Econ 2035 Chapter 5 LSU Questions
All Solved Correctly.
Risk structure of interest rates - Answer is the relationship among interest rates on bonds
that have different characteristics but the same maturity
default risk - Answer also called credit risk, is the risk that the bond user will fail to make
payments of interest or principal
Bond rating - Answer is a single statistic that summarizes a rating agency's view of the
issuer's likely ability to make the required payments on its bonds
default risk premium - Answer on a bond is the difference between the interest rate on the
bond and the interest rate on a treasury bond with the same maturity
As default risk on corporate bonds increase, the demand for corporate bonds shifts to the -
Answer Left and the demand for the treasury bonds shift to the right
Tax treatment - Answer the way the tax laws treat the interest earned on the bond. Most
bonds are taxable
Example: if a stock has a 10% return and a 10% tax rate then after tax your return is 10% * 0.9 =
9%
Municipal bonds - Answer are bonds issued by state and local governments
-they are usually not taxed at the federal level
-this means the yield on municipal bonds is typically lower
•If the default risk for Company A rises then the equilibrium price of Company A bonds will
______ and the yield will_______.
•A. increase; increase
•B. increase; decrease
•C. decrease; increase
•D decrease; decrease - Answer C. decrease;increase
•Municipal bonds typically offer a ______ yield then other bonds of similar risk because their
interest is taxed at a _______ rate.
, •A. higher; higher
•B. higher; lower
•C. lower; higher
D lower; lower - Answer D. lower;lower
term structure of interest rates - Answer is the relationship among the interest rates on
bonds that are otherwise similar but have different maturities
Term structure - Answer 1. interest rates on long-term bonds are usually higher than interest
rates on short-term bonds
2. interest rates on short-term bonds are occasionally higher than interest rates on long term
bonds
3. interest rates of all bond maturities tend to rise and fall together
Expectations theory - Answer holds that the interest rate on a long-term bond is an average
of the interest rates investors expect on short-term bonds over the lifetime of the long-term
period.
2 key assumptions
1. investors have the same investment objectives
2. for a given holding period, investors view bonds of different maturities as being perfect
substitutes for one another
Shortcomings of the Expectations Theory - Answer The expectations theory explains an
upward sloping yield curve as the result of investors expecting future short term rates to be
higher than the current short term rate
-but if the yield curve is typically upward sloping, investors must be expecting short term rates
to rise most of the time
-this explanation seems unlikely because short term rates are about as likely to fall as to rise at
any given time
Segmented Markets Theory - Answer holds that the interest rate on a bond of a particular
maturity is determined by only by the demand and supply of bonds of that maturity
2 related observations
1. investors in the bond markets do not have all the same objectives
2. investors do not see bonds of different maturities as being perfect substitutes for each other
Segmented markets means that - Answer investors in the market for bonds of one maturity
do not participate in markets for bonds of other maturities
All Solved Correctly.
Risk structure of interest rates - Answer is the relationship among interest rates on bonds
that have different characteristics but the same maturity
default risk - Answer also called credit risk, is the risk that the bond user will fail to make
payments of interest or principal
Bond rating - Answer is a single statistic that summarizes a rating agency's view of the
issuer's likely ability to make the required payments on its bonds
default risk premium - Answer on a bond is the difference between the interest rate on the
bond and the interest rate on a treasury bond with the same maturity
As default risk on corporate bonds increase, the demand for corporate bonds shifts to the -
Answer Left and the demand for the treasury bonds shift to the right
Tax treatment - Answer the way the tax laws treat the interest earned on the bond. Most
bonds are taxable
Example: if a stock has a 10% return and a 10% tax rate then after tax your return is 10% * 0.9 =
9%
Municipal bonds - Answer are bonds issued by state and local governments
-they are usually not taxed at the federal level
-this means the yield on municipal bonds is typically lower
•If the default risk for Company A rises then the equilibrium price of Company A bonds will
______ and the yield will_______.
•A. increase; increase
•B. increase; decrease
•C. decrease; increase
•D decrease; decrease - Answer C. decrease;increase
•Municipal bonds typically offer a ______ yield then other bonds of similar risk because their
interest is taxed at a _______ rate.
, •A. higher; higher
•B. higher; lower
•C. lower; higher
D lower; lower - Answer D. lower;lower
term structure of interest rates - Answer is the relationship among the interest rates on
bonds that are otherwise similar but have different maturities
Term structure - Answer 1. interest rates on long-term bonds are usually higher than interest
rates on short-term bonds
2. interest rates on short-term bonds are occasionally higher than interest rates on long term
bonds
3. interest rates of all bond maturities tend to rise and fall together
Expectations theory - Answer holds that the interest rate on a long-term bond is an average
of the interest rates investors expect on short-term bonds over the lifetime of the long-term
period.
2 key assumptions
1. investors have the same investment objectives
2. for a given holding period, investors view bonds of different maturities as being perfect
substitutes for one another
Shortcomings of the Expectations Theory - Answer The expectations theory explains an
upward sloping yield curve as the result of investors expecting future short term rates to be
higher than the current short term rate
-but if the yield curve is typically upward sloping, investors must be expecting short term rates
to rise most of the time
-this explanation seems unlikely because short term rates are about as likely to fall as to rise at
any given time
Segmented Markets Theory - Answer holds that the interest rate on a bond of a particular
maturity is determined by only by the demand and supply of bonds of that maturity
2 related observations
1. investors in the bond markets do not have all the same objectives
2. investors do not see bonds of different maturities as being perfect substitutes for each other
Segmented markets means that - Answer investors in the market for bonds of one maturity
do not participate in markets for bonds of other maturities
