ECON 101 PFP Chapter 2 Exam Review Test Answered 100% Correctly!

2. Summarize the expectation theory and the preferred habitat the theory of the term structure of interest rates. Are these theories related, or are they alternative explanations of the term structure? Answer: The expectation theory holds that the shape of the yield curve is determined by the investors’ expectations of future interest rate movements and that changes in these expectations change the shape of the yield curve. The preferred habitat theory asserts that investors will not hold debt securities outside their preferred habitat without an additional reward in the form of a risk premium Available evidence is not sufficiently persuasive to establish any one theory as being totally correct in explaining the term structure of interest rates. Market participants tend to favor the preferred habitat theory, whereas economists tend to favor the expectation and liquidity premium approaches. Day to day changes in the term structure reveal patterns that are most consistent with the preferred appear not to be transmitted immediately to other segments. 5. What do bond ratings measure? Explain some of the important factors in determining a security’s bond rating Answer: Bond ratings are published rankings of bonds based on relative default risk. Three major firms on Wall Street do bond ratings: Moody’s Investors Service, Standard & Poor’s, and Fitch. All three agencies rank bonds in order of their perceived probability of default and publish the ratings as letter grades. The highest grade bonds, those with the lowest default risk, are rated Aaa. As the default risk p