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101. What is meant by a subprime mortgage?
102. If an investor wants to compare commercial paper to a corresponding default-free
investment, which security would he/she use and why?
103. How did asset backed commercial paper (ABCP) rollover risk contribute to the financial
crisis of 2007-2009?
104. An investor sees the current twelve-month rate at 4% and expects the following future
twelve-month rate for each of the subsequent years; 4.5%, 5.5% and 6.0%. If this investor views
a four-year maturity at 5.65% as equal to four consecutive one-year securities, what is
hi
s
/he
r
ri
sk premium?
105. Why do economists pay particular attention to inverted yield curves?
106. If the yield curve is flat, using liquidity premium theory, what do you know about the
expected future short-term interest rate?
107. Explain why many mayors of cities facing the need to borrow for infrastructure
improvements, may not look favorably on a large federal income tax rate reduction?
108. What is the effective after-tax yield to an investor from a bond paying $70 per $1,000
annually, if the investor is in a 25% marginal tax bracket? Explain.
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109. Consider the following four investors. Rank each according to who has the most to gain from
investing in 30-year tax-exempt municipal bonds. Each investor has $1,000 in a savings account that
he/she plans to use to buy bonds. Explain briefly why you ranked the investors this way.
(a) A 20-year old college student who earns low income through working over summers and breaks. The
student plans to graduate next year.
(b) The CEO of a large company who is currently in the highest tax bracket.
(c) A middle-income household saving up to move into a larger home.
(d) A 60-year old nurse who plans to retire at age 62. He uses a tax-exempt pension fund for all
of his savings.
110. Using the information provided and the expectations hypothesis, compute the yields for a
two-year, three-year, and four-year bonds.
Now, suppose there is a risk premium attached to each bond. These risk premiums are given in
the table below:
Using the information above and the liquidity premium theory, compute the yields for a two-
year, three-year, and four-year bonds. How does this yield curve compare to the one you
computed using the expectations hypothesis?
111. What is the equivalent tax-exempt bond yield for a taxable bond with an 8% yield and a
bondholder in a 35% marginal tax rate? Explain.
112. Assuming the expectations hypothesis is correct, and given the following information:
The current four-year interest rate is 5.0%
The current one-year interest rate is 4.0%
The expected one-year rate for one year from now is 5.0%
The expected one-year rate for two years from now is 5.5%
What is the expected one-year rate for three years from now? Explain.
113. Any theory of the yield curve must be able to explain what three general conditions?
114. The usually upward sloping yield curve indicates that long-term bonds have higher yields
than short-term bonds. Why is this?
115. Why can't the expectations hypothesis stand alone as an adequate theory to explain yield
curves?
116. What impact should an economic slowdown have on the risk structure of interest rates?
117. During economic slowdowns why would you expect the risk premium to increase the most
between U.S. Treasury bonds and junk bonds?
118. When we compare the graphs of GDP growth over time to the corresponding risk spread on
Baa bonds compared to 10-year U.S. Treasury bonds, what relationship can be
inferred?
119. Describe the concept of flight to quality in terms of the Russian government default of
August 1998.
120. Why do yield curves usually slope upward?
121. Explain why an inverted yield curve is a valuable forecasting tool?
122. Why might we expect to see a high correlation between increases in the risk structure of
interest rates and the yield curve becoming inverted?
123. Does the expectations hypothesis allow for people to have a preference for longer-term
investments? Explain
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124. Explain why most retired individuals are not likely to be heavily invested in municipal
bonds.
125. At the beginning of 2006 the yield curve was usually flat, and sometimes downward
sloping (inverted). This raised concerns that a recession might be on the way. But the slope of
the yield curve is only part of the story. What else is important?
Essay Questions
126. Please use the graphs to show what happens to the risk (yield) differential in each situation
and why.
Assume the corporate and Treasury bonds have the same maturity;
a) If the corporate bonds are default-risk free, what could you tell about the price and yields of
each?
b) If the corporate bonds are now viewed as having the possibility of default, what happens in
each market?
c) If the corporate bonds are granted tax-exempt status, what happens in each market?
d) If the corporate bonds have a longer maturity than the Treasury bonds what would happen?
127. Under the expectations hypothesis of the term structure of interest rates, explain the impact
of a U.S. Treasury decision to phase out the 30-year bond and to only focus on 3-month,
1-year, 5-year and 10-year bonds?
128. We have heard the predictions regarding the large number of people that will be retiring
over the next 25-50 years and the strain this is going to place on the federal budget. Assuming that
federal borrowing will have to increase, what is the likely impact going to be on the risk and term
structure (if any) of interest rates and why?
129. The paper-bill spread refers to the interest rate spread between commercial paper and
Treasury bills with the same maturity. Is this a risk spread or a term spread? How do you expect
the paper-bill spread is related to GDP growth? What is the intuition for this result? What does
this imply about the yield curve?
130. Suppose that the Federal Reserve is concerned about rising inflation, so they increase short-
term interest rates. How will this affect long-term rates and the yield curve? What does the slope
of the yield curve reveal about the effectiveness of the Fed's policy? Explain in the context of the
Liquidity Premium Theory.
