Handout 3-

[Q1] U.S. government bonds have no default risk because

A) they are backed by the full faith and credit of the federal government.

B) the federal government can increase taxes to pay its obligations.

C) they are backed with gold reserves.

D) they can be exchanged for silver at any time.

[Q2]) 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

[Q3] 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

B) positive; lower

C) negative; raise

D) negative; lower

[Q4] 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

[Q5] Which of the following securities has the lowest interest rate?

A) Junk bonds

B) U.S. Treasury bonds

C) Investment-grade bonds

D) Corporate Baa bonds

[Q6] 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

[Q7] Everything else held constant, if the tax-exempt status of municipal bonds were eliminated, then

A) the interest rates on municipal bonds would still be less than the interest rate on Treasury bonds.

B) the interest rate on municipal bonds would equal the rate on Treasury bonds.

C) the interest rate on municipal bonds would exceed the rate on Treasury bonds.

D) the interest rates on municipal, Treasury, and corporate bonds would all increase.

[Q8] Everything else held constant, the interest rate on municipal bonds rises relative to the interest rate on Treasury securities when

A) income tax rates are lowered.

B) income tax rates are raised.

C) municipal bonds become more widely traded.

D) corporate bonds become riskier.

[Q9] If the expected path of 1-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of

A) two years.

B) three years.

C) four years.

D) five years.

[Q10] If 1-year interest rates for the next three years are expected to be 4, 2, and 3 percent, and the 3-year term premium is 1 percent, than the 3-year bond rate will be

A) 1 percent.

B) 2 percent.

C) 3 percent.

D) 4 percent.

[Q11] If the yield curve slope is flat for short maturities and then slopes steeply upward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting

A) a rise in short-term interest rates in the near future and a decline further out in the future.

B) constant short-term interest rates in the near future and further out in the future.

C) a decline in short-term interest rates in the near future and a rise further out in the future.

D) constant short-term interest rates in the near future and a decline further out in the future.

[Q12] According to the liquidity premium theory of the term structure, a downward sloping yield curve indicates that short-term interest rates are expected to

A) rise in the future.

B) remain unchanged in the future.

C) decline moderately in the future.

D) decline sharply in the future.