CH-6-7 The Risk and Term Structure of Interest Rates – The Economics of Money, Banking and Financial Markets : Exam Guide

This Document Contains Chapters 6 to 7 Chapter 6 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. Answer: B 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) moral hazard. D) default risk. Answer: D 3) Bonds with no default risk are called A) flower bonds. B) no-risk bonds. C) default-free bonds. D) zero-risk bonds. Answer: C 4) Which of the following bonds are considered to be default-risk free? A) Municipal bonds B) Investment-grade bonds C) U.S. Treasury bonds D) Junk bonds Answer: C 5) 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. Answer: B 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. Answer: A 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 Answer: D 8) 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 Answer: A 9) If a corporation begins to suffer large losses, then the default risk on the corporate bond will A) increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall. B) increase and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall. C) decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will fall. D) decrease and the bond's return will become less uncertain, meaning the expected return on the corporate bond will rise. Answer: A 10) If the possibility of a default increases because corporations begin to suffer losses, then the default risk on corporate bonds will ________, and the bonds' returns will become ________ uncertain, meaning that the expected return on these bonds will decrease, everything else held constant. A) increase; less B) increase; more C) decrease; less D) decrease; more Answer: B 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 Answer: C 12) An increase in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Treasury bonds, everything else held constant. A) increase; increase B) reduce; reduce C) reduce; increase D) increase; reduce Answer: C 13) An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on Treasury securities, everything else held constant. A) increase; increase B) reduce; reduce C) increase; reduce D) reduce; increase Answer: C 14) An increase in default risk on corporate bonds ________ the demand for these bonds, but ________ the demand for default-free bonds, everything else held constant. A) increases; lowers B) lowers; increases C) does not change; greatly increases D) moderately lowers; does not change Answer: B 15) As default risk increases, 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 Answer: D 16) As their relative riskiness ________, the expected return on corporate bonds ________ relative to the expected return on default-free bonds, everything else held constant. A) increases; increases B) increases; decreases C) decreases; decreases D) decreases; does not change Answer: B 17) 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. Answer: B 18) Everything else held constant, if the federal 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 ________. A) increase; increase B) increase; decrease C) decrease; increase D) decrease; decrease Answer: C 19) Bonds with relatively high risk of default are called A) Brady bonds. B) junk bonds. C) zero coupon bonds. D) investment grade bonds. Answer: B 20) 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 Answer: B 21) Which of the following bonds would have the highest default risk? A) Municipal bonds B) Investment-grade bonds C) U.S. Treasury bonds D) Junk bonds Answer: D 22) Which of the following long-term bonds has the highest interest rate? A) Corporate Baa bonds B) U.S. Treasury bonds C) Corporate Aaa bonds D) Municipal bonds Answer: A 23) 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 Answer: B 24) The spread between interest rates on low quality corporate bonds and U.S. government bonds A) widened significantly during the Great Depression. B) narrowed significantly during the Great Depression. C) narrowed moderately during the Great Depression. D) did not change during the Great Depression. Answer: A 25) During the Great Depression years 1930-1933 there was a very high rate of business failures and defaults, we would expect the risk premium for ________ bonds to be very high. A) U.S. Treasury B) corporate Aaa C) municipal D) corporate Baa Answer: D 26) 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 Answer: C 27) The collapse of the subprime mortgage market A) did not affect the corporate bond market. B) increased the perceived riskiness of Treasury securities. C) reduced the Baa-Aaa spread. D) increased the Baa-Aaa spread. Answer: D 28) The collapse of the subprime mortgage market increased the spread between Baa and default-free U.S. Treasury bonds. This is due to A) a reduction in risk. B) a reduction in maturity. C) a flight to quality. D) a flight to liquidity. Answer: C 29) During a "flight to quality" A) the spread between Treasury bonds and Baa bonds increases. B) the spread between Treasury bonds and Baa bonds decreases. C) the spread between Treasury bonds and Baa bonds is not affected. D) the change in the spread between Treasury bonds and Baa bonds cannot be predicted. Answer: A 30) 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 U.S. Treasury bond B) a municipal bond C) a corporate bond with a rating of Aaa D) a corporate bond with a rating of Baa Answer: D 31) Which of the following statements are 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. Answer: A 32) 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. Answer: A 33) When the Treasury bond market becomes more liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________. A) right; right B) right; left C) left; right D) left; left Answer: C 34) 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 Answer: D 35) An increase in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the yield of Treasury bonds, everything else held constant. A) increase; increase B) reduce; reduce C) increase; reduce D) reduce; increase Answer: A 36) The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ U.S. Treasury bonds. A) less liquid than B) less speculative than C) tax-exempt unlike D) lower-yielding than Answer: A 37) Which