Function of Financial Markets

The Risk and Term Structure of Interest Rates


6.1 Risk Structure of Interest Rates

1) The risk structure of interest rates is

A) the structure of how interest rates move over time.
B) the relationship among interest rates of different bonds with the same maturity.
C) the relationship among the term to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.

2) The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is

A) interest rate risk.
B) inflation risk.
C) liquidity risk.
D) default risk.

3) Bonds with no default risk are called

A) flower bonds.
B) no-risk bonds.
C) default-free bonds.
D) zero-risk bonds.

4) Which of the following bonds are considered to be default-risk free?

A) municipal bonds
B) investment-grade bonds
C) Treasury bonds
D) junk bonds

5) Government bonds have no default risk because

A) they are issued in strictly limited quantities.
B) the government can increase taxes or print money to pay its obligations.
C) they are backed with gold reserves.
D) they can be exchanged for silver at any time.

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

A) risk premium.
B) junk margin.
C) bond margin.
D) default premium.

7) If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on corporate bonds will ________ and the expected return on these bonds will ________, everything else held constant.

A) decrease; increase
B) decrease; decrease
C) increase; increase
D) increase; decrease

11) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the ________ and the demand curve for Treasury bonds to the ________.

A) right; right
B) right; left
C) left; right
D) left; left

13) A(n) ________ in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

A) increase; increase; increase
B) increase; decrease; increase
C) decrease; increase; increase
D) decrease; decrease; decrease

21) As default risk decreases, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant.

A) increases; less
B) increases; more
C) decreases; less
D) decreases; more

23) Which of the following statements are TRUE?

A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds.
B) The expected return on corporate bonds decreases as default risk increases.
C) A corporate bond's return becomes less uncertain as default risk increases.
D) As their relative riskiness increases, the expected return on corporate bonds increases relative to the expected return on default-free bonds.

25) Bonds with relatively high risk of default are called

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

26) Junk bonds, bonds with a low bond rating, are also known as

A) high-yield bonds.
B) investment grade bonds.
C) high quality bonds.
D) zero-coupon bonds.

27) Bonds with relatively low risk of default are called ________ securities and have a rating of Baa (or BBB) and above; bonds with ratings below Baa (or BBB) have a higher default risk and are called ________.

A) investment grade; lower grade
B) investment grade; junk bonds
C) high quality; lower grade
D) high quality; junk bonds

28) Which of the following bonds would have the highest default risk?

A) municipal bonds
B) investment-grade bonds
C) Treasury bonds
D) junk bonds

30) Which of the following securities has the lowest interest rate?

A) junk bonds
B) Treasury bonds
C) investment-grade bonds
D) corporate Baa bonds

33) Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant.

A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease

37) If you have a very low tolerance for risk, which of the following bonds would you be least likely to hold in your portfolio?

A) a Treasury bond
B) a municipal bond
C) a corporate bond with a rating of Aaa
D) a corporate bond with a rating of Baa

38) Which of the following statements is TRUE?

A) A liquid asset is one that can be quickly and cheaply converted into cash.
B) The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds.
C) The differences in bond interest rates reflect differences in default risk only.
D) The corporate bond market is the most liquid bond market.

39) Corporate bonds are not as liquid as government bonds because

A) fewer corporate bonds for any one corporation are traded, making them more costly to sell.
B) the corporate bond rating must be calculated each time they are traded.
C) corporate bonds are not callable.
D) corporate bonds cannot be resold.

42) A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds to the ________ and the demand curve for Treasury bonds shifts to the ________.

A) right; right
B) right; left
C) left; left
D) left; right

44) A(n) ________ in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield on corporate bonds, all else equal.

A) increase; increase; decrease
B) increase; decrease; decrease
C) decrease; increase; increase
D) decrease; decrease; decrease

47) The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ Treasury bonds.

A) less liquid than
B) less speculative than
C) tax-exempt unlike
D) lower-yielding than

50) Municipal bonds have default risk, yet their interest rates are lower than the rates on default-free Treasury bonds. This suggests that

A) the benefit from the tax-exempt status of municipal bonds is less than their default risk.
B) the benefit from the tax-exempt status of municipal bonds equals their default risk.
C) the benefit from the tax-exempt status of municipal bonds exceeds their default risk.
D) Treasury bonds are not default-free.

52) Everything else held constant, a decrease in marginal tax rates would likely have the effect of ________ the demand for municipal bonds, and ________ the demand for government bonds.

A) increasing; increasing
B) increasing; decreasing
C) decreasing; increasing
D) decreasing; decreasing

58) Three factors explain the risk structure of interest rates

A) liquidity, default risk, and the income tax treatment of a security.
B) maturity, default risk, and the income tax treatment of a security.
C) maturity, liquidity, and the income tax treatment of a security.
D) maturity, default risk, and the liquidity of a security.