LOS c, (Part 1): Explain the basic theories of the term structure of interest rates.

Q1. The term structure theory that rests on the interaction of supply and demand forces in the debt market is the:

A)   expectation hypothesis.

B)   GIC inverse term structure theory.

C)   market segmentation theory.

Q2. Which of the following statements regarding the different theories of the term structure of interest rates is least accurate?

A)   The market segmentation theory, pure expectations theory, preferred habitat theory, and liquidity preference theory are all consistent with any shape of the yield curve.

B)   The preferred habitat theory suggests that investors prefer to stay within a particular maturity range of the yield curve regardless of yields in other maturity ranges.

C)   An upward sloping yield curve can be consistent with the liquidity preference theory even with expectations of declining short term interest rates.

Q3. Which of the following is a correct interpretation of forward rates under the pure expectations hypothesis? Forward rates are equal to the expected future:

A)   rate differences between short and long-term bonds.

B)   spot rates.

C)   risk premiums on short-term bills.

Correct answer is B)

The pure expectations theory purports that forward rates are solely a function of expected future spot rates.

Q4. An analyst forecasts that spot interest rates will increase more than the increase implied by the current forward interest rates. Under these circumstances:

A)   the analyst should establish a bullish bond portfolio.

B)   the analyst should establish a bearish bond portfolio.

C)   all bond positions earn the same return.

Q5. The liquidity preference theory holds that:

A)   the yield curve should be upward-sloping.

B)   because they are so marketable, there is a liquidity premium that normally has to be paid to invest in short-term debt securities.

C)   cash should be preferred to Treasury securities because it is more liquid.

Q6. According to the expectations hypothesis, investors’ expectations of decreasing inflation will result in:

A)   a downward-sloping yield curve.

B)   a flat yield curve.

C)   an upward-sloping yield curve.

Q7. Suppose that the one-year forward rate starting one year from now is 6%. Which of the following statements is most accurate under the pure expectations hypothesis? The expected:

A)   future risk premium for short-term bills is 6%.

B)   future one-year spot rate in one year's time is equal to 6%.

C)   one-year forward rate in one year's time is equal to 6%.

Q8. According to the pure expectations theory an upward-sloping yield curve implies:

A)   longer-term bonds are riskier than short-term bonds.

B)   interest rates are expected to decline in the future.

C)   interest rates are expected to increase in the future.

LOS c, (Part 1): Explain the basic theories of the term structure of interest rates.fficeffice" />

Q1. The term structure theory that rests on the interaction of supply and demand forces in the debt market is the:

A)   expectation hypothesis.

B)   GIC inverse term structure theory.

C)   market segmentation theory.

Correct answer is C)

The market segmentation theory holds that the market is segmented into different parts based on the maturity preferences of investors. The theory also holds that the supply and demand forces at work within each segment determine the prevailing level of interest rates for that part of the market.

Q2. Which of the following statements regarding the different theories of the term structure of interest rates is least accurate?

A)   The market segmentation theory, pure expectations theory, preferred habitat theory, and liquidity preference theory are all consistent with any shape of the yield curve.

B)   The preferred habitat theory suggests that investors prefer to stay within a particular maturity range of the yield curve regardless of yields in other maturity ranges.

C)   An upward sloping yield curve can be consistent with the liquidity preference theory even with expectations of declining short term interest rates.

Correct answer is B)

The preferred habitat theory states that investors prefer to stay within a particular maturity range but will move from their preferred range to another area on the curve to achieve higher yields. With the liquidity preference theory the yield curve can remain upward sloping even if short term rates are predicted to decline as long as the liquidity premium is sufficiently large.

Q3. Which of the following is a correct interpretation of forward rates under the pure expectations hypothesis? Forward rates are equal to the expected future:

A)   rate differences between short and long-term bonds.

B)   spot rates.

C)   risk premiums on short-term bills.

Correct answer is B)

The pure expectations theory purports that forward rates are solely a function of expected future spot rates.

Q4. An analyst forecasts that spot interest rates will increase more than the increase implied by the current forward interest rates. Under these circumstances:

A)   the analyst should establish a bullish bond portfolio.

B)   the analyst should establish a bearish bond portfolio.

C)   all bond positions earn the same return.

Correct answer is B)

Bond prices fall with a rise in interest rates. If realized rates rise more than the associated forward rate implied, then a bearish bond position will be the most beneficial.

Q5. The liquidity preference theory holds that:

A)   the yield curve should be upward-sloping.

B)   because they are so marketable, there is a liquidity premium that normally has to be paid to invest in short-term debt securities.

C)   cash should be preferred to Treasury securities because it is more liquid.

Correct answer is A)

The liquidity preference theory definitely has an upward-sloping bias with regard to the shape of the yield curve. That is because it holds that investors generally prefer the greater liquidity and reduced risk that accompanies short-term securities and, as a result, require a premium (higher yields) to get them to invest in longer-term securities.

Q6. According to the expectations hypothesis, investors’ expectations of decreasing inflation will result in:

A)   a downward-sloping yield curve.

B)   a flat yield curve.

C)   an upward-sloping yield curve.

Correct answer is A)

The expectations hypothesis holds that the shape of the yield curve reflects investor expectations about the future behavior of inflation and market interest rates. Thus, if investors believe inflation will be slowing down in the future, they will require lower long-term rates today and, therefore, the yield curve will be downward-sloping.

Q7. Suppose that the one-year forward rate starting one year from now is 6%. Which of the following statements is most accurate under the pure expectations hypothesis? The expected:

A)   future risk premium for short-term bills is 6%.

B)   future one-year spot rate in one year's time is equal to 6%.

C)   one-year forward rate in one year's time is equal to 6%.

Correct answer is B)

Under the pure expectations hypothesis forward rates are equal to expected future spot rates.

Q8. According to the pure expectations theory an upward-sloping yield curve implies:

A)   longer-term bonds are riskier than short-term bonds.

B)   interest rates are expected to decline in the future.

C)   interest rates are expected to increase in the future.

Correct answer is C)

According to the expectations hypothesis, the shape of the yield curve results from the interest rate expectations of market participants.  More specifically, it holds that any long-term interest rate simply represents the geometric mean of current and future 1-year interest rates expected to prevail over the maturity of the issue.  The expectations theory can explain any shape of yield curve. 

Expectations for rising short-term rates in the future cause a rising (upward-sloping) yield curve; expectations for falling short-term rates in the future will cause long-term rates to lie below current short-term rates, and the yield curve will decline (or slope downward).

Thus, an upward-sloping yield curve implies that interest rates are expected to increase in the future.

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