of the following statements is true? A) State and local governments cannot default on their bonds. B) Bonds issued by state and local governments are called municipal bonds. C) All government issued bonds — local, state, and federal — are federal income tax exempt. D) The coupon payment on municipal bonds is usually higher than the coupon payment on Treasury bonds. Answer: B 38) 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. Answer: C 39) 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. Answer: C 40) Everything else held constant, an increase in marginal tax rates would likely have the effect of ________ the demand for municipal bonds, and ________ the demand for U.S. government bonds. A) increasing; increasing B) increasing; decreasing C) decreasing; increasing D) decreasing; decreasing Answer: B 41) 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. Answer: A 42) Everything else held constant, if income tax rates were lowered, then A) the interest rate on municipal bonds would fall. B) the interest rate on Treasury bonds would rise. C) the interest rate on municipal bonds would rise. D) the price of Treasury bonds would fall. Answer: C 43) Everything else held constant, abolishing all taxes will A) increase the interest rate on corporate bonds. B) reduce the interest rate on municipal bonds. C) increase the interest rate on municipal bonds. D) increase the interest rate on Treasury bonds. Answer: C 44) Which of the following statements are true? A) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates. B) Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates were low, they had higher interest rates than U.S. government bonds before World War II. C) Interest rates on municipal bonds will be higher than comparable bonds without the tax exemption. D) Because coupon payments on municipal bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in lower income tax brackets. Answer: B 45) The Bush tax cut reduced the top income tax bracket from 39% to 35% over a ten-year period. Supply and demand analysis predicts the impact of this change was a ________ interest rate on municipal bonds and a ________ interest rate on Treasury bonds. A) higher; lower B) lower; lower C) higher; higher D) lower; higher Answer: A 46) 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. Answer: A 47) The spread between the interest rates on Baa corporate bonds and U.S. government bonds is very large during the Great Depression years 1930-1933. Explain this difference using the bond supply and demand analysis. Answer: During the Great Depression many businesses failed. The default risk for the corporate bond increased compared to the default-free Treasury bond. The demand for corporate bonds decreased while the demand for Treasury bonds increased resulting in a larger risk premium. 48) If the federal government where to raise the income tax rates, would this have any impact on a state's cost of borrowing funds? Explain. Answer: Yes, if the federal government raises income tax rates, demand for municipal bonds which are federal income tax exempt would increase. This would lower the interest rate on the municipal bonds thus lowering the cost to the state of borrowing funds. 6.2 Term Structure of Interest Rates 1) The term structure of interest rates is A) the relationship among interest rates of different bonds with the same maturity. B) the structure of how interest rates move over time. C) the relationship among the term to maturity of different bonds. D) the relationship among interest rates on bonds with different maturities. Answer: D 2) A plot of the interest rates on default-free government bonds with different terms to maturity is called A) a risk-structure curve. B) a default-free curve. C) a yield curve. D) an interest-rate curve. Answer: C 3) Differences in ________ explain why interest rates on Treasury securities are not all the same. A) risk B) liquidity C) time to maturity D) tax characteristics Answer: C 4) Typically, yield curves are A) gently upward sloping. B) mound shaped. C) flat. D) bowl shaped. Answer: A 5) When yield curves are steeply upward sloping, A) long-term interest rates are above short-term interest rates. B) short-term interest rates are above long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) medium-term interest rates are above both short-term and long-term interest rates. Answer: A 6) When yield curves are flat, A) long-term interest rates are above short-term interest rates. B) short-term interest rates are above long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) medium-term interest rates are above both short-term and long-term interest rates. Answer: C 7) When yield curves are downward sloping, A) long-term interest rates are above short-term interest rates. B) short-term interest rates are above long-term interest rates. C) short-term interest rates are about the same as long-term interest rates. D) medium-term interest rates are above both short-term and long-term interest rates. Answer: B 8) An inverted yield curve A) slopes up. B) is flat. C) slopes down. D) has a U shape. Answer: C 9) Economists' attempts to explain the term structure of interest rates A) illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence. B) illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate movements. C) prove that the real world is a special case that tends to get short shrift in theoretical models. D) have proved entirely unsatisfactory to date. Answer: A 10) According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond. A) average B) sum C) difference D) multiple Answer: A 11) If bonds with different maturities are perfect substitutes, then the ________ on these bonds must be equal. A) expected return B) surprise return C) surplus return D) excess return Answer: A 12) If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that today's interest rate on the five-year bond is A) 4 percent. B) 5 percent. C) 6 percent. D) 7 percent. Answer: C 13) If the expected path of 1-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the expectations theory predicts that today's interest rate on the four-year bond is A) 1 percent. B) 2 percent. C) 3 percent. D) 