TRAINING

Part 2.3 How Do Risk and Term Structure Affect Interest Rates?

Multiple Choice Questions

1) Which of the following long-term bonds should have the highest interest rate?
A) Corporate Baa bonds
B) U.S. Treasury bonds
C) Corporate Aaa bonds
D) Municipal bonds

2) Bonds with relatively high risk of default are called

A) Brady bonds.
B) junk bonds.
C) zero coupon bonds.
D) investment-grade bonds.

3) A corporation suffering big losses might be more likely to suspend interest payments on its
bonds, thereby
A) raising the default risk and causing the demand for its bonds to rise.
B) raising the default risk and causing the demand for its bonds to fall.
C) lowering the default risk and causing the demand for its bonds to rise.
D) lowering the default risk and causing the demand for its bonds to fall.

4) Holding everything else the same, if a corporation's earnings rise, then the default risk on its
bonds will ________ and the expected return on those bonds will ________.
A) increase; decrease
B) decrease; decrease
C) increase; increase
D) decrease; increase

5) When the default risk on corporate bonds decreases, other things equal, the demand curve for
corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right

6) The spread between interest rates on low-quality corporate bonds and U.S. government bonds
________ during the Great Depression.
A) was reversed
B) narrowed significantly
C) widened significantly
D) did not change
1
7) Moody's and Standard and Poor's are agencies that
A) help investors collect when corporations default on their bonds.
B) advise municipal bond issuers on the tax exempt status of their bonds.
C) produce information about the probability of default on corporate bonds.
D) maintain liquid markets for corporate bonds.

8) (I) The risk premium widens as the default risk on corporate bonds increases.
(II) The risk premium widens as corporate bonds become less liquid.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.

9) (I) If a corporate bond becomes less liquid, the demand for the bond will fall, causing the
interest rate to rise.
(II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.

10) If income tax rates rise, then

A) the prices of municipal bonds will fall.
B) the prices of Treasury bonds will rise.
C) the interest rate on Treasury bonds will rise.
D) the interest rate on municipal bonds will rise.

11) Based on the expectations hypothesis, the steep upward sloping yield curve in June of 2013
indicted that short-term rates would ________ in the future.
A) climb
B) fall
C) remain the same
D) change in a random fashion

12) A decrease in marginal tax rates would likely have the effect of ________ the demand for
municipal bonds and ________ the demand for U.S. government bonds.
A) increasing; increasing
B) increasing; decreasing
C) decreasing; increasing
D) decreasing; decreasing

13) When a municipal bond is given tax-free status, the demand for municipal bonds shifts
________, causing the interest rate on the bond to ________.
A) leftward; rise
B) leftward; fall
C) rightward; rise
D) rightward; fall
2
14) The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35
percent over the next ten years. As a result of this tax cut, the demand for municipal bonds
should shift to the ________ and the interest rate on municipal bonds should ________.
A) right; decline
B) right; increase
C) left; decline
D) left; increase

15) As of 2016, the debt of Microsoft and Johnson & Johnson both had ________ ratings from
Standard and Poor's.
A) AAA
B) AA
C) A
D) BBB

16) By the end of July 2007, the interest rate on Baa-rated bonds rose by 280 basis points. At the
same time, the interest rate on Treasury bonds
A) also rose by about 280 basis points.
B) remained unchanged.
C) rose as well, but only by 100 basis points.
D) fell by 80 basis points.

17) Yield curves can be classified as

A) upward-sloping.
B) downward-sloping.
C) flat.
D) all of the above.
E) only A and B of the above.

18) As shown in the text, the yield curve in May of 2016 was
A) upward-sloping.
B) downward-sloping.
C) flat.
D) bowl shaped.
E) mound shaped.

19) According to the expectations theory of the term structure,

A) the interest rate on long-term bonds will exceed the average of expected future short-term
interest rates.
B) interest rates on bonds of different maturities move together over time.
C) buyers of bonds prefer short-term to long-term bonds.
D) all of the above.
E) only A and B of the above.

3
20) According to the expectations theory of the term structure,
A) yield curves should be equally likely to slope downward as to slope upward.
B) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise
in the future.
C) when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
D) all of the above.
E) only A and B of the above.

21) If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent,
1 percent, 4 percent, and 3 percent, then the pure expectations theory predicts that the bond with
the lowest interest rate today is the one with a maturity of
A) one year.
B) two years.
C) three years.
D) four years.

22) The liquidity premium theory of the term structure

A) indicates that today's long-term interest rate equals the average of short-term interest rates that
people expect to occur over the life of the long-term bond.
B) assumes that bonds of different maturities are perfect substitutes.
C) suggests that markets for bonds of different maturities are completely separate because people
have different preferences.
D) does none of the above.

23) According to the liquidity premium theory of the term structure,

A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on
bonds of different maturities do not move together over time.
B) the interest rate on long-term bonds will equal an average of short-term interest rates that
people expect to occur over the life of the long-term bonds plus a term premium.
C) because of the positive term premium, the yield curve cannot be downward-sloping.
D) all of the above.
E) only A and B of the above.

24) According to the liquidity premium theory of the term structure, a downward-sloping yield
curve indicates that short-term interest rates are expected to
A) rise in the future.
B) remain unchanged in the future.
C) decline moderately in the future.
D) decline sharply in the future.

25) Which theory of the term structure proposes that bonds of different maturities are not
substitutes for one another?
A) Market segmentation theory
B) Expectations theory
C) Liquidity premium theory
D) Separable markets theory

4
26) ________ cannot explain the empirical fact that interest rates on bonds of different maturities
tend to move together.
A) The market segmentation theory
B) The expectations theory
C) The liquidity premium theory
D) Both A and B of the above
E) Both A and C of the above

27) A moderately upward-sloping yield curve indicates that short-term interest rates are expected
to
A) neither rise nor fall in the near future.
B) remain relatively unchanged, but that long-term rates are expected to fall.
C) neither rise nor fall, but that long-term rates are expected to rise moderately.
D) rise moderately in the near future.

28) Closely related to the ________ is the preferred habitat theory, which takes a somewhat less
direct approach to modifying the expectations hypothesis but comes to a similar conclusion.
A) liquidity premium theory
B) expectations theory
C) market segmentation theory
D) supply theory

5
True/False

1) When a bond defaults, the issuer of the bond is unable or unwilling to make interest payments
when promised or to pay off the face value when the bond matures.

2) Bonds with the lowest risk of default are often referred to as junk bonds.

3) The spread between the interest rates on bonds with default risk and default-free bonds is
called the risk premium.

4) An increase in the marginal tax rate would likely increase the demand for municipal bonds,
and decrease the demand for U.S. government bonds.

5) The term structure of interest rates describes how interest rates move over time.

6) According to the expectations theory, the interest rate on a long-term bond is the average of
the short-term interest rates expected over the life of the long-term bond.

7) A mildly upward-sloping yield curve suggests that the market is predicting constant short-
term interest rates.

6
Open Questions

1. "Corporate bonds and stocks are a bad combination of investments as both have different
characteristics that do not complement each other." Discuss.

7
Quantitative Exercices

1.What is the yield on a $1,000,000 municipal bond with a coupon rate of 8%, paying interest
annually, versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying
interest annually? Assume that you are in the 25% tax bracket.

2. One-year T-bill rates are expected to steadily increase by 250 basis points per year over the
next nine years. Determine the required interest rate on a five-year T-bond and a nine-year T-
bond if the current one-year interest rate is 15.5%. Assume that the Pure Expectations
Hypothesis for interest rates holds.

3. Suppose that the expectations theory is true and that you can buy a three-year bond with an
interest rate of 6% or three consecutive one-year bonds with interest rates of 4%, 5% and 6%.
Which option would you choose to undertake?

4.One-year T-bill rates over the next five years are expected to be 4%, 5%, 6%, 6.5%, and 8%. If
five-year T-bonds are yielding 35.5%, what is the liquidity premium on this bond?

5. Predict the one-year interest rate three years from today if interest rates are 3.5%, 4.0%, 4.5%,
and 5% for bonds with one to four years to maturity, and liquidity premiums are 0%, 0.1%,
0.25%, and 0.50%.

8
TRAINING - Correction

Part 2.3 How Do Risk and Term Structure Affect Interest Rates?

Multiple Choice Questions

1) Which of the following long-term bonds should have the highest interest rate?
A) Corporate Baa bonds
B) U.S. Treasury bonds
C) Corporate Aaa bonds
D) Municipal bonds
Answer: A

2) Bonds with relatively high risk of default are called

A) Brady bonds.
B) junk bonds.
C) zero coupon bonds.
D) investment-grade bonds.
Answer: B

3) A corporation suffering big losses might be more likely to suspend interest payments on its
bonds, thereby
A) raising the default risk and causing the demand for its bonds to rise.
B) raising the default risk and causing the demand for its bonds to fall.
C) lowering the default risk and causing the demand for its bonds to rise.
D) lowering the default risk and causing the demand for its bonds to fall.
Answer: B

4) Holding everything else the same, if a corporation's earnings rise, then the default risk on its
bonds will ________ and the expected return on those bonds will ________.
A) increase; decrease
B) decrease; decrease
C) increase; increase
D) decrease; increase
Answer: D

5) When the default risk on corporate bonds decreases, other things equal, the demand curve for
corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right
Answer: B

6) The spread between interest rates on low-quality corporate bonds and U.S. government bonds
9
________ during the Great Depression.
A) was reversed
B) narrowed significantly
C) widened significantly
D) did not change
Answer: C

