Instructor: Ayse Sevencan

Student: Salih Durmus

Course: Money, Banking, and the Financial Assignment: Assignment 4
Date: 4/2/23
System, 4th Ed

1. A bond rating reflects the rating​agency's view on the likelihood that a bond issuer will make the required payments . These bond

ratings are produced by companies such as Moody's Investment Service, S&P, and Fitch Ratings .

The key factor that bond raters evaluate when making their ratings is a​bond's default risk .

2. What are the two types of income an investor can earn on a​bond?

A. ​Tax-free interest income from coupon payments and realized capital gains.
B. Interest income from coupon payments and any increase in the principal of the bond.
C. Realized capital gains and unrealized capital gains.
D. Interest income from coupon payments and capital gains from price changes.

Interest income is taxed at the same rate as wage and salary income while a capital gain is taxed at a lower
rate.

3. What is the tax treatment of the coupons on a bond issued by the city of​Houston?

A. The bond is subject to​federal, state, and local taxes.

B. The bond is subject to federal tax only.
C. The bond is subject to state and local taxes only.
D. The bond is not subject to​federal, state, or local taxes.

What is the tax treatment of the coupons on a bond issued by​GE?

A. The bond is subject to federal tax only.

B. The bond is subject to state and local taxes only.
C. The bond is not subject to​federal, state, or local taxes.
D. The bond is subject to​federal, state, and local taxes.

What is the tax treatment of the coupons on a bond issued by the U.S.​Treasury?

A. The bond is subject to state and local taxes only.

B. The bond is not subject to​federal, state, or local taxes.
C. The bond is subject to federal tax only.
D. The bond is subject to​federal, state, and local taxes.
4. Assume that a bond had its rating lowered. What is the likely
effect on this bond in the bond​market?

S1
A. Demand for the bond cannot be

Price of bonds
determined without the bond rating.
E1
B. Demand for the bond will remain the
same.
C. Demand for the bond will decrease. E2 D
2 D1
D. Demand for the bond will increase.
0
Using the graph to the​right, show the effect on a bond that has 0
its rating lowered. Quantity of bonds

​ ) Using the line drawing​tool, draw a new curve. Properly label

1
your curve.

​ ) Using the point drawing tool​, locate the new equilibrium price
2
of the bond after the rating is lowered. Label your point ​'E2​'.

Carefully follow the instructions​above, and only draw the

required objects.

5. An article in the Wall Street Journal had the​headline, "Investors Should Fear More Competition Among Ratings​Companies." In
most​markets, economists believe that more competition increases economic efficiency and makes the customers of firms better off.

Who are the bond rating​agencies' customers?

A. Rating agencies work for the U.S. Congress.

B. Rating agencies are hired by the companies that they are rating.
C. Rating agencies work on behalf of the Securities and Exchange Commission.
D. Rating agencies do not have​customers, they are​non-profits that rate all bonds.

What does the headline mean when it says​"Investors Should Fear More Competition Among Ratings​Companies"?

A. That rating agencies will lower their ratings on corporate bonds as they compete to be the official
government rating agency.
B. That as the number or rating agencies increases the quality of ratings will deteriorate since talent
will be spread across multiple agencies.
C. That rating agencies may inflate their ratings in the presence of more competition to attract
customers.
D. That having multiple rating agencies will result in numerous ratings for each​firm's bonds,
causing confusion for investors.
6. [​Related to Solved Problem 5.1​] In early​2020, an article in the
Wall Street Journal described the effect on the bond market of Market for Treasury
the spread of the coronavirus. According to the​article, fears that bonds
the coronavirus would lead to a worldwide slowdown in
economic growth caused investors to engage in a​"flight S1
to​safety."

Price of bonds
When bond market investors engage in a flight to​safety, are
E2
they likely to buy more Treasury bonds or more E1
corporate​bonds? D2

A. Corporate bonds since they have no risk

while Treasury bonds have interest rate
D1
risk. Quantity of bonds
B. Corporate bonds since they only have
interest rate risk while Treasury bonds
have both interest rate and default risk. Market for corporate
bonds
C. Treasury bonds since they only have
interest rate risk while corporate bonds
S1
have both interest rate and default risk.

Price of bonds
D. Treasury bonds since they have no risk
while corporate bonds have interest rate
risk. E1

E2
What impact will the flight to safety have on the market for D2
Treasury​bonds?
D1
​ .) Using the line drawing​tool, depict the impact on the demand
1 Quantity of bonds
for Treasury bonds of the flight to safety by investors. Label this
line as ​'D2 ​'.

