FIN 310 CORRECT TEST PAPER QUESTIONS AND
ANSWERS SURE A+
✔✔Pure Expectations Theory:
Explain how a yield curve would shift in response to a sudden expectation of rising
interest rates, according to the pure expectations theory. - ✔✔The demand for short-
term securities would increase, placing upward (downward) pressure on their prices
(yields).
The demand for long-term securities would decrease, placing downward (upward)
pressure on their prices (yields).
If the yield curve was originally upward sloped, it would now have a steeper slope as a
result of the expectation.
If it was originally downward sloped, it would now be more horizontal (less steep), or
may have even become upward sloping.
✔✔What is the meaning of the forward rate in the context of the term structure of
interest rates? - ✔✔The forward rate is the expected interest rate at a future point in
time.
✔✔Why might forward rates consistently overestimate future interest rates? How could
such a bias be avoided? - ✔✔If forward rates are estimated without considering the
liquidity premium, it may overestimate the future interest rates.
If a liquidity premium is accounted for when estimating the forward rate, the bias can be
eliminated.
✔✔Pure Expectations Theory - ✔✔A theory that states that the shape of the yield curve
depends on investors' expectations about future interest rates.
,✔✔Assume an expectation of lower interest rates in the future arises quite suddenly.
What would be the effect on the shape of the yield curve? Explain. - ✔✔The demand for
short-term securities would decrease, placing downward (upward) pressure on their
prices (yields). The demand for long-term securities would increase, placing upward
(downward) pressure on their prices (yields). If the yield curve was originally upward
sloped, it would now be more horizontal (less steep). If it was downward sloped, it would
now be more steep.
✔✔Liquidity Premium Theory - ✔✔Investors prefer short-term liquid securities but will
be willing to invest in long-term securities if compensated with a premium for lower
liquidity
If investors believe that securities with larger maturities are less liquid, they will require a
premium when investing in such securities to compensate. This theory can be combined
with the other theories to explain the shape of a yield curve.
✔✔Impact of Liquidity Premium on a Forward Rate - ✔✔When considering a liquidity
premium, the estimate of a forward interest rate will be reduced.
✔✔Segmented Markets Theory - ✔✔a theory of term structure that sees the markets for
different-maturity bonds as completely separated and segmented, so that the interest
rate on bonds of a given maturity is determined solely by supply of and demand for
bonds of that maturity
✔✔If a downward-sloping yield curve is mainly attributed to segmented markets theory,
what does that suggest about the demand for and supply of funds in the short-term and
long-term maturity markets? - ✔✔A downward-sloped yield curve suggests that the
demand for short-term funds is high relative to the supply of short-term funds, causing a
high yield. In addition, the demand for long-term funds is low relative to the supply of
long-term funds, causing a low yield.
✔✔If the segmented markets theory causes an upward-sloping yield curve, what does
this imply? If - ✔✔An upward-sloped yield curve caused by segmented markets implies
that the demand for short-term funds is low relative to the supply of short-term funds. In
addition, the demand for long-term funds is high relative to the supply of long-term
funds.
✔✔if markets are not completely segmented, should we dismiss the segmented
markets theory as even a partial explanation for the term structure of interest rates? -
✔✔Even if markets are not completely segmented, investors and borrowers may prefer
a particular maturity market. Therefore, they may only switch to a different maturity if
there is sufficient compensation (such as a higher return for investors or a lower cost of
borrowing for borrowers).
, ✔✔Preferred Habit Theory - ✔✔The preferred habitat theory suggests that while
investors and borrowers may prefer a natural maturity, they may wander from that
maturity under conditions where they can benefit from selecting a different maturity.
✔✔What happens when long-term borrowing takes place? - ✔✔the Treasury borrowed
heavily in the long-term markets, it could place upward pressure on long-term rates
without having as much of an impact on short-term rates. If the markets are segmented,
the effect of the Treasury's actions would be more pronounced.
✔✔Flat Yield Curve - ✔✔flat yield curve without consideration of a liquidity premium
would represent no expected change in interest rates according to the pure
expectations theory. Therefore, if the flat yield curve reflects the existence of a liquidity
premium, this curve would actually have a slight downward slope when removing the
liquidity premium. This suggests expectations of a slight decline in future interest rates.
✔✔Global Interaction among Yield Curves - ✔✔If yield curves are affected in the US
they are similarly affected in other countries
✔✔Effects of crises on the yield curve - ✔✔The movement into money market securities
results in a larger supply of short-term funds and lowers short-term interest rates. Thus,
the yield curve becomes more steeply sloped. The shift in the yield curve is due to a
preference for investors to move their funds into safe short-term securities, which
reflects segmented markets theory, a preference for liquidity.
✔✔Assessing interest rate differentials among countries - ✔✔The risk-free foreign
interest rates are determined by supply and demand for funds in their local currency.
Inflationary expectations affect the risk-free interest rate. Thus, the difference in interest
rates between the countries with very high interest rates versus low interest rates is
primarily attributed to risk-free rate differentials. The credit risk premium is typically
higher in the countries with very high interest rates, but that is not the primary reason for
the large difference between countries with very interest rates versus low interest rates.
✔✔Changes to credit rating process - ✔✔close more information about how they
derived their credit ratings. In addition, the employees of each credit rating agency that
promotes the services of the agency are not allowed to influence the ratings assigned
by the rating agency. They are giving more attention to sensitivity analysis in which they
assess how creditworthiness might change in response to abrupt changes in the
economy.
✔✔How a credit crisis can paralyze credit markets - ✔✔- Fed can ensure availability of
funds in the financial system, by using monetary policy to expand money supply= a
large increase in the supply of funds available, and decline in demand for funds, results
in a decline in the risk-free interest rate.