7) Moody's and Standard and Poor's are agencies that

A) help investors collect when corporations default on their bonds.
B) advise municipal bond issuers on the tax exempt status of their bonds.
C) produce information about the probability of default on corporate bonds.
D) maintain liquid markets for corporate bonds.
Answer: C

8) (I) The risk premium widens as the default risk on corporate bonds increases.
(II) The risk premium widens as corporate bonds become less liquid.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

9) (I) If a corporate bond becomes less liquid, the demand for the bond will fall, causing the
interest rate to rise.
(II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: A

10) If income tax rates rise, then

A) the prices of municipal bonds will fall.
B) the prices of Treasury bonds will rise.
C) the interest rate on Treasury bonds will rise.
D) the interest rate on municipal bonds will rise.
Answer: C

11) Based on the expectations hypothesis, the steep upward sloping yield curve in June of 2013
indicted that short-term rates would ________ in the future.
A) climb
B) fall
C) remain the same
D) change in a random fashion
Answer: A

12) A decrease in marginal tax rates would likely have the effect of ________ the demand for
municipal bonds and ________ the demand for U.S. government bonds.
10
A) increasing; increasing
B) increasing; decreasing
C) decreasing; increasing
D) decreasing; decreasing
Answer: C

13) When a municipal bond is given tax-free status, the demand for municipal bonds shifts
________, causing the interest rate on the bond to ________.
A) leftward; rise
B) leftward; fall
C) rightward; rise
D) rightward; fall
Answer: D

14) The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35
percent over the next ten years. As a result of this tax cut, the demand for municipal bonds
should shift to the ________ and the interest rate on municipal bonds should ________.
A) right; decline
B) right; increase
C) left; decline
D) left; increase
Answer: D

15) As of 2016, the debt of Microsoft and Johnson & Johnson both had ________ ratings from
Standard and Poor's.
A) AAA
B) AA
C) A
D) BBB
Answer: A

16) By the end of July 2007, the interest rate on Baa-rated bonds rose by 280 basis points. At the
same time, the interest rate on Treasury bonds
A) also rose by about 280 basis points.
B) remained unchanged.
C) rose as well, but only by 100 basis points.
D) fell by 80 basis points.
Answer: D

17) Yield curves can be classified as

A) upward-sloping.
B) downward-sloping.
C) flat.
D) all of the above.
E) only A and B of the above.
Answer: D

18) As shown in the text, the yield curve in May of 2016 was
11
A) upward-sloping.
B) downward-sloping.
C) flat.
D) bowl shaped.
E) mound shaped.
Answer: A

19) According to the expectations theory of the term structure,

A) the interest rate on long-term bonds will exceed the average of expected future short-term
interest rates.
B) interest rates on bonds of different maturities move together over time.
C) buyers of bonds prefer short-term to long-term bonds.
D) all of the above.
E) only A and B of the above.
Answer: B

20) According to the expectations theory of the term structure,

A) yield curves should be equally likely to slope downward as to slope upward.
B) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise
in the future.
C) when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
D) all of the above.
E) only A and B of the above.
Answer: E

21) If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent,
1 percent, 4 percent, and 3 percent, then the pure expectations theory predicts that the bond with
the lowest interest rate today is the one with a maturity of
A) one year.
B) two years.
C) three years.
D) four years.
Answer: A

22) The liquidity premium theory of the term structure

A) indicates that today's long-term interest rate equals the average of short-term interest rates that
people expect to occur over the life of the long-term bond.
B) assumes that bonds of different maturities are perfect substitutes.
C) suggests that markets for bonds of different maturities are completely separate because people
have different preferences.
D) does none of the above.
Answer: D

23) According to the liquidity premium theory of the term structure,

A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on
bonds of different maturities do not move together over time.
B) the interest rate on long-term bonds will equal an average of short-term interest rates that
12
people expect to occur over the life of the long-term bonds plus a term premium.
C) because of the positive term premium, the yield curve cannot be downward-sloping.
D) all of the above.
E) only A and B of the above.
Answer: B

24) According to the liquidity premium theory of the term structure, a downward-sloping yield
curve indicates that short-term interest rates are expected to
A) rise in the future.
B) remain unchanged in the future.
C) decline moderately in the future.
D) decline sharply in the future.
Answer: D

25) Which theory of the term structure proposes that bonds of different maturities are not
substitutes for one another?
A) Market segmentation theory
B) Expectations theory
C) Liquidity premium theory
D) Separable markets theory
Answer: A

26) ________ cannot explain the empirical fact that interest rates on bonds of different maturities
tend to move together.
A) The market segmentation theory
B) The expectations theory
C) The liquidity premium theory
D) Both A and B of the above
E) Both A and C of the above
Answer: A

