Lecture 4, problem set Flashcards
(16 cards)
A bond with default risk will always have a ________ risk premium and
an increase in its default risk will ________ the risk premium
A) positive; raise
The coronavirus pandemic increased the spread between Baa and default-
free U.S. Treasury bonds. This is due to a…
C) …flight to quality
Everything else held constant, if the government were to guarantee today
that it will pay creditors if a corporation goes bankrupt in the future, the
interest rate on corporate bonds will ________ and the interest rate on
Treasury securities will ________.
C) decrease; increase
Currently, a three-month Treasury bill has a yield of 5% while the yield
on a ten-year Treasury bond is 4.7%. What is the risk premium of the
typical A-rated ten-year corporate bond with a yield of 5.5%?
B) 0.8%
If lenders anticipate no changes in liquidity, information costs, and tax
differences, the yield on a risky security should be…
– A) …less than that on a safe security and the price of a risky security
should be greater than that on a safe security.
– B) …less than that on a safe security and the price of a risky security
should also be less than that of a safe security.
– C) …greater than that on a safe security and the price of a risky
security should also be greater than that of a safe security.
– D) …greater than that on a safe security and the price of a risky
security should be lower than that of a safe security.
D) …greater than that on a safe security and the price of a risky
security should be lower than that of a safe security
Which of the following statements is true?
– A) Tax-free bonds normally have a higher interest rate than other
types of bonds.
– B) The price of a bond increases as it becomes more risky.
– C) The more liquid the bond, the lower the yield.
– D) The yield curve illustrates the relative default risks of alternative
types of bonds
C) The more liquid the bond, the lower the yield.
According to the expectations theory of the term structure…
A) …the interest rate on long-term bonds will exceed the average of
short-term interest rates that people expect to occur over the life of
the long-term bonds, because of their preference for short-term
securities.
– B) …interest rates on bonds of different maturities move together
over time.
– C) …buyers of bonds prefer short-term to long-term bonds.
– D) …buyers require an additional incentive to hold long-term bonds
B) …interest rates on bonds of different maturities move together
over time.
According to the liquidity premium theory of the term structure, a slightly
upward sloping yield curve indicates that short-term interest rates are
expected to…
C) …remain unchanged in the future
According to the segmented markets theory of the term structure…
– A) …bonds of one maturity are close substitutes for bonds of other
maturities, therefore, interest rates on bonds of different maturities
move together over time.
– B) …the interest rate for each maturity bond is determined by supply
and demand for that maturity bond.
– C) …investors’ strong preferences for short-term relative to long-
term bonds explains why yield curves typically slope downward.
– D) …because of the positive term premium, the yield curve will not
be observed to be downward-sloping
B) …the interest rate for each maturity bond is determined by supply
and demand for that maturity bond
When the yield curve is downward-sloping…
D) …short-term yields are higher than long-term yields
According to the liquidity premium theory, the yield curve normally has a
positive slope because…
A) …term premiums rise as the time to maturity increases
If a one-year bond currently yields 5% and is expected to yield 7% next
year, the liquidity premium theory predicts that the yield today on a two-
year bond should be…
B) …more than 6%.
Suppose that a candidate runs for prime minister on a programme of a flat
tax. Under a flat tax, there would be only one tax bracket for the federal
income tax and most tax deductions and tax exemptions would be
eliminated. Suppose that the candidate is expected to win the elections.
What would be the likely impact on the market for municipal bonds?
Draw the necessary graph.
If municipal bonds were no longer exempt from the federal income tax,
their real expected return would decrease.
– A shift of the demand curve for municipal bonds to the left.
■ Excess supply → market forces → 𝑃 ↓ → 𝑖 ↑.
■ Reducing the marginal tax rate on high income tax-payers, as would be
done under most flat-tax proposals, would reduce the incentive many
high-income people have for buying municipal bonds.
– This would also result in a decline in the prices of these bonds and a rise in
their yields.
■ Higher interest rates are required to hold a bond that is considered as less
liquid and more risky than the corresponding Treasury bond.
Suppose the private credit-rating agencies ceased to exist. What
would be the impact on the bond market?
If the private bond-rating agencies ceased to exist, the information
available to investors on the default risk of bonds would decline.
■ Demand for corporate bonds, or in general for bonds with a positive
default risk, decreases; hence demand for default-free bonds increases.
■ The risk premium would increase, bond yields would rise, and some
firms might find they were unable to raise funds on the bonds’ market.
■ Graph and analysis: Please see Lecture 4, presentation slide 9.
Consider the market for corporate and Treasury bonds, where initially
they both have identical attributes. Let now Treasury bonds to be exempt
from state and local income taxes. Using the demand/supply framework
for bonds, explain why interest rates on corporate bonds are higher than
those on Treasury bonds.
Exactly the same story regarding municipal vs. Treasury bonds; but now
Treasury bonds have a tax advantage over corporate bonds.
■ The tax advantage makes Treasury bonds more desirable, since it
increases their expected after-tax return; so, their demand curve shifts to
the right.
– Excess demand → market forces → 𝑃 ↑ → 𝑖 ↓.
■ At the same time, corporate bonds become less desirable; their demand
curve shifts to the left.
– Excess supply → market forces → 𝑃 ↓ → 𝑖 ↑.
■ Graph: Please see Lecture 4, presentation slide 17.
Assume a reduction in the supply of thirty-year UK government bonds.
Explain whether this will affect their yields, assuming that (i) the
expectations theory of the term structure is valid; and (ii) the liquidity
premium theory of the term structure is valid
(i) The answer is no. The expectations theory says that long-term interest
rates are an average of current and expected short-term interest rates. As
long as expectations for short-term interest rates do not change, then the
yield of the 30-year UK government bond will not change.
■ (ii) Yes. A shift of the supply curve to the left creates an excess demand,
hence market forces drive the price upwards, reducing the interest rate;
which corresponds to the term premium. Thus, the interest rate on a 30-
year UK government bond decreases, since a decrease in supply
decreases its term premium (the second part in the liquidity premium
theory that attributes to demand/supply conditions).
