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Bond investors can avoid the risk that interest rates will rise and drive bond prices down by: A) buying zero coupon bonds. B) buying Treasury bonds. C) holding bonds over one year. D) holding bonds till maturity. Ans: D 2. Which of the following is not a reason U.S.investors invest in foreign bonds? A) to gain diversification B) potentially higher returns than U.S. bonds C) lower transactions costs and taxes. D) All of the above are reasons U.S. investors invest in foreign bonds. Ans: C 3. The introduction of the Euro is expected to: A) increase the transactions cost of trading foreign bonds. B) decrease the transactions cost of trading foreign bonds. C) have no effect on the transactions cost of trading foreign bonds. D) have a minimal effect on the transactions cost of trading foreign bonds. Ans: B 4. Which of the following is considered to have the biggest impact on bond yields? A) economic growth B) business cycles C) inflation D) Federal Reserve actions Ans: C 5. The term structure of interest rates is also known as the: A) yield to maturity. B) probability distribution. C) yield differential. D) yield curve. Ans: D

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6. Under the expectations theory, investors expecting interest rates to rise will: A) invest more now in short term bonds rather than in long term bonds. B) invest more now in long term bonds rather than in short term bonds. C) invest more now in Treasury bonds rather than in corporate bonds. D) invest more now in corporate bonds rather than in Treasury bonds. Ans: A 7. Which of the following yield curve theories expect investors to stay in one maturity segment, regardless of opportunities in other maturity segments? A) expectations theory B) liquidity preference theory C) market segmentation theory D) preferred habitat theory Ans: C 8. Since the 1930s, the yield curve most likely to be seen has been the: A) upward sloping yield curve. B) downward sloping yield curve. C) flat yield curve. D) skewed yield curve. Ans: A 9. An inverted yield curve or flattening of the yield curve is considered a good predictor of a: A) rising economy. B) recession. C) depression. D) stock market crash. Ans: B 10. Which of the following is not a reason for a yield spread? A) differences in call features. B) differences in coupon rates. C) differences in maturity D) differences in quality. Ans: C

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11. Investors would expect a higher yield on a smaller, regional corporate bond than on a large, national corporate bond mainly due to: A) differences in coupon rates. B) differences in quality. C) differences in tax treatments. D) differences in marketability. Ans: D 12. Which of the following statements concerning yield spreads is not true? A) Yield spreads may be positive or negative. B) Yield spreads are often calculated by changing the maturity of the different bonds. C) Yield spreads are influenced by the level of interest rates in the market. D) Yield spreads can change over time. Ans: B 13. According to the expectations theory, long-term rates must; A) equal the present value of the expected cashflows from the bonds involved. B) equal the geometric mean of a series of expected future short-term rates. C) always be higher than short-term rates. D) be an average of the present and future short-term rates. Ans: D 14. The yield curve is normally plotted using Treasury securities because: A) they have a wide range of maturities. B) it is easier to obtain accurate and complete data on them. C) they have no default risk. D) it is easier to obtain historical data on them. Ans: C 15. The preferred habitat theory is most similar to the: A) expectations theory. B) liquidity preference theory. C) market segmentation theory. D) pecking order theory. Ans: C

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16. A major difference between the liquidity preference theory and the expectations theory is that the: A) liquidity preference theory only deals in short-term securities. B) liquidity preference theory recognizes that interest rate expectations are uncertain. C) liquidity preference theory only deals in long-term securities. D) liquidity preference theory assumes investors are risk averse and the expectations theory does not. Ans: B 17. According to the expectations theory, an upward sloping curve indicates that investors expect: A) interest rates to become more volatile in the future. B) interest rates to rise in the future. C) interest rates to fall in the future. D) interest rates to become negative in the future. Ans: B 18. According to the preferred habitat theory, which of the following is NOT true? A) Borrowers and lenders have preferred maturity sectors. B) The yield curve can take any shape. C) Borrowers and lenders do not go outside their preferred maturity segments. D) Expectations of future interest rates affects the shape of the yield curve. Ans: C 19. Forward rates: A) are an average of current short-term and long-term rates. B) are observable and anticipated. C) are observable and unanticipated. D) are unobservable and anticipated Ans: D 20. Yield spreads tend to____ during recessions and ________ during times of economic prosperity. A) narrow . . . widen B) widen . . . narrow C) stay constant . . . widen D) widen . . . stay constant Ans: B

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21. The _________ theory of yield curves states that investors will not invest long term unless they have an economic incentive. A) expectations. B) liquidity premium C) market segmentation D) economic value added Ans: B 22. Which of the following is not a passive bond strategy? A) an immunization strategy B) a bond swap strategy C) a buy and hold strategy D) an indexing strategy Ans: B 23. A bond strategy attempting to immunize the portfolio from interest rate risk is based on the concept of: A) buy and hold. B) horizon analysis. C) duration concept. D) indexing. Ans: C 24. A portfolio is said to be immunized if: A) the present value of the cashflows equals the principal. B) the duration of the portfolio is equal to the term. C) the present value of the cashflows is greater than the principal. D) the duration of the portfolio is equal to the investment horizon. Ans: D 25. One form of interest rate forecasting has the investor evaluating bonds being considered for purchase over a selected holding period in order to determine which will perform the best and is known as: A) holding-period analysis. B) time-series analysis. C) horizon analysis. D) duration planning. Ans: C

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26. Which of the following statements regarding classical immunization is false? A) It is easy to implement. B) It requires frequent rebalancing. C) It is not a passive bond strategy. D) It faces real-world problems in its implementation. Ans: A 27. Immunization is a strategy in which bond investors: A) buy only high-quality bonds. B) attempt to avoid default risk. C) attempt to avoid call and convertible risk. D) attempt to avoid reinvestment and price risk. Ans: D 28. James wants to invest in bonds and has a 10 year investment horizon. To immunize his portfolio, he must buy bonds with durations of ________ 10 years. These bonds will have maturities __________ 10 years. A) greater than; less than B) equal to; less than C) less than; equal to D) equal to; greater than Ans: D 29. Interest rate risk is composed of: A) market risk and default risk. B) price risk and credit risk. C) price risk and reinvestment risk. D) default risk and money risk. Ans: C 30. A bond investor has $100,000 to invest and has determined 10 years is his maximum term. He puts $10,000 in one-year bonds, $10,000 in two-year bonds, $10,000 in threeyear bonds, etc. all the way to $10,000 in ten-year bonds. This is an example of: A) bond equality B) bond laddering C) bond blending D) bond term management Ans: B

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31. Which of the following statements regarding bond terms is FALSE? A) Short maturities protect investors when interest rates rise. B) Longer maturities have greater price fluctuations. C) Longer maturities are more liquid than shorter maturies. D) Longer maturities have a chance for larger gains. Ans: C 32. A major advantage of bond index funds is their: A) higher performance than regular bond funds. B) ability to shelter income from taxes. C) relatively low expense ratios. D) all of the above are true, Ans: C 33. Which of the following is not one of the strategies normally employed by conservative bond investors? A) flexible-income funds strategy B) buy-and-hold approach C) shorter-term Treasury bonds D) bond swaps Ans: D 34. Which of the following often emphasize short-term European securities and have been popular in recent years? A) international money market fund B) short-term world multimarket income funds C) global short-term government securities funds D) foreign short-term index funds Ans: B 35. Speculation in the bond market has decreased significantly in the last 20 years. A) True B) False Ans: B 36. A weaker dollar increases the value of dollar-denominated assets to foreign investors. A) True B) False Ans: B

