M and B 2, 2nd Edition by Dean Croushore - Test Bank

M and B 2, 2nd Edition by Dean Croushore – Test Bank

 

Instant Download – Complete Test Bank With Answers

 

 

Sample Questions Are Posted Below

 

Chapter 5—The Structure of Interest Rates

 

MULTIPLE CHOICE

 

1. The process of turning assets such as mortgages into securities sold to investors is

a.	default.
b.	standard deviation.
c.	standardization.
d.	securitization.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

2. The ten-year bond that was the most recently issued is known as the

a.	off-the-run security.
b.	on-the-run security.
c.	in-the-money security.
d.	out-of-the-money security.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

3. A U.S. Treasury security that is not the most recently issued is called a(n) ________-the-run security.

a.	on
b.	by
c.	down
d.	off

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

4. Put the following securities in order according to their likely yields to maturity, from highest to lowest, in the middle of an economic expansion.

 

A:	The on-the-run Treasury bond with ten years to maturity
B:	The off-the-run Treasury bond with nine-and-one-half years to maturity
C:	The off-the-run Treasury bond with twenty-four years to maturity

 

a.	A, C, B
b.	B, A, C
c.	C, B, A
d.	C, A, B

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate

TOP:   What Explains Differences in Interest Rates?                     TYP:   Conceptual

 

 

5. Securitization is

a.	the process of turning assets such as mortgages into securities sold to investors.
b.	the method used by financial intermediaries when they purchase securities in the secondary market.
c.	a procedure used by the Federal Reserve and the Securities and Exchange Commission when allowing a bond to be sold on the primary market.
d.	the main method used by the Department of Homeland Securitization.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

6. Put the following securities in order according to their likely yields to maturity, from highest to lowest:

 

A:	A corporate bond rated Aaa (low risk)
B:	A corporate bond identical in every way to bond A, but rated Baa (medium risk)
C:	A corporate bond identical in every way to bond A, but rated C (high risk)

 

a.	A, B, C
b.	B, A, C
c.	C, B, A
d.	C, A, B

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate

TOP:   What Explains Differences in Interest Rates?                     TYP:   Conceptual

 

7. The on-the-run ten-year Treasury security is

a.	the ten-year government bond that is in greatest demand by investors who want to hold it until it matures.
b.	a ten-year government bond that can be used to pay estate taxes, also known as a flower bond.
c.	a non-taxable ten-year government bond.
d.	the ten-year government bond that was the most recently issued.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

8. A basis point equals

a.	one hundredth of a percentage point.
b.	one tenth of a percentage point.
c.	one half of a percentage point.
d.	ten percentage points.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

 

9. One hundredth of a percentage point is

a.	also called a minion.
b.	one basis point.
c.	a centipercent.
d.	.01 cubits.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

10. Put the following securities in order according to their after-tax interest rates, from lowest to highest. The federal tax rate on interest income is 20 percent.

 

A:	A corporate bond pays an interest rate of 8 percent.
B:	A corporate bond identical in every way to bond A, but with an interest rate of 8.5 percent.
C:	A local government bond identical in every way to bond A, but with an interest rate of 7 percent

 

a.	A, B, C
b.	B, A, C
c.	C, B, A
d.	C, A, B

 

 

ANS:  A                    PTS:   1                    DIF:    Moderate

TOP:   What Explains Differences in Interest Rates?                     TYP:   Conceptual

 

11. In October 2001, when the U.S. government announced that it would stop selling 30-year bonds, the price of 30-year bonds in the secondary market ____ and the yield ____.

a.	rose; rose
b.	rose; fell
c.	fell; rose
d.	fell; fell

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   What Explains Differences in Interest Rates?                     TYP:   Factual

 

12. The relationship between interest rates with differing times to maturity is known as the ________ ________ of interest rates.

a.	term structure
b.	term curve
c.	yield curve
d.	yield structure

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

 

13. The term structure of interest rates is the relationship between ________ with differing times to maturity.

a.	securities
b.	interest rates
c.	default rates
d.	bonds

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

14. What does a flat yield curve imply, according to the expectations theory of the term structure of interest rates?

a.	The price level will not change in the future.
b.	Future long-term rates are expected to rise.
c.	Future long-term rates are expected to fall.
d.	Future short-term rates are not expected to change.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

15. According to the expectations theory of the term structure of interest rates, if the interest rate on a one-year bond today is 3.0 percent, the expected interest rate on a one-year bond one year from now is 4.0 percent, and the expected interest rate on a one-year bond two years from now is 4.5 percent, then the interest rate on a two-year bond today is

a.	3.00 percent.
b.	3.50 percent.
c.	3.83 percent.
d.	4.00 percent.