27) A moderately upward-sloping yield curve indicates that short-term interest rates are expected
to
A) neither rise nor fall in the near future.
B) remain relatively unchanged, but that long-term rates are expected to fall.
C) neither rise nor fall, but that long-term rates are expected to rise moderately.
D) rise moderately in the near future.
Answer: A

28) Closely related to the ________ is the preferred habitat theory, which takes a somewhat less
direct approach to modifying the expectations hypothesis but comes to a similar conclusion.
A) liquidity premium theory
B) expectations theory
C) market segmentation theory
D) supply theory
Answer: A

13
True/False

1) When a bond defaults, the issuer of the bond is unable or unwilling to make interest payments
when promised or to pay off the face value when the bond matures.
Answer: TRUE

2) Bonds with the lowest risk of default are often referred to as junk bonds.
Answer: FALSE

3) The spread between the interest rates on bonds with default risk and default-free bonds is
called the risk premium.
Answer: FALSE

4) An increase in the marginal tax rate would likely increase the demand for municipal bonds,
and decrease the demand for U.S. government bonds.
Answer: TRUE

5) The term structure of interest rates describes how interest rates move over time.
Answer: FALSE

6) According to the expectations theory, the interest rate on a long-term bond is the average of
the short-term interest rates expected over the life of the long-term bond.
Answer: TRUE

7) A mildly upward-sloping yield curve suggests that the market is predicting constant short-
term interest rates.
Answer: TRUE
Topic: Chapter 5.2 Term Structure of Interest Rates

14
Open Questions

1. "Corporate bonds and stocks are a bad combination of investments as both have different
characteristics that do not complement each other." Discuss.

Corporate bonds and stocks can be a good or bad combination based on the timing of the
investment concerned. During times of increasing interest rates, the bond value will go down. So,
it is better to purchase stocks and vice versa at such times. Bonds and equity shares have
different characteristics that can complement each other in a portfolio held by an investor. Equity
shares are riskier compared to government bonds which can generate a fixed income. A portfolio
should be balanced, and it should include a combination of risky as well as less-risky assets.

15
Quantitative Exercices

1.What is the yield on a $1,000,000 municipal bond with a coupon rate of 8%, paying interest
annually, versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying
interest annually? Assume that you are in the 25% tax bracket.

Solution: Municipal bond coupon payments equal $80,000 per year. No taxes are deducted;
therefore, the yield would equal 8%.

The coupon payments on a corporate bond equal $100,000 per year. But you only
keep $75,000 because you are in the 25% tax bracket. Therefore your after-tax yield
is only 7.5%

2. One-year T-bill rates are expected to steadily increase by 250 basis points per year over the
next nine years. Determine the required interest rate on a five-year T-bond and a nine-year T-
bond if the current one-year interest rate is 15.5%. Assume that the Pure Expectations
Hypothesis for interest rates holds.

Solution: 5-year bond:

Year 1 interest rate = 15.5%
Year 2 interest rate = 18.0%
Year 3 interest rate = 20.5%
Year 4 interest rate = 23%
Year 5 interest rate = 25.5%
Number of years = 5
(15.5% + 18.0% + 20.5%+ 23%+ 25.5%)/5 = 20.5%

9-year bond:
Year 1 interest rate = 15.5%
Year 2 interest rate = 18.0%
Year 3 interest rate = 20.5%
Year 4 interest rate = 23%
Year 5 interest rate = 25.5%
Year 6 interest rate = 28%
Year 7 interest rate = 30.5%
Year 8 interest rate = 33%
Year 9 interest rate = 35.5%
Number of years = 9
(15.5% + 18.0% + 20.5% + 23% + 25.5% + 28% + 30.5% + 33% + 35.5%)/9 = 25.5%

3. Suppose that the expectations theory is true and that you can buy a three-year bond with an
interest rate of 6% or three consecutive one-year bonds with interest rates of 4%, 5% and 6%.
Which option would you choose to undertake?

Solution: The three-year bond is a better option, since the three consecutive short term bonds
yield an average interest rate equal to (4% + 5% + 6%) / 3 = 5%.
16
4.One-year T-bill rates over the next five years are expected to be 4%, 5%, 6%, 6.5%, and 8%. If
five-year T-bonds are yielding 35.5%, what is the liquidity premium on this bond?

Solution: 4.5% = (3% + 4% + 5% + 5.5%)/4 + LP

4.5% = 4.375% + LP
LP = 0.125%

5. Predict the one-year interest rate three years from today if interest rates are 3.5%, 4.0%, 4.5%,
and 5% for bonds with one to four years to maturity, and liquidity premiums are 0%, 0.1%,
0.25%, and 0.50%.

Solution: The expected one-year interest rate three years from now is:

(1 + 0.05 − 0.005)4/(1 + 0.045 − 0.0025)3 − 1 = (1.0450)4/(1.0425)3 − 1 = 0.0525 or 5.25%

17