The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

Chapter 6

The Risk and Term Structure of Interest Rates - all with Video Answers

Educators

Chapter Questions

Problem 1

If junk bonds are "junk," then why would investors buy them?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 2

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?

Sandile Ndlovu

Numerade Educator

Problem 3

Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs?

Sandile Ndlovu

Numerade Educator

Problem 4

In the fall of $2008,$ AlG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result. the U.S. government stepped in to support AlG with large capital injections, and an ownership stake. How would this affect, if at all, the yield and risk premium on $\mathrm{AlG}$ corporate debt?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 5

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Rashmi Sinha

Numerade Educator

Problem 6

"If bonds of different maturities are close substitutes, their interest rates are more likely to move together." Is this statement true, false, or uncertain? Explain your
answer.

Sandile Ndlovu

Numerade Educator

Problem 7

The U.S. Treasury offers some of its debt as Treasury Inflation Protected Securities, or TIPS, in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premium between TIPS and nominal U.S. bonds?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 8

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?

Rashmi Sinha

Numerade Educator

Problem 9

Predict what would happen to the risk premiums on corporate bonds if brokerage commissions were lowered in the corporate bond market.

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 10

During 2008 , the difference in yield (the yicld spread) between three-month AA-rated financial commercial paper and three-month AA-rated non financial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October $2008 .$ What explains this sudden increase?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 11

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 12

Prior to 2008 , mortgage lenders required a house inspection to assess its value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in $2008,$ mortgage lenders required a house inspection, but this was arranged through a third party How does this illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 13

"According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond, if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 14

If bond investors decide that 30 -year bonds are no longer as desirable an investment, predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds; and
(b) the segmented markets theory of the term structure holds.

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 16

Suppose the interest rates on one-, five-, and ten-year
U.S. Treasury bonds are currently $3 \%, 6 \%,$ and $6 \%$ respectively, Investor A chooses to hold only one-year bonds, and Investor $\mathrm{B}$ is indifferent with regard to holding five- and ten-year bonds. How can you explain the behavior of Investors $A$ and $B ?$

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 16

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the markets predictions for the inflation rate in the future?

Sandile Ndlovu

Numerade Educator

Problem 17

If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the markets predictions for the inflation rate in the future?

Sandile Ndlovu

Numerade Educator

Problem 18

If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?

Heather Duong

Numerade Educator

Problem 19

If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 20

If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 21

Following a policy meeting on March 19,2009 , the Federal Reserve made an announcement that it would purchase up to $\$ 300$ billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 22

In 2010 and 2011 , the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, show the effect on the risk premium between U.S. Treasury debt and comparable maturity Greek debt.

Oluwadamilola Ameobi

Oluwadamilola Ameobi

Numerade Educator

Problem 23

Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yicld curves for the following paths of one-year interest rates over the next five years:
a. $5 \%, 7 \%, 7 \%, 7 \%, 7 \%$
b. $5 \%, 4 \%, 4 \%, 4 \%, 4 \%$
How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?

Jennifer Stoner

Jennifer Stoner

Numerade Educator

Problem 24

Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years:
a. $5 \%, 6 \%, 7 \%, 6 \%, 5 \%$
b. $5 \%, 4 \%, 3 \%, 4 \%, 5 \%$
How would your yield curves change if people preferred shorter-term bonds over longer-term bonds?

Jennifer Stoner

Jennifer Stoner

Numerade Educator

Problem 25

The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
$$\begin{array}{|ccc|}
\hline \text { Year } & \begin{array}{l}
\text { One-Year } \\
\text { Bond Rate }
\end{array} & \begin{array}{l}
\text { Multiyear } \\
\text { Bond Rate }
\end{array} \\
\hline 1 & 2 \% & 2 \% \\
2 & 3 \% & 3 \% \\
3 & 4 \% & 5 \% \\
4 & 6 \% & 6 \% \\
5 & 7 \% & 8 \% \\
\hline
\end{array}$$

Aryan Tiwari

Numerade Educator