Exam 7: The Risk and Term Structure of Interest Rates

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?

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?

In 2003, ratings agencies downgraded bonds issued by the State of California several times. How will this affect the market for these bonds?

A flight to quality should result in:

Which of the following assigns widely followed bond ratings?

What role did rating agencies play in the financial crisis of 2007-2009?

Using the information provided and the Expectations Hypothesis, compute the yields for a two-year, three-year, and four-year bonds.

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?

The terrorist attack on the World Trade Center on September 11, 2001:

What is meant by a subprime mortgage?

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.

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?

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.

Increased borrowing by the U.S. Treasury to finance growing budget deficits will:

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:

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 $1000 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.

Explain why most retired individuals are not likely to be heavily invested in municipal bonds.

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, what is the yield on a three-year bond today?

What is the main purpose (function) of bond rating services?

Holding 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: