Gypsy

Suppose the term structure of interest rates makes an instantaneous parallel upward shift of 100 basis points. Which of the following securities experiences the largest change in value? A five-year:

A) zero-coupon bond.

B) floating rate bond.

C) coupon bond with a coupon rate of 5%.

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The duration of a zero-coupon bond is equal to its time to maturity since the only cash flows made is the principal payment at maturity of the bond. Therefore, it has the highest interest rate sensitivity among the four securities. A floating rate bond is incorrect because the duration, which is the interest rate sensitivity, is equal to the time until the next coupon is paid. So this bond has a very low interest rate sensitivity.
A coupon bond with a coupon rate of 5% is incorrect because the duration of a coupon paying bond is lower than a zero-coupon bond since cash flows are made before maturity of the bond. Therefore, its interest rate sensitivity is lower.

Gypsy

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.

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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.

Gypsy

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.

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

Gypsy

Which theory of the term structure of interest rates concludes that the shape of the yield curve is determined by the supply and demand for securities in particular maturity ranges, and what shape of the yield curve is implied by this theory?

Theory

Yield curve

A) market segmentation    no specific shape

B) market segmentation upward sloping

C) liquidity preference   upward sloping

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The shape of the yield curve under market segmentation is determined by the supply and demand for securities within a given maturity range. No specific shape of the yield curve is implied by this theory.

Gypsy

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 increase in the future.

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

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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.

Gypsy

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

C) 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.

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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.

Gypsy

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

A) expectation hypothesis.

B) market segmentation theory.

C) GIC inverse term structure theory.

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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.

Gypsy

The liquidity preference theory holds that:

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

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

C) the yield curve has an upward-sloping bias.

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The liquidity preference theory suggests an upward-sloping bias with regard to the shape of the yield curve because 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. However, the yield curve can still be downward sloping even with a liquidity premium, for example if short-term interest rates are expected to decrease sharply in the future.

Gypsy

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

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

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

Gypsy

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

A) a flat yield curve.

B) a downward-sloping yield curve.

C) an upward-sloping yield curve.

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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.