CHAPTER 1



CHAPTER 8

THE STRUCTURE OF INTEREST RATES

1. The price at which a market maker will sell a security is called the

a. bid price.

b. asked price.

c. dealer price.

d. discount basis price.

ANSWER: b

2. The is the price the market maker (dealer) is willing to pay to acquire a security.

a. bid price

b. asked price

c. dealer price

d. discount basis price

ANSWER: a

3. postulates that many borrowers and lenders favor securities that have maturities of a particular length. This favoritism creates a degree of market segmentation between the short-term and long-term securities markets.

a. The term structure of interest rates

b. The geometric average theory

c. The expectations theory

d. The preferred habitat theory

ANSWER: d

4. The sweetener or bribe required to induce lenders to abandon their preferred habitats is referred to as

a. a risk premium.

b. a habitat premium.

c. taxability.

d. a liquidity premium.

ANSWER: d

5. suggests that the long-term interest rate is the geometric average of the present short-term rate and the short-term rates expected to prevail over the term to maturity of the long-term security.

a. The term structure of interest rates

b. The geometric average theory

c. The expectations theory

d. The preferred habitat theory

ANSWER: c

6. The expectations theory posits that

a. the long-term rate is the geometric average of the current short-term rate and short-term rates expected to prevail over the term to maturity of the long-term security.

b. the short-term rate is the geometric average of the current long-term rate and long-term rates expected to prevail over the term to maturity of the short-term security.

c. the long-term rate is the geometric average of the current long-term rate and short-term rates expected to prevail over the term to maturity of the long-term security.

d. the long-term rate is the geometric average of the current short-term rate and the rate of inflation expected to prevail over the term to maturity of the long-term security.

ANSWER: a

7. The pattern or spread among interest rates determined by the term to maturity, credit risk, and tax treatment is best described as the

a. term structure of interest rates.

b. geometric average theory.

c. expectations theory.

d. preferred habitat theory.

ANSWER: a

8. The pattern or spread among interest rates is usually referred to as the

a. term to maturity.

b. credit risk.

c. term structure of interest rates.

d. yield to maturity.

ANSWER: c

9. What happens to the shape of the yield curve if, ceteris paribus, expectations about future interest rates change such that future short term interest rates are expected to be higher than previously expected?

a. the slope (shape) of the yield curve remains the same but the curve shifts up.

b. the differences among various yield curves narrows.

c. the yield curve becomes steeper.

d. Both a and b

ANSWER: c

10. The tax rate paid on the last dollar of income that the taxpayer earns is the

a. IRS discount rate.

b. average tax rate.

c. average marginal tax rate.

d. marginal tax rate.

ANSWER: d

11. The is the extra return or interest with which a lender is compensated for accepting more risk.

a. risk premium

b. liquidity premium

c. credit risk

d. liquidity risk

ANSWER: a

12. The is the extra return required to induce lenders to lend long term rather than short term.

a. risk premium

b. liquidity premium

c. credit risk

d. liquidity risk

ANSWER: b

13. is the probability of a debtor not paying the principal and/or interest due on an outstanding debt

a. Risk premium

b. Liquidity premium

c. Credit risk

d. Liquidity risk

ANSWER: c

14. A graphic representation of the relationship between interest rates on a particular security and different terms to maturity for that security is called the

a. term structure of interest rates.

b. yield curve.

c. geometric average.

d. discount basis.

ANSWER: b

15. The yield curve is a graphic relationship between

a. the spreads among interest rates and their tax treatment.

b. interest rates (yields) on a particular security and its term structure.

c. interest rates (yields) on a particular structure and its after-tax return.

d. interest rates (yields) on a particular security and its term to maturity.