 

 

ANS:  B                    PTS:   1                    DIF:    Moderate

TOP:   The Term Structure of Interest Rates                                 TYP:   Conceptual

 

16. What does a yield curve show?

a.	The yield to maturity on the vertical axis and the time to maturity on the horizontal axis
b.	The time to maturity on the vertical axis and the yield to maturity on the horizontal axis
c.	The yield to maturity on the vertical axis and the date on the horizontal axis
d.	The date on the vertical axis and the yield to maturity on the horizontal axis

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

17. A plot of the yield to maturity on the vertical axis and the time to maturity on the horizontal axis is known as

a.	an interest rate graph.
b.	a graphic term structure.
c.	a yield curve.
d.	a term structure plot.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

18. Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 4 percent today, a two-year bond paying 5 percent today, a three-year bond paying 5.3 percent today, or a four-year bond paying 5.5 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 5.5 percent, a one-year bond purchased two years from now is expected to have an interest rate of 6 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 7 percent. The investor would buy

a.	a one-year bond today.
b.	a two-year bond today.
c.	a three-year bond today.
d.	a four-year bond today.

 

 

ANS:  B                    PTS:   1                    DIF:    Moderate

TOP:   The Term Structure of Interest Rates                                 TYP:   Conceptual

 

19. Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 4 percent today, a two-year bond paying 5 percent today, a three-year bond paying 5.3 percent today, or a four-year bond paying 5.8 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 5.5 percent, a one-year bond purchased two years from now is expected to have an interest rate of 6 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 7 percent. The investor would buy

a.	a one-year bond today.
b.	a two-year bond today.
c.	a three-year bond today.
d.	a four-year bond today.

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate

TOP:   The Term Structure of Interest Rates                                 TYP:   Conceptual

 

20. According to ____, the long-term interest rate is equal to the average of current and expected future short-term interest rates.

a.	the expectations theory of the term structure of interest rates
b.	the rational-expectations hypothesis
c.	the segmented-markets hypothesis
d.	the yield curve theory

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

21. According to the expectations theory of the term structure of interest rates,

a.	the short-term interest rate is equal to the average of current and expected future long-term interest rates.
b.	the short-term interest rate has no relation to long-term interest rates.
c.	the long-term interest rate is equal to the average of current and expected future short-term interest rates.
d.	the yield curve is always flat.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

 

22. What does a downward-sloping yield curve imply, according to the expectations theory of the term structure of interest rates?

a.	Investors expect long-term interest rates to rise in the future.
b.	Investors expect future short-term interest rates to be lower than the current short-term interest rate.
c.	Investors expect future short-term interest rates to be the same as the current short-term interest rate.
d.	Investors expect future short-term interest rates to be higher than the current short-term interest rate.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

23. What does a flat yield curve imply, according to the expectations theory of the term structure of interest rates?

a.	Investors expect long-term interest rates to rise in the future.
b.	Investors expect future short-term interest rates to be lower than the current short-term interest rate.
c.	Investors expect future short-term interest rates to be the same as the current short-term interest rate.
d.	Investors expect future short-term interest rates to be higher than the current short-term interest rate.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

24. What does an upward-sloping yield curve imply, according to the expectations theory of the term structure of interest rates?

a.	Investors expect long-term interest rates to fall in the future.
b.	Investors expect future short-term interest rates to be lower than the current short-term interest rate.
c.	Investors expect future short-term interest rates to be the same as the current short-term interest rate.
d.	Investors expect future short-term interest rates to be higher than the current short-term interest rate.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   The Term Structure of Interest Rates                                 TYP:   Factual

 

25. According to the complete theory of the term structure of interest rates (the theory that incorporates a term premium), when the yield curve slopes downward investors expect short-term interest rates in the future to

a.	rise.
b.	not change.
c.	fall.
d.	rise for a short time, then fall later.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Term Premium

TYP:   Factual

 

26. Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates. The current interest rate on one-year bonds is 3.0 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 3.5 percent. Assume that there is no term premium on a one-year bond. Suppose the term premium equals 0.75 percent ´ the number of years to maturity, for the two-year bond. The interest rate today on the two-year bond is

a.	3.25 percent.
b.	4.00 percent.
c.	4.75 percent.
d.	5.00 percent.

