CHAPTER 6

TRUE/FALSE QUESTIONS

(T) 1. If interest rates are expected to increase in the future, one would expect to see an upward
sloping yield curve.

(F) 2. An inverted yield curve forecasts higher short-term rates in the future.

(F) 3. Expected lower rates of inflation in the future will lead to an upward sloping yield curve.

(F) 4. The major reason that municipal bonds have lower yields than corporate bonds is that, as
a class, municipal debt has less marketability than corporate debt.

(F) 5. A downward sloping yield curve forecasts higher future interest rates.

(F) 6. A downward sloping yield curve is typically seen just before an economic expansion.

(T) 7. The less marketable a security, the higher its yield.

(T) 8. Default risk premiums are usually smaller during periods of high economic growth.

(F) 9. Bonds rated BBB would have lower yields than AAA-rated bonds, and higher prices,
everything else the same.

(T) 10. Callable bonds have higher market yields than otherwise similar noncallable bonds.

(F) 11. The call price of a bond is usually below the bond's par value.

(T) 12. Everything else the same, the higher the marginal tax rate of an investor, the more likely
the investor is to invest in municipal bonds as opposed to similarly rated corporate bonds.

(F) 13. Liquidity premiums cause an observed yield curve to be less upward sloping than that
predicted by the expectations theory.

(F) 14. Investment-grade bonds are more likely to default than speculative-grade bonds.

(T) 15. An investor in the 33 percent tax bracket should buy a 6 percent municipal bond rather
than a similarly rated 8.5 percent corporate bond.

(F) 16. A put option sets a "floor" or minimum price of a bond at the exercise price, which is
generally at or above par value.

(F) 17. A convertible bond will generally have a higher market yield relative to similar
nonconvertible bonds.

(F) 18. Treasury and corporate security yields are often combined on the same yield curve.

(F) 19. Putable bonds offer higher yields than similar non-putable bonds

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(T) 20. The market segmentation theory allows for the possibility of a discontinuous yield curve.

(F) 21. The market segmentation theory assumes that investors are risk-neutral.

(F) 22. The preferred habitat theory explains the existence of forecasts in the yields curve.

(T) 23. According to the preferred habitat theory, investors may change their preferred maturity
in response to expected yield premiums.

(T) 24. The pure expectations theory maintains that long term rates are averages of expected future
short term rates.

(T) 25. Ceteris paribus, the required interest rate of a callable bond will be higher than
the interest rate on a convertible bond.

(T) 26. The yield curves show the relationship between interest rates on bonds similar in
terms except for maturity.

(T) 27. The shape of the yield curve is at least partly determined by expectations of changes
in future interest rates.

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 MULTIPLE CHOICE QUESTIONS

(b) 1. Which of the following statements about bonds is NOT true?

a. The greater the default risk, the greater the yield.
b. Bonds selling at premium are especially high quality.
c. The less marketable a bond, the higher the yield.
d. Municipal bonds have lower yields than similar corporate bonds.

(b) 2. Which of the following statements is true?

a. Interest rates always rise before recessions.
b. Default risk premiums vary inversely with economic activity.
c. Municipal bond yields are usually higher than similar risk corporate yields.
d. Treasury bond yields are always higher than Treasury bill yields.

(a) 3. 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 coupons.
d. plots coupons versus time to maturity.

(c) 4. The yield curve is a plot of

a. maturity versus bond risk.
b. yields of securities with different levels of default risk.
c. yields by maturity of securities with similar default risk.
d. how interest rates evolve over time.

(d) 5. The source of data for a yield curve might be

a. bond yield for different issuers over time.
b. historical Treasury security yields.
c. realized Treasury security yields over the last 5 years.
d. outstanding Treasury security yields by maturity.

(a) 6. An investor is more likely to exercise a put option on a bond after

a. an increase in interest rates.
b. a decrease in interest rates.
c. an increase in the bond’s price.
d. an upgrade of the bond’s rating by Moody's.

(c) 7. An upward sloping yield curve indicates that security investors expect future interest
rates to _____ and security prices to ______.
a. fall; fall.
b. fall; rise.
c. rise; fall.
d. rise; rise.

(a) 8. A downward sloping yield curve indicates that future short-term rates are expected to
______ and outstanding security prices to _______.
a. fall; rise.
b. fall; fall.
c. rise; rise.
d. rise; fall.