ANSWER: d

16. The takes into account the effects of compounding; it is used to calculate the long-term rate from the short rate and the short-term rates expected to prevail over the term to maturity of the long-term security.

a. marginal average rate

b. marginal rate

c. average marginal rate

d. geometric average

ANSWER: d

17. Which of these is a major corporate credit-rating agency that evaluates a borrower's probability of default and assigns the borrower to a particular risk class?

a. Dow Jones Industrial Average (DJIA)

b. Moody's Investors Services

c. FDIC

d. Dow Jones Investor Service (DJIS)

ANSWER: b

18. Which of these is a major corporate credit-rating agency that evaluates a borrower's probability of default and assigns the borrower to a particular risk class?

a. Dow Jones Industrial Average (DJIA)

b. Standard & Poor’s

c. the FDIC

d. the Federal Reserve System

ANSWER: b

19. What happens to the shape of the yield curve if expectations about future interest rates change such that future short term interest rates are expected to be lower than previously expected?

a. the slope (shape) of the yield curve remains the same but the curve shifts up.

b. the differences among various yield curves narrows.

c. the yield curve becomes flatter.

d. Both a and b

ANSWER: c

20. The risk that funds may have to be reinvested at a lower rate in the future is the _______________. It is generally _____________ than the ___________________.

a. reinvestment risk, less, liquidity premium.

b. liquidity risk, less, reinvestment premium.

c. reinvestment risk, more, liquidity premium.

d. liquidity premium, more, reinvestment risk.

ANSWER: a

21. Which of the following typically has the shortest term to maturity?

a. Treasury bills

b. Treasury notes

c. Treasury bonds

d. Municipal notes

ANSWER: a

22. The pattern among interest rates and their maturity is generally referred to as which of the following?

a. Nominal interest rates

b. Term structure of interest rates

c. Implicit interest rates

d. Effective structure of rates

ANSWER: b

23. Treasury notes and bonds are issued with an original maturity of which of the following?

a. 1 to 3 months

b. 3 to 6 months

c. 6 to 12 months

d. 12 or more months

ANSWER: d

24. Changes in the slope of the yield curve

a. reflect only changes in the demand for securities, since lenders dominate the securities markets.

b. reflect only changes in the supply of securities, since borrowers dominate the securities markets.

c. reflect changes in the supply of and demand for securities which are induced by changes in interest rate expectations.

d. come about magically.

ANSWER: c

25. A yield curve graphically depicts the relationship between which of these pairs?

a. Term to maturity and interest rates

b. Term to maturity and structure of stock options

c. Term to maturity and tax treatment

d. Term to maturity and credit risk

ANSWER: a

26. Typically, an individual asset is depicted on

a. a single yield curve

b. two yield curves combined

c. three yield curves combined

d. several yield curves

ANSWER: a

27. On a yield curve, term to maturity is shown

a. as downward sloping.

b. as upward sloping.

c. on the horizontal axis.

d. on the vertical axis.

ANSWER: c

28. If the slope of the yield curve is positive, this means which of the following?

a. Yields decline as the term to maturity increases

b. Yields decline as the term to maturity decreases

c. Yields rise as the term to maturity increases

d. Yields rise as the term to maturity decreases

ANSWER: c

29. The slope and the position of the yield curve depicts

a. the term structure of interest rates.

b. the term structure of tax treatment.

c. the term structure of stock options.

d. the term structure of credit risk.

ANSWER: a

30. When the yield curve is upward sloping, this means which of the following?

a. Short-term securities yield more than long-term securities

b. Short-term securities yield less than long-term securities

c. Short-term securities yield the same as long-term securities

d. None of the above

ANSWER: b

31. When the yield curve is downward sloping or inverted, this means

a. short-term securities yield more than long-term securities.

b. short -term securities yield less than long-term securities.

c. short -term securities yield the same as long-term securities.

d. None of the above

ANSWER: a

32. When the yield curve is flat, this means which of the following?

a. Short-term securities yield more than long-term securities

b. Short-term securities yield less than long-term securities

c. Short-term securities yield the same as long-term securities

d. None of the above

ANSWER: c

33. According to the expectations theory, if next year's expected short-term rate is above the current short-term rate, the yield curve will be

a. horizontal.

b. vertical.

c. upward sloping.

d. downward sloping.

ANSWER: c

34. According to the expectations theory, if next year's expected short-term rate is above the current short-term rate,

a. the current long-term rate will be below the current short-term rate.

b. the current long-term rate will be above the current short-term rate.

c. the current long-term rate will be horizontal.

d. the current long-term rate will be vertical.

