Money and Banking - ECON 3115 (Chapter 6)

If junk bonds are​ "junk," then why would investors buy​ them?
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If junk bonds are​ "junk," then why would investors buy​ them?
Junk bonds can provide high yields.
Will a U.S. Treasury bill have a risk premium that is higher​ than, lower​ than, or the same as that of a similar security​ (in terms of maturity and​ liquidity) issued by the government of​ Colombia?
A U.S. Treasury bill will have a lower risk premium since U.S. government issued securities are usually considered to be default free.
In the fall of​ 2008, AIG, 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 AIG with large capital injections and an ownership stake. How would this​ affect, if at​ all, the yield and risk premium on AIG corporate​ debt?
The yield and risk premium will fall since demand for AIG corporate debt will increase.
Risk premiums on corporate bonds are usually anticyclical​; that​ is, they decrease during business cycle expansions and increase during recessions. Why is this​ so?
As the economy enters an​ expansion, there is greater likelihood that borrowers will be able to service their debt.
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.

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

Should we always trust​ credit-rating agencies?
When housing prices began to fall and subprime mortgages began to​ default, many​ AAA-rated products had to be downgraded over and over again.

No. Sometimes there are conflicts of interests in​ credit-rating agencies.
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?
Interest rates on corporate bonds will _____________ .
decrease
What would happen to the risk premiums of municipal bonds if the federal government guarantees today that it will pay creditors if municipal governments default on their payments.

Do you think that it will then make sense for municipal bonds to be exempt from income​ taxes?
Risk premium on municipal bonds will decrease.

No. If this were to​ happen, then municipal bonds will be even better than U.S. government bonds.
During​ 2008, the difference in yield​ (the yield spread​) between​ 3-month AA-rated financial commercial paper and​ 3-month AA-rated nonfinancial 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. Which of the following explains this sudden​ increase?
The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.
If the income tax exemption on municipal bonds were​ abolished, the interest rates on these bonds would _____
increase
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?
Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.
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?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?The risk premium would​ increase, which corresponds to segment B on the graphs above.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?The liquidity premium for a TIPS bond is usually smaller than inflation compensation in nominal U.S. bond yields of equal maturity.​"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?​False: These investments are almost of the same profitability.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:steepen at the end of the yield curve and flatten somewhere along the rest of the curveSuppose 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 B is indifferent with regard to holding​ five- and​ ten-year bonds. Which theories best explain the behavior of Investors A and​ B?Investor​ A's preferences are best explained by the segmented markets​ theory, while Investor​ B's preferences are more consistent with the expectations theory.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 B is indifferent with regard to holding​ five- and​ ten-year bonds. Which theories best explain the behavior of Investors A and​ B? Investor​ A's preferences are best explained by the _____ theory, while Investor​ B's are best explained by the ______ theory.segmented markets expectationsIf a yield curve looks like the one shown in the figure to the​ right, what is the market predicting about the movement of future​ short-term interest​ rates? The market is predicting that future​ short-term interest rates will ________. The​ market's predictions indicate that inflation will be ____ in the future.increase higherIf 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 _______ What might the yield curve indicate about the​ market's predictions for the inflation rate in the​future? The​ market's predictions indicate that inflation will ________ .increase in the near term, then decrease in the long term increase in the near term, then decrease in the long term .Suppose you observe a change in the relationship between​ short-term and​ long-term bonds.​ Specifically, you note that although interest rates on both​ short-term and​ long-term bond are rising​together, as​ expected, the rate on​ long-term bonds is not rising by as much as has been observed in the past. Assuming the liquidity premium theory of term​ structure, you conclude that the liquidity premium is ________ . As a​ result, the yield curve becomes ______decreasing flatterIf the yield curve suddenly becomes​ steeper, how would you revise your predictions of interest rates in the​ future? You would ______ change your predictions of future interest rates.raiseFollowing 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?The yield curve would shift​ down, but mostly on​ medium- and​ long-term maturities.How would your yield curve change if people preferred​ shorter-term bonds over​ longer-term bonds? The yield curve would become _____.steeperIf expectations of future​ short-term interest rates suddenly​ fall, what would happen to the slope of the yield​ curve?flatterYield curves for July 06, 2017 and July 06, 2016 across all the maturities are shown below. ​*Real time data provided by Federal Reserve Economic Data​ (FRED), Federal Reserve Bank of St. Louis. How do the two yield curves​ compare? What does the changing slope potentially say about changes in economic​ conditions? The most recent FOMC meeting policy statement occurred on June​ 14, 2017. The yield curve below shows yields for the end of trading day on that​ day, and the day prior. Was there any significant change in the yield curve as a result of the policy​ statement? How might this be​ explained?In​ general, the more recent yield curve is shifted up across most maturities by about 75 basis points. Increases in future​ short-term interest rates​ won't be as significant as anticipated a year earlier with a somewhat steeper long end of the yield curve. There is very little change between the two yield​ curves, indicating that for the most​ part, markets were not surprised by monetary policy​ actions, and that no unexpected monetary policy changes were implemented.The following table contains selected interest rate data from FREDopens in a new tab​* for March of 2021. ​*Real-time data provided by Federal Reserve Economic Data​ (FRED), Federal Reserve Bank of Saint Louis. Do the magnitudes of these interest rates conform to what economic theory would​ predict? ​(Check all that​ apply.)Yes. Since​Baa-rated corporate bonds have the highest default​risk, they also have the highest interest rate. Yes. Corporate bonds always have higher interest rates than U.S. Treasury bonds because they always have some risk of​default, whereas U.S. Treasury bonds have little to no risk of default.