Financial Markets and Institutions 8th Edition Mishkin Test Bank 1

Solution Manual for Financial Markets and Institutions
8th Edition by Mishkin and Eakins ISBN 013342362X

9780133423624
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Financial Markets and Institutions, 8e (Mishkin)

Chapter 5 How Do Risk and Term Structure Affect Interest Rates?
5.1 Multiple Choice
1) The term structure of interest rates is

A) the relationship among interest rates of different bonds with the same risk and maturity.
B) the structure of how interest rates move over time.
C) the relationship among the terms to maturity of different bonds from different issuers.
D) the relationship among interest rates on bonds with different maturities but similar risk.
Answer: D
Topic: Chapter 5.2 Term Structure of Interest Rates
Question Status: Updated from Previous Edition
2) The risk structure of interest rates is

A) the structure of how interest rates move over time.
B) the relationship among interest rates of different bonds with the same maturity.
C) the relationship among the terms to maturity of different bonds.
D) the relationship among interest rates on bonds with different maturities.
Answer: B
Topic: Chapter 5.1 Risk Structure of Interest Rates
Question Status: Previous Edition
3) Which of the following long-term bonds should have the lowest interest rate?
A) Corporate Baa bonds
B) U.S. Treasury bonds
C) Corporate Aaa bonds
D) Municipal bonds
Answer: D
1
Copyright © 2015 Pearson Education, Inc.
4) Which of the following long-term bonds should have the highest interest rate?
A) Corporate Baa bonds
B) U.S. Treasury bonds
C) Corporate Aaa bonds
D) Municipal bonds
Answer: A
2
5) The risk premium on corporate bonds becomes smaller if
A) the riskiness of corporate bonds increases.
B) the liquidity of corporate bonds increases.
C) the liquidity of corporate bonds decreases.
D) the riskiness of corporate bonds decreases.
E) either B or D of the above occur.
Answer: E
6) Bonds with relatively low risk of default are called

A) zero coupon bonds.
B) junk bonds.
C) investment-grade bonds.
D) none of the above.
Answer: C
7) Bonds with relatively high risk of default are called

A) Brady bonds.
B) junk bonds.
C) zero coupon bonds.
D) investment-grade bonds.
Answer: B
8) A corporation suffering big losses might be more likely to suspend interest payments on its
bonds, thereby
A) raising the default risk and causing the demand for its bonds to rise.
B) raising the default risk and causing the demand for its bonds to fall.
C) lowering the default risk and causing the demand for its bonds to rise.
D) lowering the default risk and causing the demand for its bonds to fall.
Answer: B
3
9) (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher
interest rates the firm must pay.
(II) The spread between the interest rates on bonds with default risk and default-free bonds is
called the risk premium.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: B
10) Holding everything else constant, if a corporation begins to suffer large losses, then the
default risk on its bonds will ________ and the expected return on those bonds will ________.
A) increase: increase
B) decrease; increase
C) increase; decrease
D) decrease; decrease
Answer: C
11) Holding everything else the same, if a corporation's earnings rise, then the default risk on its
bonds will ________ and the expected return on those bonds will ________.
A) increase; decrease
B) decrease; decrease
C) increase; increase
D) decrease; increase
Answer: D
12) If a corporation begins to suffer large losses, then the default risk on its bonds will ________
and the equilibrium interest rate on these bonds will ________.
B) decrease; increase
D) decrease; decrease
Answer: C
4
13) If a corporation's earnings rise, then the default risk on its bonds will ________ and the
equilibrium interest rate on these bonds will ________.
B) decrease; decrease
D) decrease; increase
Answer: B
14) When the default risk on corporate bonds decreases, other things equal, the demand curve for
corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right
Answer: B
15) (I) An increase in default risk on corporate bonds shifts the demand curve for corporate
bonds to the right.
(II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to
the left.
C) Both are true.
D) Both are false.
Answer: D
16) (I) An increase in default risk on corporate bonds shifts the demand curve for corporate
bonds to the left. (II) An increase in default risk on corporate bonds shifts the demand curve for
Treasury bonds to the right.
C) Both are true.
D) Both are false.
Answer: C
5
17) The spread between interest rates on low-quality corporate bonds and U.S. government
bonds ________ during the Great Depression.
A) was reversed
B) narrowed significantly
C) widened significantly
D) did not change
Answer: C
18) As a result of the subprime collapse, the demand for low -quality corporate bonds ________,
the demand for high-quality Treasury bonds ________, and the risk spread ________.
A) increased; decreased; was unchanged
B) decreased; increased; increased
C) increased; decreased; decreased
D) decreased; increased; was unchanged
Answer: B
19) Moody's and Standard and Poor's are agencies that