ANSWER: b

35. According to the expectations theory, if next year's expected short-term rate is below the current short-term rate, the yield curve will be

a. horizontal.

b. vertical.

c. upward sloping.

d. downward sloping.

ANSWER: d

36. According to the expectations theory, if next year's expected short-term rate is below the current short-term rate,

a. the current long-term rate will be below the current short-term rate.

b. the current long-term rate will be above the current long-term rate.

c. the current long-term rate will be horizontal.

d. the current long-term rate will be vertical.

ANSWER: a

37. Ceteris paribus, when borrowers increase their current supply of long-term securities, then

a. short-term interest rates will rise.

b. long-term interest rates will rise.

c. long-term interest rates will fall.

d. All of the above

ANSWER: b

38. Ceteris paribus, when borrowers decrease their current supply of long-term securities, the

a. short-term interest rates will fall.

b. long-term interest rates will rise.

c. long-term interest rates will fall.

d. All of the above

ANSWER: c

39. The term structure of interest rates is determined by

a. interest rate expectations.

b. the supply of securities.

c. the demand for securities.

d. All of the above

ANSWER: d

40. According to the expectations theory, if the 1-year rate is 2.5% and the 2-year rate is 3.64%, the expected 1-year rate would be

a. 3.80%.

b. 4.80%.

c. 5.80%.

d. 6.80%.

ANSWER: b

41. According to the expectations theory, when the yield curve is rising, market participants expect

a. future long-term interest rates to rise above current short-term rates.

b. future long-term interest rates to fall below current long-term rates.

c. future short-term interest rates to rise above current short-term rates.

d. future short-term interest rates to fall below current short-term rates.

ANSWER: c

42. According to the expectations theory, when the yield curve is falling, market participants expect

a. future long-term interest rates to rise above current short-rate rates.

b. future long-term interest rates to fall below current short-term rates.

c. future short-term interest rates to rise above current short-term rates.

d. future short-term interest rates to fall below current short-term rates.

ANSWER: d

43. Expectations about future short-term interest rates depend on expectations about which of the following?

a. Future income

b. The money supply and inflation

c. Long-term interest rates

d. Both a and b

ANSWER: d

44. The expected short-term interest rate is inversely related to expectations about future

a. national income.

b. money supply.

c. currency in circulation.

d. inflation.

ANSWER: b

45. If the yield curve was negatively sloped, this would most likely reflect expectations of a combination of future

a. declines in the money supply and income.

b. declines in income and inflation.

c. increases in income and inflation.

d. increases in income and money supply.

ANSWER: b

46. When market participants see the economy going into an expansion, they most likely expect

a. falling interest rates.

b. stabilizing future interest rates.

c. rising future interest rates.

d. falling future interest rates.

ANSWER: c

47. During the late part of the business expansion, interest rates will most likely do which of the following?

a. Fall

b. Rise

c. Remain the same

d. Fall slightly, then plateau

ANSWER: b

48. According to the expectations theory, a negatively sloped yield curve usually reflects

a. an increase in expected income.

b. an increase in expected future prices.

c. a decrease in expected future prices.

d. a decrease in the money supply.

ANSWER: c

49. According to the expectations theory, a positively sloped yield curve usually reflects

a. an increase in expected future income.

b. a decrease in expected future income.

c. a decrease in expected future prices.

d. an increase in the money supply.

ANSWER: a

50. Some researchers believe the expectations theory needs to be modified in order to reflect

a. liquidity premiums.

b. that lenders may have some preference for either long- or short-term securities and hence not be indifferent between the two.

c. the tendency of borrowers to prefer longer term securities so they don’t have to issue and reissue short term securities.

d. All of the above

ANSWER: d

51. Preferred habitats refers to

a. preferring stocks over bonds.

b. minimal allowance for write-offs.

c. preferred maturities for borrowers and lenders that may lead to market segmentation.

d. investment in newly constructed housing.

