Chapter 5

The Risk and Term Structure of Interest Rates

D1Factual
1. The relationship between yield and maturity of the same type of security is known as the A) term structure of interest rates. B) risk-reward structure of interest rates. C) asset duration structure of interest rates. D) market structure of interest rates. Answer: A

D1Factual
. A !raphic depiction of the relationship between yield and maturity is A) the term structure of interest rates. B) the yield cur"e. C) the #hillips cur"e. D) the risk-reward cur"e. Answer: B

D1Factual
$. The term structure of interest rates pro"ides a framework for analy%in! securities of the same A) class. B) yield. C) maturity. D) corporation. Answer: A

D1Factual
&. The yield cur"e depicts the relationship between A) interest rates and risk. B) yield and risk. C) yield and interest rates. D) yield and maturity. Answer: D

52

53'itter()ilber(*dell Money, Banking, and Financial Markets + ,le"enth ,dition

D2Interpretive
-. .f the yield on lon!-term securities is !reater than the yield on comparable short-term securities+ the yield cur"e will be A) ne!ati"ely sloped. B) positi"ely sloped. C) in the ne!ati"e /uadrant. D) undefined. Answer: B

D2Interpretive
0. .f the yield on short-term securities is !reater than the yield on comparable lon!-term securities+ the yield cur"e will ha"e a A) positi"e slope. B) ne!ati"e slope. C) constant slope. D) %ero slope. Answer: B

D2Interpretive
1. .f the yield on short-term securities is the same as the yield on comparable lon!-term securities+ the yield cur"e will ha"e a A) positi"e slope. B) ne!ati"e slope. C) constant slope. D) %ero slope. Answer: C

D2Applied
2. Currently+ 3-year Treasury bonds ha"e a yield of 1 percent+ while one-year Treasury bills ha"e a yield of - percent. Based on this information+ the yield cur"e is A) upward slopin!. B) downward slopin!. C) a hori%ontal line. D) 4one of the abo"e Answer: A

D2Interpretive
5. The supply-demand approach to e6plainin! the term structure of interest rates assumes that A) bond prices and yields are positi"ely related. B) the yield cur"e is hori%ontal. C) the yield cur"e is upward slopin!. D) each maturity class is independent. Answer: D

Chapter -The 'isk and Term )tructure of .nterest 'ates 54

D2Factual
13. The assumption that prices for short-term and lon!-term securities are determined independently is the basis for the 777777777777777777 approach to e6plainin! the term structure. A) li/uidity preference B) supply and demand C) e6pectations D) yield cur"e Answer: B

D2Interpretive
11. 8hen the supply of a security 777777777777777777+ the yield on the security . A) increases9 rises B) decreases9 rises C) increases9 falls D) 4one of the abo"e Answer: A

D2Interpretive
1 . The supply and demand approach to term structure assumes that securities with different maturities are A) close substitutes. B) independent. C) in"ersely related. D) complements. Answer: B

D2Interpretive
1$. .!norin! the interrelationship between similar securities is a serious weakness of the A) e6pectations approach to term structure. B) supply and demand approach to term structure. C) e/uilibrium approach to term structure. D) li/uidity approach to term structure. Answer: B

D2Interpretive
1&. Accordin! to the pure e6pectations approach to term structure+ in"estors "iew securities with different maturities as A) close substitutes. B) complements. C) in"ersely related. D) independent. Answer: A

55'itter()ilber(*dell Money, Banking, and Financial Markets + ,le"enth ,dition

D3Applied
1-. :ne-year securities are currently yieldin! 2 percent. ;ou e6pect one-year securities to yield 13 percent ne6t year. Currently+ two-year securities are yieldin! 5.- percent. <i"en this situation+ portfolio mana!ers would 777777777777777777 two-year securities+ pushin! their yield 777777777777777777. A) buy9 up B) buy9 down C) sell9 up D) sell9 down Answer: B

D3Applied
10. Two-year securities are yieldin! 0 percent+ and comparable one-year securities are yieldin! 2 percent. Accordin! to the pure e6pectations theory+ the market e6pects ne6t year=s comparable one-year securities to yield A) 1& percent. B) 2 percent. C) 0 percent. D) & percent. Answer: D

D3Applied
11. .f one-year securities are yieldin! - percent+ but the market anticipates that rates for one-year securities will rise to 1 percent+ then accordin! to the e6pectations theory+ current two-year securities should be yieldin! A) 1 percent. B) 1 percent. C) 0 percent. D) - percent. Answer: C

D3Interpretive
12. *sin! the pure e6pectations theory of term structure+ a ne!ati"ely sloped yield cur"e indicates that in"estors e6pect A) fallin! short term interest rates. B) risin! short term interest rates. C) fallin! lon! term interest rates. D) risin! lon! term interest rates. Answer: A

