5: Risk and Term Structure of Interest Rates Risk and Uncertainty 1.

A person who is relatively risk averse will be likely to hold: (a) no money as a financial asset. (b) relatively large amounts of real estate. (c) assets expected to earn relatively low rates of return, but the variance and standard deviations on these returns also tend to be relatively low. (d) a single financial asset such as stock in XYZ corporation. (e) a relatively more diversified asset portfolio, overall. 2. The likelihood of an event during a given time interval: (a) can be precisely determined from comprehensive data about the historical frequency of the event. (b) has no effect on the rate an insurer will charge to guarantee a policyholder against losses if the event occurs. (c) can never be exactly and precisely determined. (d) is either zero or one after the time interval has passed. (e) can be measured cardinally, but not ordinally. 3. Frank Knights definition of uncertainty is (relatively) most applicable to the concept of: (a) interest rate risk. (b) default risk. (c) market risk. (d) foreign exchange risk. (e) specific risk. (f) inflation risk. 4. According to Frank Knight, risk, unlike pure uncertainty: (a) is totally unpredictable. (b) is a major source of pure economic profits. (c) may reasonably be estimated. (d) cannot be taken into account when firms make decisions about production and pricing. 5. According to Frank Knight, economic profits are: (a) rewards to entrepreneurs for bearing uncertainty. (b) easily capitalized for firms possessing monopoly power. (c) rewards for innovation. (d) easily predicted if competent economic forecasting is employed. (e) equal to accounting profits in short-run equilibrium. 6. According to Frank Knight, risk: (a) exists when the probability of any given event can reasonably be predicted. (b) appeals to the gambler personalities of innovators who further social progress. (c) is irrelevant to good estimates of the economic costs of production. (d) is a synonym for uncertainty. 7. The magnitudes of actuarial risk and other fuzzy forms of risk can be reduced by: (a) acquiring better information. (b) diversification. (c) hedging. (d) all of the above. 8. When estimating the nature of a probability function for an event entails considerable guesswork because experience with the event is so sporadic or rare that any estimates are extremely speculative, then we confront a concept termed: (a) risk. (b) Knightian uncertainty. (c) the veil of ignorance. (d) meta-probabilities. (e) stochasticity. 9. Optimal diversification can effectively eliminate the specific risk associated with portfolios of financial assets issued by specific firms, but it is relatively ineffective as a mechanism for reducing market risk e.g. the bursting of a stock market bubble. This suggests that market risk is closely related to the concept of: (a) Knightian uncertainty. (b) illiquidity. (c) negative covariance. (d) entrepreneurial risk. (e) asymmetric information.

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Test Bank for Corporate Finance and Financial Markets

10. An actuary using historical tables of data to estimate risk provides an example of how estimates are calculated for: (a) Knightian uncertainty. (b) creative response. (c) certainty. (d) fuzzy risk. (e) precise risk. 11. The susceptibility of an investment to fluctuations in the interest rate is known as: (a) volatility. (b) interest rate risk. (c) market fluctuation effect. (d) liquidity risk. 12. The demand for a financial asset tends to be negatively related to: (a) expected deflation. (b) liquidity. (c) wealth. (d) risk. 13. One risk most commonly associated with holdings of long-term U.S. government bonds would be: (a) revolutionary risk. (b) default risk. (c) market risk. (d) interest rate risk the possibility that interest rates will vary. (e) exchange rate risk. 14. The asset that would come closest to yielding a risk-free rate of return would be: (a) owneroccupied housing. (b) an inflation-adjusted 10-year US Treasury bond purchased within a few days of maturity. (c) an Aaa rated municipal bond. (d) stock in a well-managed hedge fund. (e) stock in a mutual fund that was perfectly diversified to eliminate specific risk. 15. Differences between the interest rates on U.S. Treasury bonds and other relatively liquid financial securities with similar maturities primarily reflect the: (a) universal preference for liquidity. (b) risk premium. (c) yield premium. (d) differential impact of taxes. 16. The difference between interest rates on investment grade corporate bonds and U.S Treasury bonds of similar maturity is a measure of the: (a) credit premium. (b) risk premium. (c) prime rate of interest. (d) actuarial risk. (e) duration premium. 17. Financial assets are claims on things with intrinsic value. Potential investors can safely ignore the: (a) time to maturity for payments to owners of the asset. (b) the relative riskiness of the asset. (c) the expected monetary returns on the asset. (d) transaction costs in dealing in the asset. (e) none of the above. 18. When analyzing financial markets, broad categories of risk do not include: (a) interest rate risk. (b) inflationary risk. (c) exchange rate risk. (d) speculative risk. (e) default risk. 19. Suppose Joe borrows $100,000 at 5% interest and 3 months into the loan the rate increases to 7%. If Joe cannot make his payments on the loan the bank is experiencing the effects of: (a) inflation risk. (b) asymmetric information. (c) default risk. (d) principal-agent problems. (e) interest rate risk. 20. If two bonds with $1,000,00 face values now traded in secondary markets have the same maturity, a possible cause of different current interest rates would be the bonds relative: (a) market values. (b) default risk. (c) demands at the time issued. (d) supplies at the time issued.