4 percent. Answer: C 14) 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. Answer: D 15) If the expected path of 1-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of A) one year. B) two years. C) three years. D) four years. Answer: A 16) Over the next three years, the expected path of 1-year interest rates is 4, 1, and 1 percent. The expectations theory of the term structure predicts that the current interest rate on 3-year bond is A) 1 percent. B) 2 percent. C) 3 percent. D) 4 percent. Answer: B 17) 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. Answer: B 18) According to the expectations theory of the term structure A) when the yield curve is steeply upward sloping, short-term interest rates are expected to remain relatively stable in the future. B) when the yield curve is downward sloping, short-term interest rates are expected to remain relatively stable in the future. C) investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward. D) yield curves should be equally likely to slope downward as slope upward. Answer: D 19) 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. Answer: B 20) According to the segmented markets theory of the term structure A) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds. B) buyers of bonds do not prefer bonds of one maturity over another. C) interest rates on bonds of different maturities do not move together over time. D) buyers require an additional incentive to hold long-term bonds. Answer: C 21) A key assumption in the segmented markets theory is that bonds of different maturities A) are not substitutes at all. B) are perfect substitutes. C) are substitutes only if the investor is given a premium incentive. D) are substitutes but not perfect substitutes. Answer: A 22) The segmented markets theory can explain A) why yield curves usually tend to slope upward. B) why interest rates on bonds of different maturities tend to move together. C) why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high. D) why yield curves have been used to forecast business cycles. Answer: A 23) According to the liquidity premium theory of the term structure A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time. B) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium. C) because of the positive term premium, the yield curve will not be observed to be downward sloping. D) the interest rate for each maturity bond is determined by supply and demand for that maturity bond. Answer: B 24) According to the liquidity premium theory of the term structure A) bonds of different maturities are not substitutes. B) if yield curves are downward sloping, then short-term interest rates are expected to fall by so much that, even when the positive term premium is added, long-term rates fall below short-term rates. C) yield curves should never slope downward. D) interest rates on bonds of different maturities do not move together over time. Answer: B 25) The additional incentive that the purchaser of a Treasury security requires to buy a long-term security rather than a short-term security is called the A) risk premium. B) term premium. C) tax premium. D) market premium. Answer: B 26) 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. Answer: D 27) If 1-year interest rates for the next five years are expected to be 4, 2, 5, 4, and 5 percent, and the 5-year term premium is 1 percent, than the 5-year bond rate will be A) 2 percent. B) 3 percent. C) 4 percent. D) 5 percent. Answer: D 28) According to the liquidity premium theory of the term structure, a steeply upward 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. Answer: A 29) 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 A) rise in the future. B) remain unchanged in the future. C) decline moderately in the future. D) decline sharply in the future. Answer: B 30) According to the liquidity premium theory of the term structure, a flat 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. Answer: C 31) 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. Answer: D 32) According to the liquidity premium theory, a yield curve that is flat means that A) bond purchasers expect interest rates to rise in the future. B) bond purchasers expect interest rates to stay the same. C) bond purchasers expect interest rates to fall in the future. D) the yield curve has nothing to do with expectations of bond purchasers. Answer: C 33) If the yield curve is flat for short maturities and then slopes downward 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 a decline 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) a decline in short-term interest rates in the near future and an even steeper decline further out in the future. Answer: D 34) 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. Answer: C 35) If the yield curve has a mild upward slope, 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) a decline in short-term interest rates in the near future and an even steeper decline further out in the future. Answer: B 36) The preferred habitat theory of the term structure is closely related to the A) expectations theory of the term structure. B) segmented markets theory of the term structure. C) liquidity premium theory of the term structure. D) the inverted yield curve theory of the term structure. Answer: C 37) The expectations theory and the segmented markets theory do not explain the facts very well, but they provide the groundwork for the most widely accepted theory of the term structure of interest rates, A) the Keynesian theory. B) separable markets theory. C) liquidity premium theory. D) the asset market approach. Answer: C 38) The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond, and investors have no preference for short-term bonds relative to long-term bonds. A) segmented markets theory B) expectations theory C) liquidity premium theory D) separable markets theory Answer: B 39) According to this theory of the term structure, bonds of different maturities are not substitutes for one another. A) Segmented markets theory B) Expectations theory C) Liquidity premium theory D) Separable markets theory Answer: A 40) In actual practice, short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the