ANSWERS SURE A+
✔✔Pure Expectations Theory:
Explain how a yield curve would shift in response to a sudden expectation of rising
interest rates, according to the pure expectations theory. - ✔✔The demand for short-
term securities would increase, placing upward (downward) pressure on their prices
(yields).
The demand for long-term securities would decrease, placing downward (upward)
pressure on their prices (yields).
If the yield curve was originally upward sloped, it would now have a steeper slope as a
result of the expectation.
If it was originally downward sloped, it would now be more horizontal (less steep), or
may have even become upward sloping.
✔✔What is the meaning of the forward rate in the context of the term structure of
interest rates? - ✔✔The forward rate is the expected interest rate at a future point in
time.
✔✔Why might forward rates consistently overestimate future interest rates? How could
such a bias be avoided? - ✔✔If forward rates are estimated without considering the
liquidity premium, it may overestimate the future interest rates.
If a liquidity premium is accounted for when estimating the forward rate, the bias can be
eliminated.
✔✔Pure Expectations Theory - ✔✔A theory that states that the shape of the yield curve
depends on investors' expectations about future interest rates.
,✔✔Assume an expectation of lower interest rates in the future arises quite suddenly.
What would be the effect on the shape of the yield curve? Explain. - ✔✔The demand for
short-term securities would decrease, placing downward (upward) pressure on their
prices (yields). The demand for long-term securities would increase, placing upward
(downward) pressure on their prices (yields). If the yield curve was originally upward
sloped, it would now be more horizontal (less steep). If it was downward sloped, it would
now be more steep.
✔✔Liquidity Premium Theory - ✔✔Investors prefer short-term liquid securities but will
be willing to invest in long-term securities if compensated with a premium for lower
liquidity
If investors believe that securities with larger maturities are less liquid, they will require a
premium when investing in such securities to compensate. This theory can be combined
with the other theories to explain the shape of a yield curve.
✔✔Impact of Liquidity Premium on a Forward Rate - ✔✔When considering a liquidity
premium, the estimate of a forward interest rate will be reduced.
✔✔Segmented Markets Theory - ✔✔a theory of term structure that sees the markets for
different-maturity bonds as completely separated and segmented, so that the interest
rate on bonds of a given maturity is determined solely by supply of and demand for
bonds of that maturity
✔✔If a downward-sloping yield curve is mainly attributed to segmented markets theory,
what does that suggest about the demand for and supply of funds in the short-term and
long-term maturity markets? - ✔✔A downward-sloped yield curve suggests that the
demand for short-term funds is high relative to the supply of short-term funds, causing a
high yield. In addition, the demand for long-term funds is low relative to the supply of
long-term funds, causing a low yield.
✔✔If the segmented markets theory causes an upward-sloping yield curve, what does
this imply? If - ✔✔An upward-sloped yield curve caused by segmented markets implies
that the demand for short-term funds is low relative to the supply of short-term funds. In
addition, the demand for long-term funds is high relative to the supply of long-term
funds.
✔✔if markets are not completely segmented, should we dismiss the segmented
markets theory as even a partial explanation for the term structure of interest rates? -
✔✔Even if markets are not completely segmented, investors and borrowers may prefer
a particular maturity market. Therefore, they may only switch to a different maturity if
there is sufficient compensation (such as a higher return for investors or a lower cost of
borrowing for borrowers).
, ✔✔Preferred Habit Theory - ✔✔The preferred habitat theory suggests that while
investors and borrowers may prefer a natural maturity, they may wander from that
maturity under conditions where they can benefit from selecting a different maturity.
✔✔What happens when long-term borrowing takes place? - ✔✔the Treasury borrowed
heavily in the long-term markets, it could place upward pressure on long-term rates
without having as much of an impact on short-term rates. If the markets are segmented,
the effect of the Treasury's actions would be more pronounced.
✔✔Flat Yield Curve - ✔✔flat yield curve without consideration of a liquidity premium
would represent no expected change in interest rates according to the pure
expectations theory. Therefore, if the flat yield curve reflects the existence of a liquidity
premium, this curve would actually have a slight downward slope when removing the
liquidity premium. This suggests expectations of a slight decline in future interest rates.
✔✔Global Interaction among Yield Curves - ✔✔If yield curves are affected in the US
they are similarly affected in other countries
✔✔Effects of crises on the yield curve - ✔✔The movement into money market securities
results in a larger supply of short-term funds and lowers short-term interest rates. Thus,
the yield curve becomes more steeply sloped. The shift in the yield curve is due to a
preference for investors to move their funds into safe short-term securities, which
reflects segmented markets theory, a preference for liquidity.
✔✔Assessing interest rate differentials among countries - ✔✔The risk-free foreign
interest rates are determined by supply and demand for funds in their local currency.
Inflationary expectations affect the risk-free interest rate. Thus, the difference in interest
rates between the countries with very high interest rates versus low interest rates is
primarily attributed to risk-free rate differentials. The credit risk premium is typically
higher in the countries with very high interest rates, but that is not the primary reason for
the large difference between countries with very interest rates versus low interest rates.
✔✔Changes to credit rating process - ✔✔close more information about how they
derived their credit ratings. In addition, the employees of each credit rating agency that
promotes the services of the agency are not allowed to influence the ratings assigned
by the rating agency. They are giving more attention to sensitivity analysis in which they
assess how creditworthiness might change in response to abrupt changes in the
economy.
✔✔How a credit crisis can paralyze credit markets - ✔✔- Fed can ensure availability of
funds in the financial system, by using monetary policy to expand money supply= a
large increase in the supply of funds available, and decline in demand for funds, results
in a decline in the risk-free interest rate.