A) help investors collect when corporations default on their bonds.
B) advise municipal bond issuers on the tax exempt status of their bonds.
C) produce information about the probability of default on corporate bonds.
D) maintain liquid markets for corporate bonds.
Answer: C
20) If Moody's or Standard and Poor's downgrades its rating on a corporate bond, the demand for
the bond ________ and its yield ________.
A) increases; decreases
B) decreases; increases
C) increases; increases
D) decreases; decreases
Answer: B
6
21) Corporate bonds are not as liquid as government bonds because
A) fewer bonds for any one corporation are traded, making them more costly to sell.
B) the corporate bond rating must be calculated each time they are traded.
C) corporate bonds are not callable.
D) all of the above.
E) only A and B of the above.
Answer: A
22) (I) The risk premium widens as the default risk on corporate bonds increases.
(II) The risk premium widens as corporate bonds become less liquid.
C) Both are true.
D) Both are false.
Answer: C
23) When the corporate bond market becomes less liquid, other things equal, the demand curve
for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right
Answer: D
24) When the corporate bond market becomes more liquid, other things equal, the demand curve
for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the
________.
A) right; right
B) right; left
C) left; left
D) left; right
Answer: B
7
25) (I) If a corporate bond becomes less liquid, the demand for the bond will fall, causing the
interest rate to rise.
(II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.
C) Both are true.
D) Both are false.
Answer: A
26) (I) If a corporate bond becomes less liquid, the interest rate on the bond will fall.
(II) If a corporate bond becomes less liquid, the interest rate on Treasury bonds will fall.
C) Both are true.
D) Both are false.
Answer: B
27) If income tax rates were lowered, then

A) the interest rate on municipal bonds would fall.
B) the interest rate on Treasury bonds would rise.
C) the interest rate on municipal bonds would rise.
D) the price of Treasury bonds would fall.
Answer: C
28) If income tax rates rise, then

A) the prices of municipal bonds will fall.
B) the prices of Treasury bonds will rise.
C) the interest rate on Treasury bonds will rise.
D) the interest rate on municipal bonds will rise.
Answer: C
8
29) An increase in marginal tax rates would likely have the effect of ________ the demand for
municipal bonds and ________ the demand for U.S. government bonds.
A) increasing; increasing
B) increasing; decreasing
C) decreasing; increasing
D) decreasing; decreasing
Answer: B
30) A decrease in marginal tax rates would likely have the effect of ________ the demand for
municipal bonds and ________ the demand for U.S. government bonds.
A) increasing; increasing
B) increasing; decreasing
C) decreasing; increasing
D) decreasing; decreasing
Answer: C
31) Which of the following statements are true?

A) Because coupon payments on municipal bonds are exempt from federal income tax, the
expected after-tax return on them will be higher for individuals in higher income tax brackets.
B) An increase in tax rates will increase the demand for municipal bonds, lowering their interest
rates.
C) Interest rates on municipal bonds will be lower than on comparable bonds without the tax
exemption.
D) All of the above are true statements.
E) Only A and B are true statements.
Answer: D
32) Which of the following statements are true?

