar risk but with different maturities are not perfect substitutes.
c. we should expect the yield curve to usually be flat.
d. we should expect the yield curve to usually slope downward.
94. The interest-rate risk that is associated with bond investing:
a. exists even if an investor plans on holding the bond to maturity.
b. arises because of a mismatch between the investor’s investment horizon and the maturity of
the bond.
c. is not reflected in the risk premium.
d. can be eliminated by holding only consols.
95. Imagine a scandal that finds the officers of bond rating agencies have been taking bribes to
inflate the rating of specific bonds. This should:
a. have no impact on the bond market since bond markets are highly efficient.
b. decrease the demand for all bonds.
c. increase the demand for U.S. Treasury securities and decrease the demand for corporate bonds.
d. decrease the risk spread.
96. Under the expectations hypothesis, bonds of different maturities are assumed to be perfect
substitutes because:
a. the risk premium is assumed to be negative.
b. market forces would always have long-term interest rates equal the average of the current and
expected short-term rate.
c. expectations of future interest rates are uncertain and therefore cannot be included in the analysis.
d. bond markets are very liquid.
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97. A proposed increase in the federal income tax rates may actually be viewed favorably by
many mayors of cities because:
a. it will allow them to also raise their tax rates.
b. it will cause the demand for municipal bonds to increase and their yields to increase.
c. people will pay less attention to local taxes.
d. it will cause the price of municipal bonds to increase and their yields to decrease.
98. As technology allows information regarding the financial health of corporations to become
easier to obtain, we should expect:
a. the risk spread to decrease.
b. the role of bond rating agencies to become more important.
c. a decrease in the number of participants in the bond market.
d. the risk spread to increase.
Short Answer Question
99. What is the main purpose (function) of bond rating services?
100. Briefly describe the two different types of junk bonds (high-yield bonds).