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate        TOP:   The Term Premium

TYP:   Conceptual

 

27. The term premium is

a.	the interest rate on a long-term bond minus the average interest rate on future short-term bonds.
b.	the interest rate on a long-term bond plus the average interest rate on future short-term bonds.
c.	the average interest rate on future short-term bonds.
d.	the standard deviation of the interest rate on long-term bonds.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Term Premium

TYP:   Factual

 

28. The interest rate on a long-term bond minus the average interest rate on future short-term bonds is known as

a.	risk.
b.	the term premium.
c.	a basis point.
d.	the yield curve.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Term Premium

TYP:   Factual

 

29. When the yield curve is flat, then according to the complete theory of the term structure of interest rates (the theory that incorporates a term premium), investors expect short-term interest rates in the future to

a.	rise.
b.	not change.
c.	fall.
d.	rise for a short time, then fall later.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Term Premium

TYP:   Factual

 

 

30. Which of the following bonds has the greatest interest-rate risk?

a.	A one-year bond
b.	A five-year bond
c.	A ten-year bond
d.	A thirty-year bond

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Term Premium

TYP:   Factual

 

31. Which of the following bonds has the greatest term premium?

a.	A one-year bond
b.	A five-year bond
c.	A ten-year bond
d.	A thirty-year bond

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Term Premium

TYP:   Factual

 

32. Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates. The current interest rate on one-year bonds is 5 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 6 percent and in two years the interest rate on one-year bonds will be 6.5 percent. Assume that there is no term premium on a one-year bond. Suppose the term premium equals 0.5 percent ´ the number of years to maturity, for two-year bonds and three-year bonds. The interest rate today on the two-year bond is ____ and the interest rate today on a three-year bond is ____.

a.	5.5 percent; 5.8 percent
b.	6.0 percent; 6.3 percent
c.	6.2 percent; 6.8 percent
d.	6.5 percent; 7.3 percent

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate        TOP:   The Term Premium

TYP:   Conceptual

 

33. A downward-sloping yield curve is called a(n) ________ yield curve.

a.	upside-down
b.	reversible
c.	negative
d.	inverted

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

34. If you observe that the current yield curve is inverted, it is likely that the state of the business cycle is that

a.	an economic expansion has just begun.
b.	an economic expansion has been going on for several years.
c.	a recession is about to begin.
d.	a recession is nearly over.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

35. Usually in recessions, short-term interest rates ____ and long-term interest rates ____.

a.	rise; rise
b.	rise; fall
c.	fall; fall
d.	fall; rise

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

36. If you observe that the current yield curve is slightly upward sloping, it is likely that the state of the business cycle is that

a.	an economic expansion has just begun.
b.	an economic expansion has been going on for several years.
c.	a recession is about to begin.
d.	a recession is nearly over.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

37. If you observe that the current yield curve is sharply upward sloping, it is likely that the state of the business cycle is that

a.	an economic expansion has just begun.
b.	an economic expansion has been going on for several years.
c.	a recession is about to begin.
d.	an economic expansion is nearly over.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

38. Usually in expansions, short-term interest rates ____ and long-term interest rates ____.

a.	rise; rise
b.	rise; fall
c.	fall; fall
d.	fall; rise

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

39. When a recession is about to begin, you are likely to observe that

a.	the yield curve is sharply upward sloping.
b.	the yield curve is somewhat upward sloping.
c.	the yield curve is flat or inverted.
d.	the yield curve is upward sloping for short times to maturity, then downward sloping for longer times to maturity.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

 

40. When an economic expansion has just begun, you are likely to observe that

a.	the yield curve is sharply upward sloping.
b.	the yield curve is somewhat upward sloping.
c.	the yield curve is flat or inverted.
d.	the yield curve is upward sloping for short times to maturity, then downward sloping for longer times to maturity.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

41. When an economic expansion has been going on for several years, you are likely to observe that

a.	the yield curve is sharply upward sloping.
b.	the yield curve is somewhat upward sloping.
c.	the yield curve is flat or inverted.
d.	the yield curve is upward sloping for short times to maturity, then downward sloping for longer times to maturity.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   The Yield Curve and the Business Cycle                           TYP:   Factual

 

42. The term spread is the interest rate on a long-term debt security ________ the interest rate on a short-term debt security.

a.	minus
b.	plus
c.	times
d.	divided by

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   Policy Perspective: Can the Term Spread Help Predict Recessions?

TYP:   Factual

 

43. If the interest rate on three-month Treasury securities is 6 percent and the interest rate on ten-year Treasury securities is 4 percent, then

a.	the economy has probably just emerged from a recession.
b.	the yield curve slopes upward steeply.
c.	a recession is likely to occur.
d.	the economy is probably in the middle of an economic expansion.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   Policy Perspective: Can the Term Spread Help Predict Recessions?