A) segmented markets theory. B) expectations theory. C) liquidity premium theory. D) separable markets theory. Answer: A 41) The ________ of the term structure states the following: the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a term premium that responds to supply and demand conditions for that bond. A) segmented markets theory B) expectations theory C) liquidity premium theory D) separable markets theory Answer: C 42) A particularly attractive feature of the ________ is that it tells you what the market is predicting about future short-term interest rates by just looking at the slope of the yield curve. A) segmented markets theory B) expectations theory C) liquidity premium theory D) separable markets theory Answer: C 43) The steeply upward sloping yield curve in the figure above indicates that A) short-term interest rates are expected to rise in the future. B) short-term interest rates are expected to fall moderately in the future. C) short-term interest rates are expected to fall sharply in the future. D) short-term interest rates are expected to remain unchanged in the future. Answer: A 44) The steeply upward sloping yield curve in the figure above indicates that ________ interest rates are expected to ________ in the future. A) short-term; rise B) short-term; fall moderately C) short-term; remain unchanged D) long-term; fall moderately Answer: A 45) The U-shaped yield curve in the figure above indicates that short-term interest rates are expected to A) rise in the near-term and fall later on. B) fall sharply in the near-term and rise later on. C) fall moderately in the near-term and rise later on. D) remain unchanged in the near-term and rise later on. Answer: B 46) The U-shaped yield curve in the figure above indicates that the inflation rate is expected to A) remain constant in the near-term and fall later on. B) fall sharply in the near-term and rise later on. C) rise moderately in the near-term and fall later on. D) remain constant in the near-term and rise later on. Answer: B 47) The mound-shaped yield curve in the figure above indicates that short-term interest rates are expected to A) rise in the near-term and fall later on. B) fall moderately in the near-term and rise later on. C) fall sharply in the near-term and rise later on. D) remain unchanged in the near-term and fall later on. Answer: A 48) The mound-shaped yield curve in the figure above indicates that the inflation rate is expected to A) remain constant in the near-term and fall later on. B) fall moderately in the near-term and rise later on. C) rise moderately in the near-term and fall later on. D) remain unchanged in the near-term and rise later on. Answer: C 49) An inverted yield curve predicts that short-term interest rates A) are expected to rise in the future. B) will rise and then fall in the future. C) will remain unchanged in the future. D) will fall in the future. Answer: D 50) When short-term interest rates are expected to fall sharply in the future, the yield curve will A) slope up. B) be flat. C) be inverted. D) be an inverted U shape. Answer: C 51) If investors expect interest rates to fall significantly in the future, the yield curve will be inverted. This means that the yield curve has a ________ slope. A) steep upward B) slight upward C) flat D) downward Answer: D 52) When the yield curve is flat or downward-sloping, it suggest that the economy is more likely to enter A) a recession. B) an expansion. C) a boom time. D) a period of increasing output. Answer: A 53) A ________ yield curve predicts a future increase in inflation. A) steeply upward sloping B) slight upward sloping C) flat D) downward sloping Answer: A 54) If a higher inflation is expected, what would you expect to happen to the shape of the yield curve? Why? Answer: The yield curve should have a steep upward slope. Nominal interest rates will increase if the inflation rate increases, therefore, bond purchasers will require a higher term premium to hold the riskier long-term bond. Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 7.1 Computing the Price of Common Stock 1) A stockholder's ownership of a company's stock gives her the right to A) vote and be the primary claimant of all cash flows. B) vote and be the residual claimant of all cash flows. C) manage and assume responsibility for all liabilities. D) vote and assume responsibility for all liabilities. Answer: B 2) Stockholders are residual claimants, meaning that they A) have the first priority claim on all of a company's assets. B) are liable for all of a company's debts. C) will never share in a company's profits. D) receive the remaining cash flow after all other claims are paid. Answer: D 3) Periodic payments of net earnings to shareholders are known as A) capital gains. B) dividends. C) profits. D) interest. Answer: B 4) The value of any investment is found by computing the A) present value of all future sales. B) present value of all future liabilities. C) future value of all future expenses. D) present value of all future cash flows. Answer: D 5) In the one-period valuation model, the value of a share of stock today depends upon A) the present value of both dividends and the expected sales price. B) only the present value of the future dividends. C) the actual value of the dividends and expected sales price received in one year. D) the future value of dividends and the actual sales price. Answer: A 6) In the one-period valuation model, the current stock price increases if A) the expected sales price increases. B) the expected sales price falls. C) the required return increases. D) dividends are cut. Answer: A 7) In the one-period valuation model, an increase in the required return on investments in equity A) increases the expected sales price of a stock. B) increases the current price of a stock. C) reduces the expected sales price of a stock. D) reduces the current price of a stock. Answer: D 8) Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate of return of 10%, the current price of the stock would be A) $110.11. B) $121.12. C) $100.10. D) $100.11 Answer: C 9) Using the one-period valuation model, assuming a year-end dividend of $1.00, an expected sales