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21. The differences between interest rates on corporate bonds and Treasury bonds with similar maturities reflect: (a) only the corporate bonds default risk. (b) only the corporate bonds relatively lower liquidity. (c) neither the corporate bonds default risk nor its liquidity. (d) both the corporate bonds default risk and its relatively lower liquidity. 22. Equilibrium investment is least likely to exist in a case where: (a) after adjusting for risk, liquidity, and time to maturity, all income-producing assets yield the same returns. (b) all asset prices exactly equal their corresponding present values. (c) the average of all expected rates of return on investments is defined as the market rate of interest. (d) interest rates are identical for investments irrespective of variations in risk. (e) the market interest rate on loanable funds and the rates of return on existing capital are equal, after adjusting for transaction costs. 23. From the perspectives of American financial investors, inflation-indexed U.S. Treasury bonds may still pose the problem of: (a) default risk. (b) exchange rate risk. (c) interest rate risk. (d) liquidity risk. (e) inflation risk. 24. Suppose a firm applies the same internal cost of capital when evaluating investments, regardless of the other characteristics of various possible investments. The firm is most likely to: (a) maximize the expected profitability of its investment portfolio. (b) accept poor low risk projects but reject good high risk projects. (c) allocate its financial capital efficiently. (d) accept poor high risk projects but reject good low risk projects. (e) maintain excessive liquidity relative to the optimal investment portfolio. 25. The relative liquidities of financial instruments are probably least influenced by the relative: (a) volumes of transactions in the securities. (b) reputations of the issuers. (c) globalization in the world economy. (d) perceptions among financial investors of the probability of default or other financial risks. 26. Risk that can be reduced significantly through diversification is: (a) inflation risk. (b) specific risk, or unique risk. (c) default risk. (d) interest rate risk. (e) exchange rate risk. (f) market risk. 27. The most liquid of the following assets would be: (a) put options. (b) investment grade corporate bonds. (c) U.S. Treasury bonds. (d) call options. (e) junk bonds. 28. The risk structure of interest rates illustrates how the market weighs: (a) actuarial risk. (b) relative economic risk. (c) Knightian uncertainty. (d) specific risk. (e) market risk. (f) predictable probabilities. (g) macroeconomic risk. (h) absolute financial risk. 29. The term structure of interest rates is shown in a: (a) yield curve. (b) velocity curve. (c) risk-reward curve. (d) realization curve. (e) liquidity curve. 30. The risk that a bonds price will change due to changes in market interest rates is called: (a) interest rate risk. (b) default risk. (c) exchange risk. (d) alteration risk. (e) market risk. 31. A bond with default risk will ____ have a ____ risk premium: (a) always, negative. (b) sometimes, negative. (c) always, positive. (d) never, positive. (e) sometimes, positive.