TYP:   Conceptual

 

44. If the interest rate on three-month Treasury securities is 5 percent and the interest rate on ten-year Treasury securities is 6 percent, then the odds of a recession are

a.	less than 15 percent.
b.	about 25 percent.
c.	about 40 percent.
d.	about 80 percent.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   Policy Perspective: Can the Term Spread Help Predict Recessions?

TYP:   Conceptual

 

45. If the interest rate on three-month Treasury securities is 5 percent and the interest rate on ten-year Treasury securities is 5 percent, then the odds of a recession are

a.	less than 15 percent.
b.	between 25 percent and 40 percent.
c.	about 80 percent.
d.	100 percent.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   Policy Perspective: Can the Term Spread Help Predict Recessions?

TYP:   Conceptual

 

46. If the interest rate on three-month Treasury securities is 8 percent and the interest rate on ten-year Treasury securities is 6 percent, then the odds of a recession are

a.	less than 15 percent.
b.	between 25 percent and 40 percent.
c.	about 80 percent.
d.	100 percent.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   Policy Perspective: Can the Term Spread Help Predict Recessions?

TYP:   Conceptual

 

PROBLEM

 

1. Put the following securities in order according to their likely yields to maturity, from lowest to highest.

 

A:	A corporate bond rated Aaa (low risk)
B:	A corporate bond identical in every way to bond A, but rated Baa (medium risk)
C:	A corporate bond identical in every way to bond A, but rated C (high risk)

 

 

ANS:

A, B, C; riskier bonds have higher interest rates, to compensate investors for taking the additional risk.

 

PTS:   1                    TOP:   What Explains Differences in Interest Rates?

 

2. Put the following securities in order according to their after-tax interest rates, from lowest to highest. The federal tax rate on interest income is 30 percent. Show your work.

 

A:	A corporate bond pays an interest rate of 6 percent.
B:	A corporate bond identical in every way to bond A, but with an interest rate of 7 percent.
C:	A local government bond identical in every way to bond A, but with an interest rate of 4.5 percent

 

 

 

ANS:

The after-tax interest rate is (1 – t) ´ i for the corporate bonds, but the local government bond is free from tax.

 

A:	(1 – 0.3) ´ 6% = 4.2%
B:	(1 – 0.3) ´ 7% = 4.9%
C:	(1 – 0.0) ´ 4.5% = 4.5%

 

Order from lowest to highest: A, C, B

 

PTS:   1                    TOP:   What Explains Differences in Interest Rates?

 

3. Compare a two-year bond with two successive one-year bonds, in which an investor buys a one-year bond today, then another one-year bond when the first matures. Suppose the two-year bond has an annual interest rate of 4 percent.

 

Consider the pattern of interest rates on the one-year bonds listed below and explain whether an investor should buy the two-year bond or the one-year bond today, assuming that the only thing that matters to the investor is the amount of money she has at the end of the two years; that is, she is risk neutral. In each case, how much would an investor have at the end of two years if she invested $1,000 today? Show your work. Round to the nearest penny ($0.01). In each case be sure to say which bond the investor would buy today.

 

a.	The one-year interest rate today is 1 percent; the one-year interest rate will be 8 percent one year from now.
b.	The one-year interest rate today is 2 percent; the one-year interest rate will be 6 percent one year from now.
c.	The one-year interest rate today is 3 percent; the one-year interest rate will be 5 percent one year from now.
d.	The one-year interest rate today is 5 percent; the one-year interest rate will be 3 percent one year from now.

 

 

ANS:

a.	Two one-year bonds:	$1,000 ´ 1.01 ´ 1.08 = $1,090.80
	One two-year bond:	$1,000 ´ 1.042 = $1,081.60
b.	Two one-year bonds:	$1,000 ´ 1.02 ´ 1.06 = $1,081.20
	One two-year bond:	$1,000 ´ 1.042 = $1,081.60
c.	Two one-year bonds:	$1,000 ´ 1.03 ´ 1.05 = $1,081.50
	One two-year bond:	$1,000 ´ 1.042 = $1,081.60
d.	Two one-year bonds:	$1,000 ´ 1.05 ´ 1.03 = $1,081.50
	One two-year bond:	$1,000 ´ 1.042 = $1,081.60

 

 

PTS:   1                    TOP:   The Term Structure of Interest Rates

 

4. Suppose that a risk-neutral investor has a choice between buying a one-year bond paying 5 percent today, a two-year bond paying 5.4 percent today, a three-year bond paying 5.8 percent today, or a four-year bond paying 6.2 percent today, if a one-year bond purchased one year from now is expected to have an interest rate of 6 percent, a one-year bond purchased two years from now is expected to have an interest rate of 7 percent, and a one-year bond purchased three years from now is expected to have an interest rate of 8 percent. What sequence of bonds would the investor buy? Show your work.