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(b) 9. According to the expectations theory of the term structure of interest rates,
a. investors prefer holding short-term securities.
b. the shape of the yield curve is determined by investors' expectations of future
short-term interest rates.
c. institutional investors' maturity preferences determine the shape of the yield
curve.
d. investors always expect short-term interest rates to increase.
e. both a and b

(d) 10. According to the expectations theory of the term structure of interest rates, if the yield
curve slopes _______, the markets expect short-term interest rates to _______ in the
future
a. upward; increase
b. downward; decrease
c. upward; decrease
d. both a and b
e. both a and c

(d) 11. The one year spot interest rate is 5.50% and the one-year forward rate next year is
6.0%. According to the expectations theory, what is the current two-year rate?
a. The rate cannot be calculated from the information above.
b. 5.50%
c. 5.66%
d. 5.75%
e. 5.95%

(c) 12. According to the expectations theory, what is the one-year forward rate three years from
now if three and four-year spot rates are 5.50% and 5.80%, respectively?
a. The rate cannot be calculated from the information above.
b. 6.2%
c. 6.7%
d. 5.6%
e. 5.8%

(a) 13. A two-year interest rate is 7% and a one-year forward rate one year from now is 8%.
According to the expectations theory, what is the current one-year rate?
a. 6.0%
b. 6.5%
c. 7.0%
d. 8.0%
e. 9.0%

(b) 14. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, future
short-term rates are expected to ______, and outstanding security prices are expected to
______.
a. fall; fall.
b. rise; fall.
c. fall; rise.
d. rise; rise

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(d) 15. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, what is
the expected one-year rate two years from now as implied by the two actual rates above?
a. 4.7%
b. 5.8%
c. 6.5%
d. 7.0%
e. 7.5%

(d) 16. The major determinant of the bond ratings assigned by Moody's, Standard and Poors, or
Fitchs is
a. marketability.
b. tax treatment.
c. term to maturity.
d. default risk.
e. frequency of interest payments.

(a) 17. Default risk premiums vary _______ with the ________ of the security.
a. directly; default risk
b. inversely; default risk
c. inversely; maturity
d. directly; marketability

(d) 18. Which of the following statements about interest rates is true?
a. Interest rates generally tend to move together.
b. The expected rate of inflation influences the level of interest rates.
c. At the bottom of the business cycle, the yield curve is typically upward sloping.
d. All the above are true.

(e) 19. a. Which of the following statements is true?

b. The more marketable a security, the higher its yield.
c. The longer the security’s term to maturity, the greater its yield.
d. Putable bonds offer higher yields than similar non-putable bonds
e. Taxable bonds have to offer higher before-tax yields than comparable tax-exempt
bonds.

Use the following interest rate data to answer Questions 20-26.

90-day Treasury bills 8.36 percent

180-day Treasury bills 8.48 percent
2-year Treasury notes 9.10 percent
3-year Treasury notes 9.25 percent
90-day Commercial paper 9.15 percent
3-year Corporate bonds (AA) 10.10 percent
3-year Municipal (AA) 7.07 percent
Expected 2-year inflation rate 3.50 percent

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 (d) 20. With reference to the data above, of the ones given below, which security did the market
view as having the greatest default risk?
a. 90-day Treasury securities
b. 180-day Treasury securities
c. 2-year Treasury securities
d. 90-day Commercial paper

(c) 21. With reference to the data above, what is the exact expected real rate of return on the 2-
year Treasury security?
a. 12.6%
b. 9.1%
c. 5.4%
d. 4.2%
e. 3.5%

(c) 22. With reference to the data above, what is the default risk premium on commercial paper?
a. 5.65%
b. 0.95%
c. 0.79%
d. 0.55%
e. 0%

(e) 23. With reference to the data above, what is the one-year forward rate on Treasury securities
two years from now according to the expectations theory?
a. 8.80%
b. 9.10%
c. 9.18%
d. 9.40%
e. 9.55%

(d) 24. With reference to the data above, at what tax rate would an investor be indifferent
between holding the 3-year municipal or 3-year corporate bond?
a. 15%
b. 20%
c. 25%
d. 30%
e. 33%

(a) 25. With reference to the data above, what is the default risk premium on 3-year AA-rated
corporate bonds?
a. 0.85%
b. 0.95%
c. 3.03%
d. 6.60%
e. There is no default risk on these bonds.

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(d) 26. With reference to the data above, the yield curve slopes _______, indicating the market
expectation of ______ future short-term rates.
a. downward; falling
b. downward; rising
c. upward; falling
d. upward; rising
e. flat; stable

(c) 27. Which of the following statements about callable bonds is not true?
a. Callable bonds have higher yields than comparable noncallable bonds.
b. The call price is usually above the bond's par value.
c. Calls usually benefit the bondholder.
d. Investors are notified when bonds are called.