​ .) Using the point drawing​tool, illustrate the new equilibrium in

2
the Treasury bond market. Label this point as ​'E2 ​'.

Carefully follow the instructions above and only draw the

required objects.

The graph illustrates that the flight to safety results in Treasury

bonds having higher prices and therefore lower yields .

What impact will the flight to safety have on the market for
corporate​bonds?

​ .) Using the line drawing​tool, depict the impact on the demand

1
for corporate bonds of the flight to safety by investors. Label this
line as ​'D2 ​'.

​ .) Using the point drawing​tool, illustrate the new equilibrium in

2
the corporate bond market. Label this point as ​'E2 ​'.

Carefully follow the instructions above and only draw the

required objects.

The graph illustrates that the flight to safety results in corporate

bonds having lower prices and therefore higher yields .
7. [​Related to the Apply the​Concept: ​"Do Credit Rating
Agencies Have a Conflict of ​Interest?"​] According to an article Price of bonds
in the Wall Street​Journal, "Investors are skeptical of some of
the​[bond] ratings. More than​$100 billion worth of bonds trade S1
with yields like junk despite their​triple-B-minus ratings."

What is a junk​bond?
E1
The term​"junk bond" refers to a bond
with a non-investment grade rating
E2 D2
From an​investor's point of​view, the difference between buying a
bond with a​BBB- rating and a junk bond is that junk bonds have D1
Quantity of junk bonds
greater default risk and therefore higher yields.

The graph shows the supply and demand for junk​bonds,

assuming that investors believe the rating​agencies' rating,
resulting in an equilibrium at point E1 . How would the market for
junk bonds change if investors became skeptical of the ratings
and believed the bonds were rated too​highly?

​ .) Using the line drawing​tool, depict the impact on the supply or

1
demand for junk bonds if investors believe they are rated too
highly. Label your new line appropriately.

​ .) Using the point drawing​tool, identify the new equilibrium in

2
this bond market. Label this point as ​'E2 ​'.

Carefully follow the instructions above and only draw the

required objects.

According to the​graph, when investors become skeptical of

bond ratings and believe they are rated too highly it causes their
price to drop and their yield to rise .

Is the situation described in this article due just to a difference of

opinion between rating agencies and investors about the
creditworthiness of the firms issuing these​bonds? Might there
be another reason the rating agencies have come to different
conclusions about these​bonds?

A. Credit rating agencies base their rating on

a​bond's interest rate risk while investors
focus on default risk.
B. Credit rating agencies are not paid for
their ratings so investors do not trust their
ratings on smaller firms to be accurate.
C. Credit rating agencies are part of the
federal government and investors believe
the government overestimates
creditworthiness.
D. Credit rating agencies are paid by the
firms whose bonds they are rating. This
can lead to inflated ratings to attract
customers.
8. Suppose​that, holding yield​constant, investors are indifferent as to whether they hold bonds issued by the federal government or
bonds issued by state and local governments​(that is, they consider the bonds the same with respect to default​risk,
information​costs, and​liquidity). Suppose that state governments have issued perpetuities​(or consoles) with ​$81 coupons and that
the federal government has also issued perpetuities with ​$81 coupons. If the state and federal perpetuities both have​after-tax yields
of 7​%, what are their​pre-tax yields?​(Assume that the relevant federal income tax rate is 38.97​%.)

The​pre-tax yield on the state perpetuity will be 7 ​%. ​(Round your response to two decimal​places.)

The​pre-tax yield on the federal perpetuity will be 11.47 ​%. ​(Round your response to two decimal​places.)

9. The term structure of interest rates is the relationship among the interest rates on bonds that are otherwise similar but differ in

maturity . The most common way to analyze the term structure is by using a graph known as the
Treasury yield curve .

10. Briefly define the three theories of the term structure.

The expectations theory states that interest rates on​long-term bonds are an average of the interest rates investors
expect on​short-term bonds over the lifetime of the​long-term bond.

The segmented markets theory holds that the interest rate on a bond of a particular maturity is determined only by the demand
and supply of bonds of that maturity.

The liquidity premium theory holds that interest rates on​long-term bonds are averages of the expected interest rates
on​short-term bonds plus a term premium.