 

ANS:

One-year bond today, followed by three successive one-year bonds: 1.05 ´ 1.06 ´ 1.07 ´ 1.08 = 1.286

 

Two-year bond today, followed by two successive one-year bonds: 1.054 ´ 1.054 ´ 1.07 ´ 1.08 = 1.284

 

Three-year bond today, followed by a one-year bond: 1.058 ´ 1.058 ´ 1.058 ´ 1.08 = 1.279

 

Four-year bond today: 1.062 ´ 1.062 ´ 1.062 ´ 1.062 = 1.272

 

The investor would buy a one-year bond today.

 

PTS:   1                    TOP:   The Term Structure of Interest Rates

 

5. Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates. You observe the following interest rates available today on bonds with differing times to maturity. (You may ignore transactions costs.)

 

Time to maturity	Yield to maturity
1 year	5.0%
2 years	7.0%
3 years	7.5%

 

The term premium for the two-year bond is the extra yield to maturity paid on a two-year bond compared with buying two separate one-year bonds (one today and another after one year). You believe that the term premium on the two-year bond is 0.5 percent.

 

The term premium for the three-year bond is the extra yield to maturity paid on a three-year bond compared with buying three separate one-year bonds (one today, another after one year, and another after two years). You believe that the term premium on the three-year bond is 1.0 percent.

 

Given your beliefs about the term premiums on two-year and three-year bonds, calculate the interest rates on one-year bonds that you expect to prevail one year from now and two years from now. In other words, what do you expect to be the yield to maturity on a one-year bond one year from now and what do you expect to be the yield to maturity on a one-year bond two years from now? Explain and show all your work.

 

 

ANS:

The term premium implies that

	.

 

 

PTS:   1                    TOP:   The Term Premium

 

6. Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates. The current interest rate on one-year bonds is 2 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 3 percent, and in two years, the interest rate on one-year bonds will be 4 percent. That is, using our standard notation,

= 2%,  = 3%, and  = 4%.

Assume that there is no term premium on a one-year bond.

 

a.	According to the expectations theory of the term structure of interest rates, what will the interest rate be today on a two-year bond and a three-year bond? That is, what is  and ?

 

Suppose the term premium equals 0.75 percent ´ the number of years to maturity, for the 2-year bond and the 3-year bond.

 

b.	Calculate the interest rate today on the two-year bond and the three-year bond, incorporating the term premium.
c.	Draw the yield curve for today, using the values you calculated in part b. Your drawing should show three points and should be drawn reasonably to scale, showing the values on each axis of each point plotted. Explain briefly (in one or two sentences) why the yield curve has the shape it does.

 

 

ANS:

a.	According to the expectations theory of the term structure, the interest rates are
		, and
		.
b.	The term premiums to be added onto the results in part a are:
		Two-year bond: 0.75% ´ 2 = 1.5%
		Three-year bond: 0.75% ´ 3 = 2.25%
	The interest rates are thus:
		Two-year bond:  = 2.5% + 1.5% = 4.0%
		Three-year bond:  = 3% + 2.25% = 5.25%

 

 

c.	Plot the points:  = 2%,  = 4%,  = 5.25%
	The yield curve slopes upward because short-term rates are expected to rise and there is a term premium.

 

 

PTS:   1                    TOP:   The Term Premium

 

7. What do steep upward-sloping yield curves indicate about the business cycle?

 

ANS:

A steep upward-sloping yield curve indicates that a recession has ended and an expansion has just begun. At such a time, people expect short-term interest rates to begin rising. Because of this expectation and because of the term premium, long-term interest rates should be greater than short-term interest rates.

 

PTS:   1                    TOP:   The Yield Curve and the Business Cycle

 

8. Explain how an economist could use the slope of the yield curve to analyze the probability that a recession will occur. Explain why the spread may matter.

 

ANS:

The smaller the term spread (the more inverted the yield curve), the greater are the odds of a recession. A smaller term spread may mean that monetary policy is tight and may show that banks will reduce lending, both of which are likely to slow economic growth.

 

PTS:   1                    TOP:   Policy Perspective: Can the Term Spread Help Predict Recessions?