Fin 221
Chapter 6
TRUE-FALSE QUESTIONS
T F 1.A yield curve plots coupon yields and maturity.
T F2.One area of expectations affecting yields by maturities is anticipated(expected) inflation.
T F3.The expectations theory states that long-term rates represent the market estimate of the average of current and future short-term rates.
T F 4. According to expectation theory, If interest rates are expected to increase in the future, one would expect to see an upward sloping yield curve
T F 5.According to the preferred habitat theory, investors may move out of their preferred maturities in response to expected yield premiums.
T F 6.The default risk premium compensates the holder of the risky security for the risk assumed.
T F 7.Liquidity premiums cause an observed yield curve to be less upward sloping than that predicted by the expectations theory
T F 8.The higher the marginal tax bracket of the investor, the less the attraction of municipal bonds.
T F9.Bonds with call options are likely to have lower yields than non-callable bonds.
MULTIPLE-CHOICE QUESTIONS
1. The term structure of interest rates
a.describes the relationship between maturity and yield for similar securities.
b.ranks security yield according to the default risk structure.
c.describes how interest rates vary over time.
d.describes the pattern of interest rates over the business cycle.
2.The yield curve is a plot of
a.maturity changes as risk changes.
b.yields by varied risk-taking of varied bond issuers.
c.yields by maturity of securities with similar default risk.
d.interest rates over time past.
3.Applying the expectations theory, a bank depositor has the option of purchasing a one-year CD at 7 percent and a 9 percent two-year CD. If indifferent between the two, the depositor must expect one-year CDs one year from now to have a rate of
a. 8 percent.
b.11 percent.
c.slightly over 11 percent.
d.12 percent.
4.The yield differentials between a AAA corporate bond and a BAA corporate bond of the same maturity may be explained by
a.marketability.
b.tax treatment.
c.default risk.
d.term to maturity.
5.A call option on a bond
a.increases the price an investor may pay.
b.decreases the price an investor may pay.
c.decreases the yield required by investors.
d.has no effect on price or yield.
Use the data below to answer questions 6 through 8.
Yield
Treasury Bill (6 month)6.41%
Treasury Bill (1 year)6.57%
Treasury Bill (2 year)7.02%
Treasury Note (10 year)7.58%
Treasury Bond (30 year)*7.43%
Corporate Bond (10 year AA)9.25%
Municipal Bond (10 year AA)7.12%
Expected Annual Inflation Rate3.50%
6.The slope of the yield curve for U.S. Treasury securities indicates
a.declining interest rates in the future.
b.increasing interest rates in the future.
c.increasing prices on U.S. Treasuries in the future.
d.constant interest rates in the future.
7.The default risk premium on the ten-year corporate bond is
a.1.67%
b.2.13%
c.2.84%
d.1.82%
8.The yield difference between the corporate and municipal bond may be best explained by the fact that
a.the municipal has lower default risk.
b.the capital gain income on a municipal bond is tax-free.
c.the interest income on each is federal tax exempt.
d.the interest income on the municipal bond is federal tax exempt.
9.Which of the following bonds probably has the highest call premium included in its yield?
a.a low coupon, short-term corporate note in an increasing rate market
b.a high coupon rate bond in a falling interest rate market
c.a high coupon rate bond in a rising interest rate market
d.a low coupon rate bond in an increasing interest rate market.
10.A downward sloping yield curve indicates that future short-term rates are expected to ______and outstanding security prices will ______.
a.fall; rise.
b.fall; fall.
c.rise; rise.
d.rise; fall.
11.Suppose we consider a yield curve that has taken into consideration both the expectations theory and the liquidity premium theory. Assume the yield curve is initially downward sloping. If liquidity premium theory is no longer important, the yield curve you would expect to see would be:
a.more steeply downward sloping
b.more upward sloping
c.less steeply downward sloping
d.none of the above.
12.According to expectations theory, an investor who believes that interest rates are likely to decrease in the near future would
a.would invest in short-term securities immediately.
b.would invest in long-term securities immediately.
c.would sell long-term securities from her portfolio.
d.would sell short-term securities from her portfolio.
13.According to expectations theory, if the market believes that interest rates are expected to increase in the near future,
a.borrowers would immediately increase their supply of short-term securities.
b.investors would immediately increase their demand for long-term securities.
c.borrowers would immediately increase their supply of long-term securities.
d.neither borrowers nor investors would do anything until the interest rates actually increased.
Calculations Questions:
- At what marginal tax rate would you be indifferent between an A-rated, ten-year corporate bond offering a yield of 10 percent and an A-rated, ten-year municipal bond offering a yield of 6 percent?
- Suppose the yield on a 30-year corporate bond rated Aaa is 8.86 percent and the yield on a 30-year Treasury bond is 8.27 percent. What is the default risk premium?
- Assume that the term structure of U.S. Treasury securities includes the following rates:
Security / Annual Yield (%)
1-year note / 4.52
2-year note / 4.51
3-year note / 4.48
Using this information, calculate: the forward one-year rate expected for two years from now bond.