11. Suppose that the interest rate on a​one-year Treasury bill is currently 7​% and that investors expect that the interest rates
on​one-year Treasury bills over the next three years will be 8​%, 9​%, and 7​%. Use the expectations theory to calculate the current
interest rates on​two-year, three-year, and​four-year Treasury notes.

The current interest rate on​two-year Treasury notes is 7.5 ​%. ​(Round your response to two decimal​places.)

The current interest rate on​three-year Treasury notes is 8 ​%. ​(Round your response to two decimal​places.)

The current interest rate on​four-year Treasury notes is 7.75 ​%. ​(Round your response to two decimal​places.)

12. [​Related to Solved Problem 5.2A​] An article on the American Express website observes that​"often, an interest carry trade
involves maturity​mismatch, since​longer-term lending typically carries higher interest rates than​short-term."

How might you be able to make a profit from the fact that​long-term interest rates are typically higher than​short-term
interest​rates?

A. By borrowing short term and investing the funds long term.

B. By purchasing more​long-term securities than​short-term securities.
C. By purchasing more​short-term securities than​long-term securities.
D. By borrowing long term and investing the funds short term.

​Why, in​practice, is it difficult for the average investor to make a profit from an interest carry trade?

A. The average investor does not have access to​long-term investments, and can only access
them through expensive brokerage arrangements.
B. The average investor often overestimates inflation rates resulting in negative real returns
on​long-term investments.
C. Borrowing rates for the average investor are much higher than​short-term Treasury rates.
D. It is very difficult for the average investor to determine​short-term and​long-term interest rates.
13. ​[Related to Solved Problem 5.2b​] Use the data on Treasury securities in the following table to answer the​question:

Date 1 year 2 year 3 year

​03/05/2010 0.38​% 0.9​% 1.52​%
​Source: U.S. Department of the Treasury.

Assuming that the liquidity premium theory is​correct, on March​5, 2010, what did investors expect the interest rate to be on
the​one-year Treasury bill two years from that date if the term premium on a​two-year Treasury note was 0.02​% and the term
premium on a​three-year Treasury note was 0.05​%?

The expected interest rate is ​%. ​(Round your response to two decimal​places.)

14. An article in the Economist noted that the ability of the Fed and other central banks to affect​long-term interest rates depended
on​"the central​bank's promises about the future path of​short-term interest​rates."

Use the expectations theory to analyze this statement.

This statement makes sense under the expectations theory since under this theory the interest rate on a​long-term bond
is the average of the rates investors expect on short-term bonds over the lifetime of the long-term bond . ​Therefore, long-
term interest rates will be impacted by the Fed if investors believe they will keep their promises on future​short-term rates.

Would the statement still be correct under the segmented market​theory?

This statement does not make sense under the segmented market theory since under this theory the interest rate on a​long-term
bond is based on the supply and demand for bonds of that particular maturity alone . ​Therefore, long-
term interest rates will not be impacted by the Fed if investors believe they will keep their promises on future​short-term rates.

15. [​Related to the Apply the​Concept: "What Happened to the Recession of ​2019?"​] In early​2020, a column in the Wall Street
Journal discussing the yield curve had the headline​"The Market's Favorite Recession Signal Probably Has It​Wrong."

How can the yield curve help predict​recessions?

A. An upward sloping yield curve may signal that investors believe that the Fed will need to increase interest rates in the
future to fight a recession in the economy.
B. A flat yield curve may signal that investors and the Fed believe the economy is growing too fast and will likely fall into a
recession soon.
C. An upward sloping yield curve indicates that short term rates are very low and the term spread is large which signals that
investors and the Fed believe the economy is currently very weak.
D. An inverted yield curve may predict a recession since it signals the Fed may be increasing short term rates to fight
inflation and will lower rates in the future to deal with an economic contraction.

Why did the yield curve give a misleading signal in 2019 about the likelihood of a recession​occurring?

A. The yield curve becoming flat in 2019 was not a sign of an impending recession since it did not account for inflation that
was above the target​level, indicating a strong economy.
B. The term spread had remained low since the 2007 financial crisis so small changes in​short-term rates could make the
yield curve invert without it being a sign of an impending recession.
C. When the yield curve became steep in 2019 it was as a result of political uncertainty in the U.S. not of weakness in the
economy overall.
D. The term spread had remained very high since the 2007 financial crisis so when the yield curve got even steeper it was
just a sign of continued weakness in the economy not of a new recession.