(c) 28. Bond A is not callable; bond B is callable. Investors will require a higher yield on bond
__ and will pay ____ for the bond.
a. A; less
b. A; more
c. B; less
d. B; more

(d) 29. Bond A is not putable; bond B is putable. Investors will require a lower yield on bond __
and will pay ____ for the bond.
a. A; less
b. A; more
c. B; less
d. B; more

(d) 30. Federal Agency securities have higher yields than similar Treasury securities because
they
a. have greater default risk.
b. have shorter maturities.
c. are less marketable.
d. both a and c

(e) 31 Yield differences between two securities may be explained by differences in

a. maturity.
b. default risk.
c. marketability.
d. call provision.
e. all of the above

(c) 32. Yield difference in Treasury securities of varied maturities may be explained by
a. differences in capital gains taxes.
b. default risk.
c. expectations of future inflation.
d. all of the above
e. none of the above

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Use the following interest rate data to answer Questions 33-37:

Treasury Bills, 90 days 4.20%

Commercial Paper, 90 days 4.84%
Treasury Bill, 1 year 4.67%
Treasury Note, 2 year 5.25%
Corporate Bond AA, 20 year 8.23%
Municipal Bond AA, 20 year 6.42%
Expected Annual Inflation Rate 3.00%

(c) 33. With reference to the data above, the default risk premium on the 90-day commercial
paper above is
a. 3.39%
b. 0.17%
c. 0.64%
d. 1.84%

(b) 34. With reference to the data above, the implied one-year forward rate (expected one-year
rate one year from now) on Treasuries is
a. 4.67%
b. 5.83%
c. 5.58%
d. 4.09%

(c) 35. With reference to the above data, at what marginal tax rate would an investor be
indifferent between owning the corporate bond and the municipal bond?
a. 18%
b. 20%
c. 22%
d. 28%

(b) 36. With reference to the above data, what is the approximate expected pre-tax real rate of
return on the one-year Treasury bill?
a. 3.00%
b. 1.62%
c. 4.67%
d. 0.13%

(c) 37. With reference to the data above, what is the expected after-tax real rate of return on the
one-year Treasury Bill for an investor in the 33 percent marginal tax bracket?
a. 1.11%
b. 3.13%
c. 0.13%
d. -1.11%

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(c) 38. Applying the expectations theory, a bank depositor chooses between purchasing a one-
year CD paying 5 percent and a two-year CD paying 5.5 percent. If indifferent between
the two, the depositor must expect one-year CDs one year from now to have a rate of
a. 6.5%
b. 4.5%
c. 6.0%
d. 5.0%

(b) 39. If the pure expectations yield curve is flat, the actual yield curve with liquidity premiums
would be
a. flat.
b. upward sloping.
c. downward sloping.
d. upward at first, then downward sloping.

(a) 40. What actions by bond investors, given their expectations of increasing interest rates,
result in an upward sloping yield curve?
a. selling long-term securities and buying short-term securities.
b. buying long-term securities and selling short-term securities.
c. selling short-term securities and holding cash.
d. selling long-term securities and holding cash.

(c) 41. A bondholder in the 30 percent tax bracket owns a $1000 par Treasury bond with an 8
percent coupon rate. What is the after-tax return on the bond?
a. 8 percent
b. 2.4 percent
c. 5.6 percent
d. 5 percent

(c) 42. The yield differentials between an AAA-rated corporate bond and an otherwise similar
BBB-rated corporate bond may be explained by
a. marketability.
b. tax treatment.
c. default risk.
d. term to maturity.

(c) 43. Which of the following statements explains the liquidity premium theory of the term
structure of interest rates?
a. Investors will pay higher prices for longer-term securities.
b. Investors demand a lower yield for securities that cannot be sold quickly at high
prices.
c. Investors demand a higher return on longer-term securities with greater price risk
and less marketability.
d. Investors will pay higher prices for securities with greater price risk and less
marketability.

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(a) 44. Which of the following theories of the term structure of interest rates best explains
discontinuities in the yield curve?
a. the market segmentation theory
b. the liquidity premium theory
c. the expectations theory
d. the loanable funds theory

(c) 45. Commercial banks, savings and loan associations, and finance companies traditionally
have better profits when
a. the level of interest rates were expected to fall sharply.
b. the yield curve had a downward slope.
c. the yield curve had an upward slope.
d. loan losses were increasing.

(a) 46. Historically, high default premiums have been associated with
a. economic recessions.
b. economic boom periods.
c. generally rising interest rates.
d. the number of bonds rated by Moody's and Standard & Poor's.