D2Interpretive
15. *sin! the pure e6pectations theory of term structure+ a positi"ely sloped yield cur"e indicates that in"estors e6pect A) short term interest rates to be lower ne6t year. B) short term interest rates to be hi!her ne6t year. C) fallin! lon! term interest rates. D) risin! lon! term interest rates. Answer: B

Chapter -The 'isk and Term )tructure of .nterest 'ates 56

D3Interpretive
3. Accordin! to the e6pectations theory of term structure+ if ne6t year=s short-term interest rate is e6pected to be abo"e the current short-term rate+ the A) current lon!-term rate will be e/ual to the current short-term rate. B) current lon!-term rate will be below the current short-term rate. C) current lon!-term rate will be abo"e the current short-term rate. D) yield cur"e will ha"e a ne!ati"e slope. Answer: C

D1Factual
1. 8hich of the followin! is not a theory used to e6plain the term structure of interest rates> A) ?i/uidity premium theory B) #ure e6pectations theory C) #referred habitat theory D) #ure li/uidity theory Answer: D

D2Factual
. Compared with lon!-term securities+ the prices of short-term securities are always A) more "olatile. B) less "olatile. C) hi!her. D) lower. Answer: B

D2Interpretive
$. .n"estors usually 777777777777777777+ because lon!-term securities ha"e a !reater risk of capital loss than do short-term securities. A) re/uire a hi!her yield on lon!-term securities B) re/uire a lower yield on lon!-term securities C) pay a hi!her price for lon!-term securities D) a"oid lon!-term securities Answer: A

D1Interpretive
&. Commercial banks are likely to A) re/uire a li/uidity premium to hold lon!-term securities. B) purchase e/ually in each maturity se!ment of the market. C) "iew similar securities of different maturities as close substitutes. D) ha"e a preference for lon!-term securities. Answer: A

57'itter()ilber(*dell Money, Banking, and Financial Markets + ,le"enth ,dition

D2Interpretive
-. ,"erythin! else bein! e/ual+ most in"estors prefer 777777777777777777 securities+ while most bond issuers prefer to issue 777777777777777777 securities. A) short-term9 lon!-term B) lon!-term9 lon!-term C) short-term9 short-term D) lon!-term9 short-term Answer: A

D1Applied
0. 8hich of the followin! financial institutions is likely to ha"e a preferred habitat in lon!-term securities> A) Commercial banks B) @oney market mutual funds C) ?ife insurance companies D) Credit unions Answer: C

D3Interpretive
1. #roponents of the preferred habitat theory of term structure assume that a sharp reduction in the supply of one-year securities will A) decrease the yield on one-year securities. B) shift the yield cur"e upward. C) increase the yield on one year securities. D) ha"e no effect on the yield on one-year securities. Answer: A

D2Factual
2. .n the lon! run+ the yield cur"e tends to be A) positi"ely sloped. B) ne!ati"ely sloped. C) nearly "ertical. D) nearly hori%ontal. Answer: A

D2Interpretive
5. The supply of a particular security appears to influence the term structure only A) durin! recessions. B) durin! inflationary periods. C) in the short run. D) in the lon! run. Answer: C

Chapter -The 'isk and Term )tructure of .nterest 'ates 58

D3Interpretive
$3. 8hen yields are e6pected to 777777777777777777 in the future+ in"estors prefer 777777777777777777 lon!-term securities. A) rise9 hold B) rise9 not to hold C) fall9 not to hold D) 4one of the abo"e Answer: B

D3Interpretive
$1. 8hen interest rates are relati"ely hi!h+ in"estors !enerally e6pect interest rates to 777777777777777777. Thus+ in"estors prefer to hold 777777777777777777 securities. A) fall9 lon!-term B) fall9 short-term C) rise9 lon!-term D) rise9 short-term Answer: A

D3Interpretive
$ . 8hen interest rates are relati"ely low+ in"estors !enerally e6pect interest rates to 777777777777777777. Thus+ in"estors prefer to hold 777777777777777777 securities A) fall9 lon!-term B) fall9 short-term C) rise9 lon!-term D) rise9 short-term Answer: D

D2Interpretive
$$. :bser"ations of the yield cur"e su!!est that when interest rates are hi!h and in"estors e6pect interest rates to fall+ the yield cur"e will ha"e aAn) A) upward slope. B) downward slope. C) hori%ontal slope. D) "ertical slope. Answer: B

D3Interpretive
$&. Accordin! to pure e6pectations theory+ the yield cur"e should on a"era!e be A) upward slopin!. B) downward slopin!. C) flat. D) "ertical. Answer: C

59'itter()ilber(*dell Money, Banking, and Financial Markets + ,le"enth ,dition

D1Interpretive
$-. The fact that yields on short-term securities fluctuate more o"er the course of the business cycle supports which theory of the term structure> A) #ure e6pectations B) #referred habitat C) )upply and demand D) ?i/uidity premium Answer: A

D2Factual
$0. 8hich of the followin! accounts for differences in the yield to maturity on *.). !o"ernment bonds with the same maturity> A) Capital !ains ta6 treatment B) Chance of repayment C) @arketability D) Default risk Answer: C