ANSWER: c

52. A liquidity premium is used to

a. lure lenders to lend short term.

b. lure lenders to lend long term.

c. lure lenders to lend greater amounts.

d. None of the above

ANSWER: b

53. Generally, the relationship between the liquidity premium and term to maturity is

a. inverse.

b. direct.

c. negative.

d. None of the above

ANSWER: b

54. If expected future short-term interest rates are equal to current short-term rates, the liquidity premium will

a. make long-term rates lower than current short-term rates.

b. make long-term rates higher than current short-term rates.

c. make long-term rates equal to current short-term rates.

d. make have no effect.

ANSWER: b

55. Long-term interest rates are affected by

a. interest rate expectations.

b. preferred habitats.

c. liquidity premiums.

d. All of the above

ANSWER: d

56. Changes in interest rates may be caused by which of the following?

a. Changes in liquidity premiums

b. Changes in preferred habitats

c. Changes in the supply of funds driven by changes in expectations

d. All of the above

ANSWER: d

57. The current long-term interest rate is a function of all of the following except

a. the current short-term rate.

b. the short-term rates expected in the future.

c. last year's long-term rate.

d. the liquidity premium.

ANSWER: c

58. Which of the following best describes the type of relationship between the term to maturity and interest rates in the last 20 years?

a. Inverse

b. Direct

c. Negative

d. There is no consistent relationship

ANSWER: b

59. Which of the following is a measure of the credit worthiness of the issuer of a security?

a. the liquidity premium

b. the discount from par

c. the money illusion

d. the credit risk

ANSWER: d

60. Which security has the least credit risk?

a. Common stock

b. Treasury securities

c. Preferred stock

d. Equities

ANSWER: b

61. Which of the following is not considered a major credit-rating agency?

a. Standard & Poor's

b. Moody's Investors Service

c. New York Exchange Service

d. All of the above are major credit-rating agencies.

ANSWER: c

62. Credit-rating agencies do which of the following?

a. Evaluate a borrower's probability of default

b. Assign the borrower to a particular risk class

c. Help lenders determine the credit worthiness of a borrower

d. All of the above

ANSWER: d

63. Both Standard & Poor's and Moody's Credit Ratings services have how many classes of risk?

a. 5

b. 7

c. 9

d. 11

ANSWER: c

64. According to Moody's, the lowest credit rating that can be presented is

a. Daa.

b. C.

c. Ca.

d. Caa.

ANSWER: b

65. According to Standard & Poor's, the highest credit rating that can be awarded is

a. A.

b. BA.

c. AA.

d. AAA.

ANSWER: d

66. Ratings and classifications of borrowers are determined by their

a. patterns in profits and costs.

b. leverage ratios.

c. past debt redemption.

d. All of the above.

ANSWER: d

67. Ratings of state and local governments are determined by the

a. outstanding debt level.

b. growth in spending.

c. tax base.

d. All of the above.

ANSWER: d

68. The premium rewarded to purchasers for accepting more risk is referred to as which of the following?

a. Liquidity premium

b. Risk premium

c. Credit premium

d. Contingency premium

ANSWER: b

69. Selling lower-rated issues and then purchasing higher-rated securities is considered a/an

a. amortization of intangible assets.

b. purchasing power gains.

c. flight to quality.

d. quality smoothing.

ANSWER: c

70. Typically, during a recession the spread between the highest- and medium-grade-rated municipal bonds

a. narrows.

b. remains the same.

c. overlaps.

d. widens.

ANSWER: d

71. Typically, during an expansion the spread between the best quality and medium grade rated municipal bonds

a. narrows.

b. remains the same.

c. overlaps.

d. widens.

ANSWER: a

72. The fraction of an additional dollar that is paid in taxes is called which of the following?

a. The average tax rate

b. The marginal tax rate

c. The capital gains tax

d. The taxable gains tax

ANSWER: b

73. If Maureen lives in a country where no taxes are levied on the first $20,000 of income and a 10% tax is levied on all income above $20,000, what is her marginal tax rate if she has an average tax rate of 5%?

a. 5%

b. 10%

c. 15%

d. 25%

ANSWER: b

74. Assume a corporate marginal tax rate of 38%. What yield on a municipal bond would leave a corporation indifferent between a 9% corporate bond and a municipal bond?

a. 4.8%

b. 5.58%

c. 6.03%

d. 7.2%

ANSWER: b

75. If security purchasers found the after-tax yield on municipal bonds higher than that of corporate bonds, leading to an increase in municipal bond purchases and an increase in corporate bond sales, this would cause the

a. yields on municipals to increase.

b. prices on corporate bonds to increase.

c. yields on corporate bonds to decrease.

d. yields on municipals to decrease.