A) Because coupon payments on municipal bonds are exempt from federal income tax, the
expected after-tax return on them will be higher for individuals in higher income tax brackets.
B) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest
rates.
C) Interest rates on municipal bonds will be higher than on comparable bonds without the tax
exemption.
D) Only A and B are true statements.
Answer: A
9
33) When a municipal bond is given tax-free status, the demand for municipal bonds shifts
________, causing the interest rate on the bond to ________.
A) leftward; rise
B) leftward; fall
C) rightward; rise
D) rightward; fall
Answer: D
34) When a municipal bond is given tax-free status, the demand for Treasury bonds shifts
________, and the interest rate on Treasury bonds ________.
A) leftward; rises
B) leftward; falls
C) rightward; rises
D) rightward; falls
Answer: A
35) If municipal bonds were to lose their tax-free status, then the demand for Treasury bonds
would shift ________, and the interest rate on Treasury bonds would ________.
A) rightward; fall
B) rightward; rise
C) leftward; fall
D) leftward; rise
Answer: A
36) The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35
percent over the next ten years. As a result of this tax cut, the demand for municipal bonds
should shift to the ________ and the interest rate on municipal bonds should ________.
A) right; decline
B) right; increase
C) left; decline
D) left; increase
Answer: D
10
37) The relationship among interest rates on bonds with identical default risk but different
maturities is called the
A) time-risk structure of interest rates.
B) liquidity structure of interest rates.
C) yield curve.
D) bond demand curve.
Answer: C
38) Yield curves can be classified as

A) upward-sloping.
B) downward-sloping.
C) flat.
Answer: D
39) Typically, yield curves are

A) gently upward-sloping.
B) gently downward-sloping.
C) flat.
D) bowl shaped.
E) mound shaped.
Answer: A
40) When yield curves are steeply upward-sloping,

A) long-term interest rates are above short-term interest rates.
B) short-term interest rates are above long-term interest rates.
C) short-term interest rates are about the same as long-term interest rates.
D) medium-term interest rates are above both short-term and long-term interest rates.
E) medium-term interest rates are below both short-term and long-term interest rates.
Answer: A
11
41) Economists' attempts to explain the term structure of interest rates
A) illustrate how economists modify theories to improve them when they are inconsistent with
the empirical evidence.
B) illustrate how economists continue to accept theories that fail to explain observed behavior of
interest rate movements.
C) prove that the real world is a special case that tends to get short shrift in theoretical models.
D) have proved entirely unsatisfactory to date.
Answer: A
42) According to the expectations theory of the term structure,

A) the interest rate on long-term bonds will exceed the average of expected future short-term
interest rates.
B) interest rates on bonds of different maturities move together over time.
C) buyers of bonds prefer short-term to long-term bonds.
Answer: B

A) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise
in the future.
B) when the yield curve is downward-sloping, short-term interest rates are expected to decline in
the future.
C) buyers of bonds prefer short-term to long-term bonds.
Answer: E

A) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise
in the future.
B) when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
C) investors have strong preferences for short-term relative to long-term bonds, explaining why
yield curves typically slope upward.
Answer: A
12
A) yield curves should be equally likely to slope downward as to slope upward.
B) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise
in the future.
C) when the yield curve is downward-sloping, short-term interest rates are expected to remain
relatively stable in the future.
Answer: E
46) If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent,
2 percent, and 1 percent, then the pure expectations theory predicts that today's interest rate on
the four-year bond is
A) 1 percent.
B) 2 percent.
C) 4 percent.
Answer: D
47) If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent,
3 percent, 4 percent, and 5 percent, then the pure expectations theory predicts that the bond with
the highest interest rate today is the one with a maturity of
A) one year.
B) two years.
C) three years.
D) four years.
E) five years.
Answer: E
48) If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent,
1 percent, 4 percent, and 3 percent, then the pure expectations theory predicts that the bond with
the lowest interest rate today is the one with a maturity of
A) one year.
B) two years.
C) three years.
D) four years.
Answer: A
13
49) According to the market segmentation theory of the term structure,
A) the interest rate for bonds of one maturity is determined by the supply and demand for bonds
of that maturity.
B) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates
on bonds of different maturities do not move together over time.
C) investors' strong preference for short-term relative to long-term bonds explains why yield
curves typically slope upward.
E) none of the above.
Answer: D
50) According to the market segmentation theory of the term structure,