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37. An increase in expected inflation tends to decrease bond prices and bond yields. A) True B) False Ans: A 38. The term structure of interest rates shows the relationship between yields of several categories of bonds, such as municipals and corporates, and their maturities. A) True B) False Ans: B 39. The term structure of interest rates consists of a set of forward rates and a current known rate. A) True B) False Ans: A 40. A commercial bank that always invested in short-term bonds in order to meet deposit withdrawals is a a good example of the liquidity preference theory. A) True B) False Ans: B 41. The yield curve is considered one of the best ways to price a bond. A) True B) False Ans: B 42. A noncallable bond would be expected to have a higher yield to maturity than a comparable callable bond. A) True B) False Ans: B 43. The size of yield spreads tends to remain constant over time. A) True B) False Ans: B

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44. Yield spreads were at their widest during the Great Depression. A) True B) False Ans: A 45. A strong argument made for passive bond strategies is that it is very difficult to time bond transactions in order to take advantage of swings in the bond market. A) True B) False Ans: A 46. Under the ladder approach, bond investors purchase bonds with different maturities in order to gain some protection from default risk. A) True B) False Ans: B 47. If interest rates rise, then price risk and reinvestment risk decline. A) True B) False Ans: B 48. Why are upward sloping yield curves more consistent with the usual risk-return tradeoff than downward sloping yield curves? Ans: Long-term bonds have more interest-rate risk than short-term bonds. Thus the added risk of long-term is rewarded with higher returns on an upward sloping yield curve. 49. Briefly explain the four theories explaining the term structure of interest rates. Ans: Expectations theory long-term rates are the geometric average of the present yield on short term securities and expected short-term rates. Liquidity preference theory like expectations theory with a liquidity premium added. Preferred habitat theory investors have preferred maturity sectors but may shift if they expect adequate compensation. Market segmentation theory investors have preferred maturity sectors but are unwilling to shift.

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50. What are the two components of interest-rate risk? How do they work to immunize a portfolio? Ans: The two parts are price risk and reinvestment rate risk. Together immunization can occur because they offset each other. When interest rates go down, bond prices go up, but the income from reinvestment goes down. The two offset one another. 51. What are two passive management strategies? Two active strategies? Ans: Passive buy and hold and indexing. Active forecasting interest rate changes and identifying mispricing. 52. A client tells you that he strongly believes that interest rates in general will fall abruptly over the next six months. He asks you to recommend bonds for a portfolio to provide capital gains on the interest rate move. Generally, what would you suggest? What if he expected rates to rise? Ans: He will get the biggest price increases from low-coupon, long-term bonds if rates fall. If rates rise he will experience capital losses, so he should hold cash or shortterm securities. 53. What are the advantages of index funds for an individual bond investor? Ans: Many aggressively managed funds do not beat the market performance. Index funds should have lower advisory fees and operating expenses because indexing is a passive management approach. 54. Why is immunization considered to be a hybrid strategy? Ans: Immunization is a hybrid between passive and active management strategies. It appears passive in that the initial portfolio is chosen so that the portfolio duration is equal to the portfolio's designated time horizon. It must be actively managed, however, in that it must be rebalanced frequently to maintain the duration equal to the investment horizon. 55. Immunization is intended to protect a portfolio against interest rate risk. What should be done? How does it work? Ans: The portfolio duration should be set equal to a specified time horizon. It works because losses (gains) from price changes are offset by changes in income from reinvestment.

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56. You are asked to invest $30 million in a bond portfolio consisting of only two bonds. Bond A has a duration of 4.36 years, and bond B has a duration of 6.50 years. The portfolio is to have an investment horizon of 5 years. How much of each bond issue would you have to buy to immunize the portfolio? Ans: The portfolio's duration must equal the investment horizon. The portfolio's duration is the weighted average of the bonds' durations. Let W be the weight of bond A. Then (1 W) is the weight of bond B. W(4.36) + (1 W)(6.50) = 5 2.14W = 1.5 W = 0.70 Invest in 70 percent bond A and 30 percent bond B.

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