price of $100, and a required rate of return of 5%, the current price of the stock would be A) $110.00. B) $101.00. C) $100.00. D) $96.19. Answer: D 10) In the generalized dividend model, if the expected sales price is in the distant future A) it does not affect the current stock price. B) it is more important than dividends in determining the current stock price. C) it is equally important with dividends in determining the current stock price. D) it is less important than dividends but still affects the current stock price. Answer: A 11) In the generalized dividend model, a future sales price far in the future does not affect the current stock price because A) the present value cannot be computed. B) the present value is almost zero. C) the sales price does not affect the current price. D) the stock may never be sold. Answer: B 12) In the generalized dividend model, the current stock price is the sum of A) the actual value of the future dividend stream. B) the present value of the future dividend stream. C) the present value of the future dividend stream plus the actual future sales price. D) the present value of the future sales price. Answer: B 13) Using the Gordon growth model, a stock's price will increase if A) the dividend growth rate increases. B) the growth rate of dividends falls. C) the required rate of return on equity rises. D) the expected sales price rises. Answer: A 14) In the Gordon growth model, a decrease in the required rate of return on equity A) increases the current stock price. B) increases the future stock price. C) reduces the future stock price. D) reduces the current stock price. Answer: A 15) Using the Gordon growth formula, if D1 is $2.00, ke is 12% or 0.12, and g is 10% or 0.10, then the current stock price is A) $20. B) $50. C) $100. D) $150. Answer: C 16) Using the Gordon growth formula, if D1 is $1.00, ke is 10% or 0.10, and g is 5% or 0.05, then the current stock price is A) $10. B) $20. C) $30. D) $40. Answer: B 17) One of the assumptions of the Gordon Growth Model is that dividends will continue growing at ________ rate. A) an increasing B) a fast C) a constant D) an escalating Answer: C 18) In the Gordon Growth Model, the growth rate is assumed to be ________ the required return on equity. A) greater than B) equal to C) less than D) proportional to Answer: C 19) You believe that a corporation's dividends will grow 5% on average into the foreseeable future. If the company's last dividend payment was $5 what should be the current price of the stock assuming a 12% required return? Answer: Use the Gordon Growth Model. $5(1 + .05)/(.12 - .05) = $75 20) What rights does ownership interest give stockholders? Answer: Stockholders have the right to vote on issues brought before the stockholders, be the residual claimant , that is, receive a portion of any net earnings of the corporation, and the right to sell the stock. 7.2 How the Market Sets Stock Prices 1) In asset markets, an asset's price is A) set equal to the highest price a seller will accept. B) set equal to the highest price a buyer is willing to pay. C) set equal to the lowest price a seller is willing to accept. D) set by the buyer willing to pay the highest price. Answer: D 2) Information plays an important role in asset pricing because it allows the buyer to more accurately judge ________. A) liquidity B) risk C) capital D) policy Answer: B 3) New information that might lead to a decrease in an asset's price might be A) an expected decrease in the level of future dividends. B) a decrease in the required rate of return. C) an expected increase in the dividend growth rate. D) an expected increase in the future sales price. Answer: A 4) A change in perceived risk of a stock changes A) the expected dividend growth rate. B) the expected sales price. C) the required rate of return. D) the current dividend. Answer: C 5) A stock's price will fall if there is A) a decrease in perceived risk. B) an increase in the required rate of return. C) an increase in the future sales price. D) current dividends are high. Answer: B 6) A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in the ________, everything else held constant. A) reduces; future sales price; expected rate of return B) reduces; current dividend; expected rate of return C) increases; required rate of return; future sales price D) increases; required rate of return; dividend growth rate Answer: D 7) The subprime financial crisis lead to a decline in stock prices because A) of a lowered expected dividend growth rate. B) of a lowered required return on investment in equity. C) higher expected future stock prices. D) higher current dividends. Answer: A 8) Increased uncertainty resulting from the subprime crisis ________ the required return on investment in equity. A) raised B) lowered C) had no impact on D) decreased Answer: A 9) In October 2008, the stock market crashed, falling by ________ from its peak value a year earlier. A) over 40% B) over 30% C) over 50% D) over 25% Answer: A 7.3 The Theory of Rational Expectations 1) Economists have focused more attention on the formation of expectations in recent years. This increase in interest can probably best be explained by the recognition that A) expectations influence the behavior of participants in the economy and thus have a major impact on economic activity. B) expectations influence only a few individuals, have little impact on the overall economy, but can have important effects on a few markets. C) expectations influence many individuals, have little impact on the overall economy, but can have distributional effects. D) models that ignore expectations have little predictive power, even in the short run. Answer: A 2) The view that expectations change relatively slowly over time in response to new information is known in economics as A) rational expectations. B) irrational expectations. C) slow-response expectations. D) adaptive expectations. Answer: D 3) If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economics would say that expectation formation is A) irrational. B) rational. C) adaptive. D) reasonable. Answer: C 4) If expectations are formed adaptively, then people A) use more information than just