(b) 47. Bonds are called speculative grade or junk bonds if their Standard & Poor's rating is
a. above BBB.
b. below BBB.
c. AA.
d. A and BBB.

(c) 48. Which of the following is not considered when assigning a bond rating?
a. the variability of earnings
b. the issuer’s expected cash flow
c. the rating on the prior issue of securities sold
d. the amount of the fixed contractual cash payments

(b) 49. An issuer of a bond is more likely to exercise a call option on the bond after
a. an increase in interest rates.
b. a decrease in interest rates.
c. a decrease in the bond’s price.
d. a downgrade of the bond’s rating by Moody's.

(d) 50. A conversion option gives a valuable right to a bond’s _______; a put option gives a
valuable right to a bond’s _______.
a. issuer; issuer
b. issuer; holder
c. holder; issuer
d. holder; holder

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(c) 51. Which of the following statements is true?
a. Convertible bonds offer higher yields than similar nonconvertible bonds.
b. Putable bonds offer higher yields than similar nonputable bonds.
c. Bonds with call options must offer higher interest rates than similar noncallable
bonds.
d. All Treasury securities offer lower rates than any securities issued by business
firms.
e. All of the above statements are true.

(c) 52. Contingent Convertible bonds (CoCos) are NOT similar to ordinary convertible bonds
because:
a. CoCos are convertible to the firm’s preferred stock while the ordinary
convertible bonds are convertible to the firm’s common stock.
b. CoCos offer a higher coupon than ordinary convertible bonds.
c. Cocos are convertible into stock only if the firm’s stock price hits a certain level.
d. Ordinary convertible bonds are converted to the firm’s stock if the firm’s stock
falls below a certain level.

(a) 53. If you calculate an expected future spot rate using the pure expectations theory of the term
structure but liquidity premiums actually exist then your estimate of the expected future
short term interest rate should be _____________ before using it.
a. reduced
b. increased
c. divided by the inflation rate
d. multiplied by the real rate

(b) 54. According to expectations theory, an investor who believes that interest rates are likely to
decrease in the near future who wishes to maximize the capital gain on her portfolio would
a. invest in short-term securities immediately.
b. invest in long-term securities immediately.
c. sell long-term securities from her portfolio.
d. sell corporate securities and invest in Treasury securities.

(b) 55. Under the preferred habitat theory of interest rates

a. investors use the yield curve to predict future interest rates.
b. institutions choose investment maturities to match their liability maturities.
c. yields on different maturities are totally unrelated to each other.
d. liquidity premiums make long term rates greater than the average of short term
rates.

(d) 56. If liquidity premiums exist in the yield curve then

a. the yield curve has no predictive power about future interest rates.
b. institutions choose investment maturities to match their liability maturities.
c. yields for different maturities are unrelated to each other.
d. long term rates are greater than the average of expected future short term rates.

(a) 57. The relationship between maturity and yield to maturity is called the ________________.
a. term structure
b. loan covenant
c. bond indenture
d. Fisher effect

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(b) 58. According to the expectation theory
a. markets are segmented and buyers stay in their own segment
b. the long term spot rate is an average of the current and expected future short term
interest rates
c the term structure will most often be downward sloping
d liquidity premiums are negative and time varying

(d) 59. The slope of the yield curve is affected by

a. inflationary expectations.
b. liquidity preferences.
c. the comparative equilibrium of supply and demand in the short-term and long-term
market segments.
d. all of the above.

(b) 60. To analyze the current economic condition, you collect the following yields: the maximum
maturity U.S. T-bill rate = 9%, 5-year U.S. T-note yield = 8%, IBM common stock = 15%,
IBM Corporate Bond (Moody’s rating Aaa) = 14%, and 10-year U.S. T-bond = 6.5%.
Based on the above information, the shape of the yield curve is
a. upward sloping.
b. downward sloping.
c. flat.
d. normal.

(c ) 61. All of the following are common examples of restrictive debt covenants EXCEPT
a. maximum debt to equity ratio.
b. constraint on subsequent borrowing with higher seniority
c. restrictions on investment policy.
d. maximum size of dividend payments.

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 ESSAY QUESTIONS

1. List the five basic factors which explain the differences in interest rates on different securities at any
point in time.

Answer: The five basic factors which may explain yield differences include term to maturity, default
risk, tax treatment of income of security, marketability, and call, put, or conversion options attached
to the security.