D2Factual
$1. The most acti"ely traded !o"ernment securities in the secondary market are A) the oldest securities outstandin!. B) securities issued more than one year but less than fi"e years a!o. C) the securities associated with the current coupon issue. D) the securities with the lon!est maturity. Answer: C

D2Factual
$2. 8hich of the followin! types of !o"ernment bonds tend to be the most marketable> A) B:ff the runC bonds B) B:n the runC bonds C) BCon"ertibleC bonds D) BCouponC bonds Answer: B

D2Applied
$5. A ne!ati"ely sloped yield cur"e indicates that the economy A) is likely to show stron! !rowth in the comin! months. B) will not chan!e noticeably in the comin! months. C) is likely to show si!nificant weakness in the comin! months. D) 4one of the abo"e Answer: C

Chapter -The 'isk and Term )tructure of .nterest 'ates 60

D2Interpretive
&3. As a factor e6plainin! yield differences amon! *.). !o"ernment bonds+ default risk is A) always an important consideration. B) important+ but other factors such as market risk are more critical. C) rarely important. D) ne"er a consideration. Answer: D

D1Applied
&1. 8hich of the followin! will ha"e the hi!hest yield at any point in time> A) A fi"e-year Aaa-rated corporate bond B) A fi"e-year Baa-rated corporate bond C) A fi"e-year C-rated corporate bond D) A fi"e-year *.). Treasury bond Answer: C

D2Applied
& . .f the followin! securities are of e/ual maturity+ which will ha"e the lowest yield at a !i"en point in time> A) A consumer loan B) A municipal bond rated Aaa C) An Aaa-rated corporate bond D) A Baa-rated corporate bond Answer: B

D2Applied
&$. An in"estor pays 3 percent of his income in ta6es and purchases a D1+333 corporate bond yieldin! 13 percent. The after-ta6 yield on this bond is A) 5 percent. B) 2 percent. C) 1 percent. D) 0 percent. Answer: B

D2Applied
&&. A municipal bond sellin! for D1+333 pays the holder D23 per year. .f the bondholder pays a percent income ta6 rate+ the after-ta6 yield is A) 2 percent. B) 1 percent. C) 0 percent. D) - percent. Answer: A

61'itter()ilber(*dell Money, Banking, and Financial Markets + ,le"enth ,dition

D3Applied
&-. Assume that the yield on lon!-term *.). !o"ernment bonds rises. The yield on corporate bonds with the same maturity will 777777777777777777+ because in"estors will substitute 777777777777777777 for 777777777777777777. A) rise9 !o"ernment bonds9 corporate bonds B) rise9 corporate bonds9 !o"ernment bonds C) fall9 !o"ernment bonds9 corporate bonds D) fall9 corporate bonds9 !o"ernment bonds Answer: A

D2Factual
&0. 8hich theory of the term structure is usually critici%ed for underestimatin! the substitutability of different maturities of securities> A) The e6pectations theory B) The supply and demand approach C) The li/uidity premium theory D) The preferred habitat approach Answer: B

D2Applied
&1. 'elati"e to a bond with a shorter maturity+ a bond with a lon!er maturity has !reater A) interest rate "olatility. B) marketability. C) price "olatility. D) default risk. Answer: C

D2Applied
&2. .f all future e6pected short-term interest rates are e/ual to the current short-term interest rate+ the e6pectations theory predicts that the yield cur"e would be A) hori%ontal. B) upward slopin!. C) downward slopin!. D) "ertical. Answer: A

D2Factual
&5. A comprehensi"e measure of a bondEs maturity that takes into account the timin! of both coupon and principal payments is A) term structure. B) risk premium. C) current coupon. D) duration. Answer: D

Chapter -The 'isk and Term )tructure of .nterest 'ates 62

D3Factual
-3. The formula for relatin! the percenta!e chan!e in price to the bondEs duration is A) #(# F GHi(A1 I i) DJ. B) #(# F Gi(A1 I i) DJ. C) #(# F GHi A1 I i)/DJ. D) #(# F GHi(A1 I i) DJ. Answer: A

D2Interpretive
-1. .n !eneral the lower the yield to maturity of a bond+ the A) lower the duration of a bond. B) hi!her the duration of a bond. C) lower the default risk. D) lower the price of the bond. Answer: B

D3Applied
- . A bond has a duration of & years and a price of D1+333. The yield to maturity of the bond Kust chan!ed from - percent to 1 percent. The new price of the bond should be A) D1+310. B) D5 &. C) D1+35$. D) D531. Answer: B

D3Applied
-$. A bond has a face "alue of D1+333 and an annual coupon rate of 0 percent. The yield to maturity of this bond is - percent+ and the bond has years remainin! until maturity. Based on this information+ this bondEs duration is 777777777777777777 years. A) 1.5 B) .3 C) 1.3 D) . Answer: A