past data on a single variable to form their expectations of that variable. B) often change their expectations quickly when faced with new information. C) use only the information from past data on a single variable to form their expectations of that variable. D) never change their expectations once they have been made. Answer: C 5) If during the past decade the average rate of monetary growth has been 5% and the average inflation rate has been 5%, everything else held constant, when the Federal Reserve announces that the new rate of monetary growth will be 10%, the adaptive expectation forecast of the inflation rate is A) 5%. B) between 5 and 10%. C) 10%. D) more than 10%. Answer: A 6) The major criticism of the view that expectations are formed adaptively is that A) this view ignores that people use more information than just past data to form their expectations. B) it is easier to model adaptive expectations than it is to model rational expectations. C) adaptive expectations models have no predictive power. D) people are irrational and therefore never learn from past mistakes. Answer: A 7) In rational expectations theory, the term "optimal forecast" is essentially synonymous with A) correct forecast. B) the correct guess. C) the actual outcome. D) the best guess. Answer: D 8) If a forecast is made using all available information, then economists say that the expectation formation is A) rational. B) irrational. C) adaptive. D) reasonable. Answer: A 9) If a forecast made using all available information is not perfectly accurate, then it is A) still a rational expectation. B) not a rational expectation. C) an adaptive expectation. D) a second-best expectation. Answer: A 10) If additional information is not used when forming an optimal forecast because it is not available at that time, then expectations are A) obviously formed irrationally. B) still considered to be formed rationally. C) formed adaptively. D) formed equivalently. Answer: B 11) An expectation may fail to be rational if A) relevant information was not available at the time the forecast is made. B) relevant information is available but ignored at the time the forecast is made. C) information changes after the forecast is made. D) information was available to insiders only. Answer: B 12) According to rational expectations theory, forecast errors of expectations A) are more likely to be negative than positive. B) are more likely to be positive than negative. C) tend to be persistently high or low. D) are unpredictable. Answer: D 13) Rational expectations forecast errors will on average be ________ and therefore ________ be predicted ahead of time. A) positive; can B) positive; cannot C) negative; can D) zero; cannot Answer: D 14) People have a strong incentive to form rational expectations because A) they are guaranteed of success in the stock market. B) it is costly not to do so. C) it is costly to do so. D) everyone wants to be rational. Answer: B 15) If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to A) change the way they form expectations about future values of the variable. B) begin to make systematic mistakes. C) no longer pay close attention to movements in this variable. D) give up trying to forecast this variable. Answer: A 16) According to rational expectations, A) expectations of inflation are viewed as being an average of past inflation rates. B) expectations of inflation are viewed as being an average of expected future inflation rates. C) expectations formation indicates that changes in expectations occur slowly over time as past data change. D) expectations will not differ from optimal forecasts using all available information. Answer: D 17) Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea. Last night the weather forecast included a 100% chance of rain by midday but Barbara did not watch the local news program. Is Barbara's prediction of good weather at lunch time rational? Why or why not? Answer: No, this prediction is not using rational expectations. Although Barbara based her guess on the information that was available to her at the time, additional information was readily available that could have been used to improve her prediction. 7.4 The Efficient Market Hypothesis: Rational Expectations in Financial Markets 1) The theory of rational expectations, when applied to financial markets, is known as A) monetarism. B) the efficient markets hypothesis. C) the theory of strict liability. D) the theory of impossibility. Answer: B 2) According to the efficient markets hypothesis, the current price of a financial security A) is the discounted net present value of future interest payments. B) is determined by the highest successful bidder. C) fully reflects all available relevant information. D) is a result of none of the above. Answer: C 3) If the optimal forecast of the return on a security exceeds the equilibrium return, then A) the market is inefficient. B) no unexploited profit opportunities exist. C) the market is in equilibrium. D) the market is myopic. Answer: A 4) Another way to state the efficient markets condition is: in an efficient market, A) unexploited profit opportunities will be quickly eliminated. B) unexploited profit opportunities will never exist. C) arbitragers guarantee that unexploited profit opportunities never exist. D) every financial market participant must be well informed about securities. Answer: A 5) ________ occurs when market participants observe returns on a security that are larger than what is justified by the characteristics of that security and take action to quickly eliminate the unexploited profit opportunity. A) Arbitrage B) Mediation C) Asset capitalization D) Market intercession Answer: A 6) The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market, A) it will tend to go unnoticed for some time. B) it will be quickly eliminated. C) financial analysts are your best source of this information. D) prices will reflect the unexploited profit opportunity. Answer: B 7) Financial markets quickly eliminate unexploited profit opportunities through changes in A) dividend payments. B) tax laws. C) asset prices. D) monetary policy. Answer: C 8) The elimination of unexploited profit