ANSWER: d

76. The main advantage of municipal securities is that

a. their credit risk is very low.

b. the interest income earned is exempt from federal income tax and taxes in the issuing state.

c. they are the most liquid type of securities.

d. Both a and b

ANSWER: b

77. Typically, the yields on municipal securities are

a. well above the yields on other securities with similar credit ratings and similar terms to maturity.

b. well below the yields on other securities with similar credit ratings and similar terms to maturity.

c. taxed at both the state and federal level.

d. about the same as the yields on other securities with similar credit ratings and similar terms to maturity.

ANSWER: b

78. The most broadly recognized explanation for the slope and level of the yield curve is the

a. yield to maturity.

b. term to maturity.

c. expectations theory.

d. liquidity premium.

ANSWER: c

79. To calculate the long-term interest rate, the geometric average is used because of which of the following?

a. implicit interest

b. nominal interest rates

c. compounding of interest

d. accrued interest

ANSWER: c

80. According to the expectations theory, the long-term interest rate is determined by which of the following?

a. The geometric average of the current short rate and the expected future short rates

b. The geometric average of the current long rate and the expected future short rates

c. The geometric average of the future long rate and the current short rates

d. The geometric average of the current long rate and the current short rates

ANSWER: a

81. What is a difference between notes and bonds?

a. The asked price for bonds is less than the asked price for notes.

b. The original maturity for notes is less than the original maturity for bonds.

c. The original maturity for notes is greater than the original maturity for bonds.

d. The asked price for notes is less than the asked price for bonds.

ANSWER: b

82. The bid price is the price

a. the dealer is willing to pay to take possession of the security.

b. the dealer is asking when selling the security.

c. the broker is willing to pay to take possession of the security.

d. None of the above

ANSWER: a

83. In the event that a security sells at a premium above par, the yield to maturity is which of these?

a. Less than the original maturity

b. Greater than the original maturity

c. Less than the coupon rate

d. Greater than the coupon rate

ANSWER: c

84. When Treasury bills are issued at a discount from par, this means a

a. purchaser pays more than the face value and receives greater compensation.

b. purchaser pays less than the face value and at maturity, receives the face value.

c. purchaser pays less than the face value and receives greater compensation.

d. None of the above

ANSWER: b

85. Treasury bills (T-bills) carry maturities of

a. less than 6 months.

b. 1 year or less.

c. less than 2 years.

d. less than 5 years.

ANSWER: b

86.Which of the following is false?

a. Financial analysts have identified that the primary determinants of the relationships among interest rates are (1) term to maturity, (2) credit risk, (3) liquidity, and (4) tax treatment.

b. A yield curve is a graphical representation of the relationship between interest rates (yields) on several financial instruments (securities) and their terms to maturity.

c. The expectations theory postulates that the yield curve is determined by borrowers’ and lenders’ expectations of future interest rates and that changes in the slope (shape) of the curve result from changes in these expectations.

d. If expectations about future interest rates change such that future rates are expected to be higher, the original yield curve will become steeper and the long rate will rise relative to the short rate.

ANSWER: b

87. The theory that short and long term securities are not substitutes for each other but rather that there are separate markets for each is

a. the preferred habitat theory.

a. b. the modified expectations theory.

b. c. the segmented markets hypothesis.

c. d. the expectations theory modified by the preferred habitats theory.