Ralph Byrns

Test Bank for Corporate Finance and Financial Markets

32. The variable on the x-axis that would be least consistent with standard investment theories would be: (a) illiquidity. (b) time to maturity. (c) risk. (d) diversification. (e) tax rates on returns. Term Structure 21. If time to maturity is on the horizontal axis of this function, this curve is know as a/an: (a) yield curve. (b) inverted function. (c) annuity function. (d) risk / reward curve. (e) payoff curve.

22. Interest rates on given financial instruments tend to be lower the: (a) shorter the period to maturity. (b) greater the risk of default. (c) less liquid the asset is. (d) greater the expected rate of inflation. (e) greater the face value is relative to the market price. 23. A normal yield curve will be most likely to become negatively sloped if short-term interest rates were suddenly expected to: (a) rise sharply relative to long term interest rates. (b) be indexed to adjust for realized inflation. (c) fall sharply. 24. Consider the following two situations: [1] you buy a one-year bond and upon maturity you buy another one-year bond and continue to do so for the next 10 years or [2] you buy one 10-year bond. If the one-year and 10-year bonds are perfect substitutes, it must be true that: (a) the aggregate yield of each one year bond must be higher than that of the 10 year bond. (b) the interest rate realized from the 10-year bond must equal the average rates for the 10 one-year bonds. (c) the interest rate of the 10-year bond must be more than the average of the 10 one-year bond rates. (d) the interest rate of the 10 year bond must be lower than the average of the 10 one-year bond rates. 25. The average lifetime of a debt securitys stream of payments is called the securitys: (a) duration. (b) maturation. (c) seignorage. (d) longevity. (e) chronology. 26. The duration of a portfolio is: (a) the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each. (b) the average length of time that was required for the total value of the portfolio to reach its current level. (c) a measure of how effectively the portfolio manager has managed to hedge against interest rate risk. (d) a weighted estimate of the average probabilities of default for the securities in the portfolio. (e) a measure of the volatility of the value of the portfolio across a complete business cycle, as measured by the National Bureau of Economic Research. 27. A weighted average of the timing and amounts of income receivable from portfolios of bonds or other sets of obligations is termed the portfolios: (a) debenture yield. (b) terminal structure. (c) duration. (d) debt-equity ratio. (e) payoff matrix.

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28. The duration of a portfolio of financial assets and the maturity of a bond in the portfolio are: (a) inversely related. (b) positively related. (c) equal. (d) not related. 29. Duration gap analysis helps managers of financial institutions deal with interest rate risk by examining the sensitivity of: (a) the book value net worth to changes in interest rates. (b) market value net worth to changes in interest rates. (c) net income to changes in interest rates. (d) assets to changes in interest rates. (e) liabilities to changes in interest rates. 30. The average lifetime of a debt securitys stream of payments is called the securitys: (a) duration. (b) maturation. (c) seignorage. (d) longevity. (e) chronology. 31. The dates when the scheduled payments from a financial asset will be realized are central to the concept of: (a) yield ratios. (b) duration. (c) maturation. (d) financial structure. (e) debt-equity ratios. 32. Equilibrium interest rates vary among different financial instruments because of differences in all of the following EXCEPT: (a) default risk. (b) the solvency of the lender. (c) liquidity. (d) time to maturity. (e) tax structures. 33. The real market rate of interest will rise if there is an increase in: (a) pessimism on the parts of investors. (b) willingness to hold illiquid assets. (c) total capital stock relative to national output. (d) households desires to consume now instead of later. 34. The theory that appears to best explain the term structure of interest rates is the: (a) liquidity premium theory. (b) rational expectations theory. (c) segmented market theory. (d) natural rate theory. (e) pure expectations theory. (f) efficient markets theory. (g) adaptive expectations theory. (h) preferred habitat theory. 35. The structure of interest rates across financial instruments is least determined by the expected: (a) internal rates of discount of savers. (b) durations or dates of maturity of various instruments. (c) riskiness of different instruments. (d) taxes on the returns to different instruments. (e) transactions costs associated with dealing in different instruments. 36. Equilibrium interest rates vary among different financial instruments because of differences in all of the following EXCEPT: (a) default risk. (b) time to maturity. (c) liquidity. (d) the solvency of the lender. 37. Investment is in equilibrium in all of the following cases EXCEPT when: (a) after adjusting for risk, liquidity, and maturity, all income-producing assets yield the same returns. (b) all prices of assets exactly equal their respective present values. (c) the typical expected rate-of-return on investment equals the market rate of interest. (d) the risks for all investments are equal, regardless of their rates of return, as long as their present values are identical.