opportunities requires that ________ market participants be well informed. A) all B) a few C) zero D) many Answer: B 9) If in an efficient market all prices are correct and reflect market fundamentals, which of the following is a false statement? A) A stock that has done poorly in the past is more likely to do well in the future. B) One investment is as good as any other because the securities' prices are correct. C) A security's price reflects all available information about the intrinsic value of the security. D) Security prices can be used by managers to assess their cost of capital accurately. Answer: A 10) According to the efficient markets hypothesis, purchasing the reports of financial analysts A) is likely to increase one's returns by an average of 10%. B) is likely to increase one's returns by about 3 to 5%. C) is not likely to be an effective strategy for increasing financial returns. D) is likely to increase one's returns by an average of about 2 to 3%. Answer: C 11) You have observed that the forecasts of an investment advisor consistently outperform the other reported forecasts. The efficient markets hypothesis says that future forecasts by this advisor A) may or may not be better than the other forecasts. Past performance is no guarantee of the future. B) will always be the best of the group. C) will definitely be worse in the future. What goes up must come down. D) will be worse in the near future, but improve over time. Answer: A 12) Which of the following types of information most likely allows the exploitation of a profit opportunity? A) Financial analysts' published recommendations B) Technical analysis C) Hot tips from a stockbroker D) Insider information Answer: D 13) Sometimes one observes that the price of a company's stock falls after the announcement of favorable earnings. This phenomenon is A) clearly inconsistent with the efficient markets hypothesis. B) consistent with the efficient markets hypothesis if the earnings were not as high as anticipated. C) consistent with the efficient markets hypothesis if the earnings were not as low as anticipated. D) consistent with the efficient markets hypothesis if the favorable earnings were expected. Answer: B 14) You read a story in the newspaper announcing the proposed merger of Dell Computer and Gateway. The merger is expected to greatly increase Gateway's profitability. If you decide to invest in Gateway stock, you can expect to earn A) above average returns since you will share in the higher profits. B) above average returns since your stock price will definitely appreciate as higher profits are earned. C) below average returns since computer makers have low profit rates. D) a normal return since stock prices adjust to reflect expected changes in profitability almost immediately. Answer: D 15) The efficient markets hypothesis indicates that investors A) can use the advice of technical analysts to outperform the market. B) do better on average if they adopt a "buy and hold" strategy. C) let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy. D) do better if they purchase loaded mutual funds. Answer: B 16) The efficient markets hypothesis suggests that investors A) should purchase no-load mutual funds which have low management fees. B) can use the advice of technical analysts to outperform the market. C) let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy. D) act on all "hot tips" they hear. Answer: A 17) The advantage of a "buy-and-hold strategy" is that A) net profits will tend to be higher because there will be fewer brokerage commissions. B) losses will eventually be eliminated. C) the longer a stock is held, the higher will be its price. D) profits are guaranteed. Answer: A 18) For small investors, the best way to pursue a "buy and hold" strategy is to A) buy and sell individual stocks frequently. B) buy no-load mutual funds with high management fees. C) buy no-load mutual funds with low management fees. D) buy load mutual funds. Answer: C 19) A situation when an asset price differs from its fundamental value is A) a random walk. B) an inflation. C) a deflation. D) a bubble. Answer: D 20) In a rational bubble, investors can have ________ expectations that a bubble is occurring but continue to hold the asset anyway. A) irrational B) adaptive C) rational D) myopic Answer: C 21) If a corporation announces that it expects quarterly earnings to increase by 25% and it actually sees an increase of 22%, what should happen to the price of the corporation's stock if the efficient markets hypothesis holds, everything else held constant? Answer: The stock's price should fall. The price had adjusted based on the statement of expected earnings. When the actual number turned out to be lower than expected, the stock price changes to reflect the additional information. 22) Your best friend calls and gives you the latest stock market "hot tip" that he heard at the health club. Should you act on this information? Why or why not? Answer: No, if this information is readily available, it will already be reflected in the stock price. 7.5 Behavioral Finance 1) ________ is the field of study that applies concepts from social sciences such as psychology and sociology to help understand the behavior of securities prices. A) Behavioral finance B) Strategical finance C) Methodical finance D) Procedural finance Answer: A 2) If a market participant believes that a stock price is irrationally high, they may try to borrow stock from brokers to sell in the market and then make a profit by buying the stock back again after the stock falls in price. This practice is called A) short selling. B) double dealing. C) undermining. D) long marketing. Answer: A 3) ________ means people are more unhappy when they suffer losses than they are happy when they achieve gains. A) Loss fundamentals B) Loss aversion C) Loss leader D) Loss cycle Answer: B 4) Loss aversion can explain why very little ________ actually takes place in the securities market. A) short selling B) bargaining C) bartering D) negotiating Answer: A 5) Psychologists have found that people tend to be ________ in their own judgments. A) underconfident B) overconfident C) indecisive D) insecure Answer: B 6) ________ and ________ may provide an explanation for stock market bubbles. A) Overconfidence; social contagion B) Under confidence; social contagion C) Overconfidence; social isolationism D) Under confidence; social isolationism Answer: A 7.6 Web Appendix: Evidence on the Efficient Market Hypothesis 1) If a mutual fund outperforms the market in one period, evidence suggests that this fund is A) highly likely to consistently outperform the market in subsequent periods due to its superior investment strategy. B) likely to under-perform the market in subsequent periods to average its overall returns. C) not likely to consistently outperform the market in subsequent periods. D) not likely to outperform the market in any subsequent period. Answer: C 2) Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period usually A) beat the market in the next time period. B) beat the market in the next two subsequent time periods. C) beat the market in the next three subsequent time periods. D) do not beat the market in the next time period. Answer: D 3) The number and availability of discount brokers has grown rapidly since the mid-1970s. The efficient markets hypothesis predicts that people who use discount brokers A) will likely earn lower returns than those who use full-service brokers. B) will likely earn about the same as those who use full-service brokers, but will net more after brokerage commissions. C) are going against evidence suggesting that full-service brokers can help outperform the market. D) are likely to outperform the market by a wide margin. Answer: B 4) When Happy Feet Corporation announces that their fourth quarter earnings are up 10%, their stock price falls. This is consistent with the efficient markets hypothesis A) if earnings were not as high as expected. B) if earnings were not as low as expected. C) if a merger is anticipated. D) the company just invented a new bunion product. Answer: A 5) To say that stock prices follow a "random walk" is to argue that stock prices A) rise, then fall, then rise again. B) rise, then fall in a predictable fashion. C) tend to follow trends. D) cannot be predicted based on past trends. Answer: D 6) The efficient markets hypothesis predicts that stock prices follow a "random walk." The implication of this hypothesis for investing in stocks is A) a "churning strategy" of buying and selling often to catch market swings. B) turning over your stock portfolio each month, selecting stocks by throwing darts at the stock page. C) a "buy and hold strategy" of holding stocks to avoid brokerage commissions. D) following the advice of technical analysts. Answer: C 7) Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets hypothesis, A) a waste of time. B) profitably employed by all financial analysts. C) the most efficient rules to employ. D) consistent with the random walk hypothesis. Answer: A 8) Tests used to rate the performance of rules developed in technical analysis conclude that technical analysis A) outperforms the overall market. B) far outperforms the overall market, suggesting that stockbrokers provide valuable services. C) does not outperform the overall market. D) does not outperform the overall market, suggesting that stockbrokers do not provide services of any value. Answer: C 9) Which of the following accurately summarize the empirical evidence about technical analysis? A) Technical analysts fare no better than other financial analysis—on average they do not outperform the market. B) Technical analysts tend to outperform other financial analysis, but on average they nevertheless under-perform the market. C) Technical analysts fare no better than other financial analysis, and like other financial analysts they outperform the market. D) Technical analysts fare no better than other financial analysis, and like other financial analysts they under-perform the market. Answer: A 10) The small-firm effect refers to the A) negative returns earned by small firms. B) returns equal to large firms earned by small firms. C) abnormally high returns earned by small firms. D) low returns after adjusting for risk earned by small firms. Answer: C 11) The January effect refers to the fact that A) most stock market crashes have occurred in January. B) stock prices tend to fall in January. C) stock prices have historically experienced abnormal price increases in January. D) the football team winning the Super Bowl accurately predicts the behavior of the stock market for the next year. Answer: C 12) When a corporation announces a major decline in earnings, the stock price may initially decline significantly and then rise back to normal levels over the next few weeks. This impact is called ________. A) the January effect B) mean reversion C) market overreaction D) the small-firm effect Answer: C 13) A phenomenon closely related to market overreaction is A) the random walk. B) the small-firm effect. C) the January effect. D) excessive volatility. Answer: D 14) Excessive volatility refers to the fact that A) stock returns display mean reversion. B) stock prices can be slow to react to new information. C) stock price tend to rise in the month of January. D) stock prices fluctuate more than is justified by dividend fluctuations. Answer: D 15) Mean reversion refers to the fact that A) small firms have higher than average returns. B) stocks that have had low returns in the past are more likely to do well in the future. C) stock returns are high during the month of January. D) stock prices fluctuate more than is justified by fundamentals. Answer: B 16) Evidence in support of the efficient markets hypothesis includes A) the failure of technical analysis to outperform the market. B) the small-firm effect. C) the January effect. D) excessive volatility. Answer: A 17) Evidence against market efficiency includes A) failure of technical analysis to outperform the market. B) the random walk behavior of stock prices. C) the inability of mutual fund managers to consistently beat the market. D) the January effect. Answer: D Test Bank for The Economics of Money, Banking and Financial Markets Frederic S. Mishkin 9780321599797, 9780134734200, 9780133836790, 9780134734606, 9780134733821