ANSWER: c

88. A downward-sloping yield curve usually means that

a. interest rates are abnormally high.

b. market participants expect future short-term interest rates to fall.

c. long-term rates are lower than short-term rates.

d. All of the above

ANSWER: d

89. Which is most responsible for the fact that yield curves have been generally upward sloping over the past 45 years?

a. The preferred habitats modification to the expectations theory

b. Market segmentation

c. The liquidity premium

d. All of the above

ANSWER: c

90. If the present 1-year rate is 4% and the expected 1-year rate is 6%, then according to the expectations theory, the 2-year rate is approximately which of these?

a. 6%

b. Unknown

c. 5%

d. 4%

ANSWER: c

91. Which of the factors below affects the position of the yield curve?

a. Credit risk and expectations of inflation

b. Taxability

c. Maturity

d. All of the above

ANSWER: d

92. A sweetener offered to a lender to increase the term of a loan is called a

a. liquidity preference.

b. liquidity premium.

c. segmented market.

d. preferred habitat.

ANSWER: b

Use the following three figures to answer questions 93 -99.

Figure A Figure B Figure C

93. According to expectations theory, which of the figures above reflects expectations of a rise in the interest rate on short-term securities?

a. Figure A

b. Figure B

c. Figure C

d. Both a and b

ANSWER: a

94. According to expectations theory, which of the figures above reflects expectations of a fall in the interest rate on short-term securities?

a. Figure A

b. Figure B

c. Figure C

d. Both a and b

ANSWER: c

95. According to expectations theory, which of the figures is most likely to be associated with expected growth in income, expected increases in prices, and slower growth of money supply?

a. Figure A

b. Figure B

c. Figure C

d. Both a and b

ANSWER: a

96. According to expectations theory, which of the figures is most likely to be associated with business cycle peaks, including the late part of an expansion and the early part of a recession?

a. Figure A

b. Figure B

c. Figure C

d. Both a and b

ANSWER: c

97. According to expectations theory, which of the figures reflects expectations that the short-term interest rate is expected to remain constant in the future?

a. Figure A

b. Figure B

c. Figure C

d. Both a and b

ANSWER: b

98. According to expectations theory, which of the figures reflects expectations that the short-term interest rate is expected to remain constant in the future but that borrowers and lenders also must be compensated with a liquidity premium for lending long?

a. Figure A

b. Figure B

c. Figure C

d. Both a and b

ANSWER: a

99. According to expectations theory, which of the figures best reflects a situation where is > ise?

a. Figure A

b. Figure B

c. Figure C

d. None of the above

ANSWER: c

100. The expected future short-term interest rate is determined by all of the following except?

a. expectations about the future money supply

b. expectations about future income

c. expectations about the future price level

d. the current short-term interest rate

ANSWER: d

101. According to the segmented markets hypothesis, interest rates are determined by _____________________.

a. supply and demand factors in various separate markets of different terms to maturity.

b. the expectations theory modified by preferred habitats theory.

b. c. a small segment of the most influential borrowers and lenders in the market.

d. None of the above.

ANSWER: a

102. Which of the following is false?

a. The buying and selling by investors results in the yield on municipals being approximately equal to the yield on similarly rated taxable securities, such as corporate bonds, minus the portion of the yield that is taxed away.

b. Taxpayers, depending on their individual incomes, are in different marginal tax brackets, some high and some low, and there is an average marginal tax rate somewhere between the high and the low marginal tax brackets.

c. The interest rate on municipal securities will gravitate to the rate that makes the “average” taxpayer (in the average marginal tax bracket) indifferent between municipals and similarly rated corporate securities.

d. Banks and rich individuals are attracted to municipals because they are subject to a tax rate equal to the average marginal rate.

ANSWER: d

103. Which of the following is false?

a. Credit risk refers to the probability of a debtor not paying the principal or interest due on an outstanding debt.

b. Since investors are risk averse, they must be offered the “bonus” of extra interest to accept more risk; the extra return or interest is called a liquidity premium, and its size increases with the riskiness of the borrower.

c. Financial investors care about the after-tax return on their investments more than the pre-tax return.

d. Since the interest earned on municipal securities is exempt from the federal income tax, the yields on municipal securities are typically well below the yields on other (taxable) securities with similar credit ratings and similar terms to maturity.

ANSWER: b

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