2. Explain how the term structure of interest rates can be used to help forecast future interest rates.

Answer: According to the expectations theory, long-term yields are geometric averages of current
and expected short-term rates. Future short-term rates can thus be estimated from the current yield
curve. For example, an upward sloping yield curve predicts higher short-term rates in the future.

Explain why municipal bonds have lower yields than comparable corporate taxable bonds.

Answer: Since investors are concerned with the after-tax yield earned, they will bid up the prices
(lower the yields) of municipal bonds compared to corporate bonds because investors do not have to
pay federal tax on municipal bond interest income. They normally do not have to pay state taxes on
the interest income if they buy a bond issued by a municipality in the same state in which they reside.
The message: lower taxes; lower interest rates.

3. Define the term default risk premium. Why does the "premium" represent the "expected default loss
rate"? Explain how and why default risk premiums vary over the business cycle.

Answer: The default risk premium, the difference between a risky security and a U.S. Treasury
security of similar term, is the investors’ expected default loss rate on a portfolio of similarly rated
securities. If the investor in a portfolio of similarly rated securities lost the default risk premium
every year, the realized yield would equal an investment return on a similar term U.S. Treasury
security. Default risk premiums narrow with growth and expansion of the economy and widen during
recessions because many more borrowers default on their debt during recessions.

4. How do bond options such as a call, put, and convertibility influence the yields on securities relative
to bonds without such options?

Answer: Options in bond contracts are valuable for the holder of the option. A call option, the
option to redeem the bond issue early, is a valuable option to the bond issuer. Because of call risk,
investors will price the callable bond lower (i.e., to have a higher yield). A put option gives the holder
a valuable right to sell the bond back to the issuer. Investors will therefore accept lower yields (higher
prices) on putable bonds than similar non-putable bonds. A conversion option is also a valuable right
to the investor who will therefore accept a lower yield (pay a higher price) on a convertible bond all
else equal.

5. What shapes of the yield curve can be explained by each of the theories of the term structure of
interest rates?

Answer: Different theories of the term structure are not mutually exclusive. Rather, each one adds to
the explanations proposed by the other theories. The expectations theory can explain the flat yield
curve, as well as upward- and downward-sloping yield curves. The liquidity premium theory can help
explain why the yield curve slopes upward most of the time. The market segmentation theory

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 explains twists, spikes, and discontinuities in the yield curve, while the preferred habitat theory can
explain the absence of spikes and discontinuities in the yield curve.

6. Explain (a.) liquidity differences in different types of bonds, (b.) default risk, and (c.) maturity risk
premiums.

Answer:
a. Liquidity problems exist in infrequently traded bonds. Treasury bonds are highly liquid as
compared to corporate bonds and municipal bonds. Corporate bond liquidity varies by how well
known the issuer is and municipal bond liquidity generally varies with the size of the issuing
municipality.
b. Default risk (also called credit risk) is the likelihood the corporation will default on its bond
obligations, which is to pay interest and principal on time.
c. The maturity premium reflects the fact that longer-term bonds possess greater interest rate risk
and price sensitivity than shorter term bonds. If any of these exist, investors will demand to be
compensated for the risk by requiring a yield premium to own the bonds.

5. Explain the four theories of the term structure.

Answer:
a. Pure Expectations Theory of the Term Structure: Long term interest rates are geometric averages
of current and expected future short term interest rates. For an N year investment horizon one is
indifferent between investing for N years all at once or investing for a shorter time period and rolling
the investment over until an N year investment is achieved. For example for a 5 year investment
horizon an investor would be indifferent between investing for 5 years and investing for 1 year and
rolling the 1 year investment over 4 times to achieve a 5 year investment.
b. Liquidity Premium Augmented Expectations: Long term interest rates are equal to the current and
expected future short term interest rates plus a risk premium called a liquidity premium. The risk
premium exists because investors realize that longer term and short term investments are not equally
risky. Long term investments are riskier because of greater interest rate uncertainty over the long
term and greater price volatility of longer term bonds. Hence investors require a risk premium to
invest long term.
c. Preferred Habitat Theory: The preferred habitat idea recognizes that institutional investors have a
preferred maturity range that matches their liabilities. This maturity matching reduces their risk.
They will move out of their preferred maturities if rates in other segments are sufficiently misaligned.
d. Segmentations Theory: The segmentations theory is an extreme version of the preferred habitat and
can be used to imply that yields for different maturities are independent of one another and have no
predictive ability due to strict segmentations in the markets with investors staying in their preferred
segment. It is true that supply and demand conditions can cause discontinuities in interest rates for
different maturities in the short run, but if they persist then arbitrage should force a realignment of
yields. Indeed this is what hedge funds do.

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