Ralph Byrns

Test Bank for Corporate Finance and Financial Markets

Portfolios

38. The liquidity premium theory does not explain why: (a) interest rates on bonds with different maturities move together. (b) yield curves are usually positively sloped. (c) yield curves have steep slopes when short-term interest rates are unusually low. (d) securities with greater risk generate higher rates of return over the long run. 39. Transaction costs in managing a portfolio of assets are minimized by a strategy of: (a) technical analysis. (b) inertia trading. (c) day trading. (d) buy-and-hold. (e) variance minimization. (f) covariant offsets. 40. As the prices of two securities move more synchronously and in the same direction, the reduction in risk associated with diversification: (a) falls during upswings in the business cycle and increases during downswings. (b) increases. (c) rises during upswings in the business cycle and falls during downswings. (e) is reduced. 41. Diversification will be most economically efficient in reducing a stockholders portfolio risk if (a) firms merge into huge vertically integrated corporations. (b) the firms in the portfolio respond to business cycles in very similar ways. (c) firms merge into huge horizontally integrated corporations. (d) the covariances of firms net returns on economic investment tend to be highly negative. 42. Diversification tends to be most beneficial for: (a) stock brokers. (b) high spending investors. (c) risk averse investors. (d) risk loving investors. 43. One way for financial investors to spread risk and reduce the uncertainty of their income streams is through: (a) investing only in government bonds. (b) barter. (c) diversification. (d) monetization. (e) securitization. 44. The riskiness of a portfolio can be reduced by increasing how negative are the covariances of the price changes for its assets through (a) defenestration. (b) syndication. (c) underwriting. (d) diversification. (e) disintermediation. 45. Financial institutions that have relatively narrow and specialized portfolios of loans could most obviously reduce their exposure to risk for a given rate of return by: (a) reducing their excess reserve ratios. (b) screening to avoid adverse selection. (c) stringently rationing credit. (d) diversifying their portfolios. (e) borrowing federal funds to increase their financial leverage.
46.

The riskiness of a financial portfolio can be reduced through (a) defenestration. (b) disintermediation. (c) underwriting. (d) diversification. (e) syndication. 47. To minimize the interest and default risks associated with given expected rates of return, relatively unsophisticated individual investors can most reasonably and easily invest in: (a) common stock. (b) diversified mutual funds. (c) corporate bonds. (d) long term municipal bonds. (e) real estate.

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48. Diversification will be least economically efficient in reducing a stockholders portfolio risk if (a) unrelated firms merge into huge conglomerates (b) different firms respond to business cycles in very different ways. (c) Betas differ substantially among firms. (d) the covariances of firms tend to be highly negative. 49. The portfolio with the lowest average annual nominal rate of return during the period 19262002 would have been a portfolio based on (a) Small firm common stocks (b) Common stocks of Fortune 500 companies. (c) Central American government bonds. (d) Treasury bills. (e) Corporate bonds. 50. It is untrue of corporate debt and equity that: (a) both can be long-term financial instruments. (b) both involve a claim on the issuers income. (c) both enable a corporation to raise funds. (d) a lower debt/equity ratio increases both riskiness and the average rates of return [or interest rates] for both stockholders and lenders. (e) greater leverage entails a higher debt/equity ratio.

Ralph Byrns

Test Bank for Corporate Finance and Financial Markets