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7. If the yield on a 5-year U.S. corporate bond is 7.45% and the yield on a 5-year U.S. Treasury note is 4.33%, the relative yield spread of the bond is closest to: A. 3.12%. B. 172.06%. C. 72.06%.

Ans: C; C is correct because Relative yield spread = (Bond yield – Benchmark yield)/Benchmark yield = (7.45% – 4.33%)/4.33% = 72.06%. A is not correct because 3.12% is the absolute yield spread = 7.45%-4.33%=3.12% B is not correct because 172.06% is the yield ratio = 7.45%/4.33% = 172.06%

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6. According to the Liquidity Preference Theory, if the yield curve is upward sloping, expectations of short-term rates in the future: A. must be rising. B. must be declining. C. can either be rising or declining.

Ans: C; Case 1: if the market believes short-term interest rates will risk in the future, adding a liquidity premium to the resulting upward sloped yield will keep the upward sloping trend of the yield curve; Case 2: even if the market believes short-term interest rates will decline in the future, adding a liquidity premium to the resulting downward sloped yield curve can result in an upward sloping yield curve; Therefore, C is correct.

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5. According to the Liquidity Preference Theory, is the term structure of interest rates most likely related to: A. expectations about future rates. B. interest rate risk. C. both expectations about future rates and interest rate risk.

Ans: C; C is correct because the liquidity preference theory believe that in addition to expectations about future short-term rates, investors require a risk premium for holding longer term bonds. Therefore, the term structure of interest rates is related to both expectation about future rates and interest rate risk.

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4. If investors expect stable rates of inflation in the future, the pure expectations theory suggests that the yield curve is currently: A. upward sloping. B. flat. C. inverted.

Ans: B; B is correct because pure expectations theory states that the yield for a particular maturity is an average of the short-term rates that are expected in the future. If the short-term rates are expected to be stable in the future, the yield curve will be flat.

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3. According to the market segmentation theory, an upward sloping yield curve is most likely due to: A. investor expectations that short-term interest rates will fall in the future. B. an increasing yield premium required by investors for bearing interest rate risk. C. different levels of supply and demand for short-term and long-term funds.

Ans: C; C is correct because the market segmentation theory asserts that the supply and demand for funds determine the interest rates for each maturity sector. A is not correct because pure expectations theory rather than market segmentation theory states that the yield for a particular maturity is an average of the short-term rates that are expected in the future. If the short-term rates are expected to rise in the future, the yield curve will be downward sloping. B is not correct because liquidity premium theory rather than market segmentation theory believes that investors require a risk premium for holding longer term bonds and bearing greater interest rate risk (duration).

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2. A bond market analyst states, “The current term structure of interest rates is upward sloping which implies the market believes short-term interest rates will rise in the future.” Which theory of the term structure of interest rates does the analyst most likely believe? A. Pure expectations theory. B. Liquidity preference theory. C. Market segmentation theory.

Ans: A; A is correct because under the pure expectations theory the only reason the yield curve will be upward sloping is because market participants believe that short-term rates will rise in the future. B is not correct because under the liquidity preference theory, the yield curve may take on any of the shapes we have identified. Even if the market believes short-term interest rates will decline in the future, adding a liquidity premium to the resulting downward sloped yield curve can result in an upward sloping yield curve. C is not correct because under the market segmentation theory, the term structure is consistent with any yield curve shape. It is supply and demand for debt securities at each maturity range that determines the yield for that maturity range.