EC 303 - Risk and Term Structure Homework

EC 303 - JSU - Risk and Term Structure Homework

As the economy enters an​ expansion, there is greater likelihood that borrowers will be able to service their debt.

Risk premiums on corporate bonds are usually

anticyclical​;

that​ is, they decrease during business cycle expansions and increase during recessions. Why is this​ so?

A: As the economy enters an​ expansion, there is greater likelihood that borrowers will be able to service their debt.

B: During an economic​ expansion, there is greater inflationary pressure driving interest rates upward.

C: As an economy enters a​ recession, business firms are less likely to default on their debt.

D: In anticipation of a​ recession, the Federal Reserve will begin to lower interest rates.

When housing prices began to fall and subprime mortgages began to​ default, many​ AAA-rated products had to be downgraded over and over again.

Just before the collapse of the subprime mortgage market in​ 2007, the most important​ credit-rating agencies rated​ mortgage-backed securities with Aaa and AAA ratings.

Part 2

Explain how it was possible that a few months into​ 2008, the same securities had the lowest possible ratings.

A: As inflation soared in early​ 2008, returns on​ mortgage-backed securities was wiped out. Many​ AAA-rated products had to be downgraded to junk status.

B: When housing prices began to fall and subprime mortgages began to​ default, many​ AAA-rated products had to be downgraded over and over again.

C: The government revoked tax exemption to investors for these​ securities, thereby lowering returns and ratings.

No. Sometimes there are conflicts of interests in​ credit-rating agencies.

Should we always trust​ credit-rating agencies?

Yes. The​ credit-rating agencies are involved with structuring products that they rate. This ensures that their ratings are often accurate. Sometimes credit rating agencies also make mistakes in assigning risks.

A: Yes. The​ credit-rating agencies are involved with structuring products that they rate. This ensures that their ratings are often accurate. Sometimes credit rating agencies also make mistakes in assigning risks

B: No. The credit rating agencies lack the mathematics and technology to assign correct ratings to securities.

C: No. Sometimes there are conflicts of interests in​ credit-rating agencies.

Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.

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?

A: Fees for home inspections may have been unreasonably high to ensure high profits for the inspection company.

B: Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.

C: Mortgage lenders may have wanted to increase home sales without assuming the additional costs to add more inspection companies.

D: This situation does not illustrate any conflict of​ interest, as the services provided by​ credit-ratings agencies and home inspection companies are unrelated.

The risk premium would​ increase, which corresponds to segment B on the graphs above.

In 2010 and​ 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market​ graphs, determine how default would affect the risk premium between U.S. Treasury debt and Greek debt with comparable maturity.

In the case of​ default, what would happen to the risk premium between U.S. Treasury debt and comparable maturity Greek​ debt?

A: The risk premium would​ decrease, which corresponds to segment A on the graphs above.

B: The risk premium would​ increase, which corresponds to segment B on the graphs above.

C: The risk premium would​ increase, which corresponds to segment C on the graphs above.

D: The risk premium would not change and therefore would equal zero.

Interest rates would rise because the reduction in income tax rates would make the​ tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds.

What effect would reducing income tax rates have on the interest rates of municipal​ bonds?

A: Interest rates would rise because Treasury securities are now less valuable and more people will want to hold municipal bonds.

B: Interest rates would rise because the reduction in income tax rates would make the​ tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds.

C: Interest rates would fall because Treasury securities are now less valuable and more people will want to hold municipal bonds.

D: Interest rates would fall because the reduction in income tax rates would make the​ tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds.

Yes, because the reduction in the​ tax-exempt privilege in municipal bonds would raise the relative value of Treasury​ securities, making Treasury securities more desirable.

Would interest rates of Treasury securities be affected by the tax rate​ change?

A: Yes, because the increase in interest rates would increase the desire to hold more municipal bonds and less Treasury securities.

B: Yes, because municipal bonds are less risky than Treasury​ securities, the demand for Treasury securities will decrease.

C: No, there would be no impact on the market for Treasury securities.

D: Yes, because the reduction in the​ tax-exempt privilege in municipal bonds would raise the relative value of Treasury​ securities, making Treasury securities more desirable.

Steepen at the end of the yield curve and flatten somewhere along the rest of the curve

Assume the expectations theory of the term structure holds.

If bond investors decide that​ 30-year bonds are no longer as desirable an​ investment, the yield curve​ would:

A: Steepen at the end of the yield curve and flatten somewhere along the rest of the curve

B: Slope less steeply upward toward the​ 30-year rate and remain the same after it.

C: Flatten near the​ 30-year rate and steepen slightly along the smaller rates.

D: Result in a jump in the 30 minus year rate comma with the remainder of the yield curve unchanged.

increase in the near term, then decrease in the long term

If a yield curve looks like the one shown in the diagram to the​ right, what is the market predicting about the movement of future​ short-term interest​ rates?

The market is predicting that​ short-term interest rates will:

Therefore, inflation will do the same.

0.00%
1.50%
3.33%
4.25%
5.00%

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.

Year	​One-Year Bond Rate	Multiyear Bond Rate
1	2.002.00​%	2.002.00​%
2	5.005.00​%	5.005.00​%
3	7.007.00​%	8.008.00​%
4	9.009.00​%	10.0010.00​%
5	12.0012.00​%	12.0012.00​%

Part 2

The liquidity premiums for each year are given​ as: ​(Enter your responses rounded to two decimal​ places.)

l Subscript 11	equals=	%
l Subscript 21	equals=	%
l Subscript 31	equals=	%
l Subscript 41	equals=	%
l Subscript 51	equals=	​%

ET: 2
PH: 4
SM: 1

1.	The interest rate for each bond with a different maturity is determined by the supply of and demand for that​ bond, with no effects from expected returns on other bonds with other maturities.
2.	The interest rate on a​ long-term bond will equal an average of the​ short-term interest rates that people expect to occur over the life of the​ long-term bond.
3.	When​ short-term interest rates are​ low, yield curves are more likely to have an upward​ slope; when​ short-term interest rates are​ high, yield curves are more likely to slope downward and be inverted.
4.	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 liquidity premium​ (also referred to as a term​ premium) that responds to supply and demand conditions for that bond.

Expectations Theory:

Preferred Habit:

Segmented Markets: