Question 1

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?

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Question 2

The U.S. Treasury yield curve:

Accepted Answer

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.

Question 3

Tax-exempt bonds:

Accepted Answer

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.

Question 4

Once a bond rating is assigned, it:

Accepted Answer

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.

Question 5

What is meant by a subprime mortgage?

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Question 6

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.

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Question 7

Which fact about the term structure is the expectations theory unable to explain?

Accepted Answer

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.

Question 8

U.S. Treasury securities are considered to carry no risk spread because:

Accepted Answer

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.

Question 9

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.

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Question 10

How did asset backed commercial paper (ABCP) rollover risk contribute to the financial crisis of 2007-2009?

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Question 11

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?

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Question 12

The lowest rating for an investment grade bond assigned by Moody's is:

Accepted Answer

A)  Baa. 
B)  A. 
C)  BBB. 
D)  Aa.

Question 13

Briefly describe the two different types of junk bonds (high-yield bonds).

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Question 14

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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Question 15

The expectations hypothesis assumes each of the following, except:

Accepted Answer

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.

Question 16

If a bond's rating improves it should cause the bond's price:

Accepted Answer

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.

Question 17

Bonds issued by the U.S. Treasury are referred to as benchmark bonds because:

Accepted Answer

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.

Question 18

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?

Accepted Answer

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.

Question 19

A flight to quality should result in the:

Accepted Answer

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.

Question 20

Why do yield curves usually slope upward?

Accepted Answer

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Exam 7: The Risk and Term Structure of Interest Rates

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?