A) the interest rate for bonds of one maturity is determined by the supply and demand for bonds
of that maturity.
B) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates
on bonds of different maturities do not move together over time.
C) investors' strong preference for short-term relative to long-term bonds explains why yield
curves typically slope downward.
D) only A and B of the above.
Answer: D
51) The liquidity premium theory of the term structure

A) indicates that today's long-term interest rate equals the average of short-term interest rates that
people expect to occur over the life of the long-term bond.
B) assumes that bonds of different maturities are perfect substitutes.
C) suggests that markets for bonds of different maturities are completely separate because people
have different preferences.
D) does none of the above.
Answer: D
52) The liquidity premium theory of the term structure

A) assumes investors tend to prefer short-term bonds because they have less interest-rate risk.
B) assumes that interest rates on the long-term bond respond to demand and supply conditions
for that bond.
C) assumes that an average of expected short-term rates is an important component of interest
rates on long-term bonds.
D) assumes all of the above.
E) assumes none of the above.
Answer: D
14
53) According to the liquidity premium theory of the term structure,
A) the interest rate on long-term bonds will equal an average of short-term interest rates that
people expect to occur over the life of the long-term bonds plus a liquidity premium.
B) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of
different maturities move together over time.
C) even with a positive liquidity premium, if future short-term interest rates are expected to fall
significantly, then the yield curve will be downward-sloping.
Answer: D
54) According to the liquidity premium theory of the term structure,

A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on
bonds of different maturities do not move together over time.
B) the interest rate on long-term bonds will equal an average of short-term interest rates that
people expect to occur over the life of the long-term bonds plus a term premium.
C) because of the positive term premium, the yield curve cannot be downward-sloping.
Answer: B
55) If the yield curve slope is flat, the liquidity premium theory indicates that the market is
predicting
A) a mild rise in short-term interest rates in the near future and a mild decline further out in the
future.
B) constant short-term interest rates in the near future and further out in the future.
C) a mild decline in short-term interest rates in the near future and a continuing mild decline
further out in the future.
D) constant short-term interest rates in the near future and a mild decline further out in the future.
Answer: C
15
56) If the yield curve has a mild upward slope, the liquidity premium theory indicates that the
market is predicting
A) a rise in short-term interest rates in the near future and a decline further out in the future.
B) constant short-term interest rates in the near future and further out in the future.
C) a decline in short-term interest rates in the near future and a rise further out in the future.
D) a decline in short-term interest rates in the near future and an even steeper decline further out
in the future.
Answer: B
57) According to the liquidity premium theory of the term structure, a downward-sloping yield
curve indicates that short-term interest rates are expected to
A) rise in the future.
B) remain unchanged in the future.
C) decline moderately in the future.
D) decline sharply in the future.
Answer: D
58) According to the liquidity premium theory of the term structure, when the yield curve has its
usual slope, the market expects
A) short-term interest rates to rise sharply.
B) short-term interest rates to drop sharply.
C) short-term interest rates to stay near their current levels.
Answer: C
59) In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major
shortcoming of the
A) market segmentation theory.
B) expectations theory.
C) liquidity premium theory.
D) separable markets theory.
Answer: B
16
60) Which theory of the term structure proposes that bonds of different maturities are not
substitutes for one another?
A) Market segmentation theory
B) Expectations theory
C) Liquidity premium theory
D) Separable markets theory
Answer: A
61) Since yield curves are usually upward sloping, the ________ indicates that, on average,
people tend to prefer holding short-term bonds to long-term bonds.
A) market segmentation theory
B) expectations theory
C) liquidity premium theory
D) both A and B of the above
E) both A and C of the above
Answer: E
62) ________ cannot explain the empirical fact that interest rates on bonds of different maturities
tend to move together.
A) The market segmentation theory
B) The expectations theory
C) The liquidity premium theory
D) Both A and B of the above
E) Both A and C of the above
Answer: A
63) Of the four theories that explain how interest rates on bonds with different terms to maturity
are related, the one that views long-term interest rates as equaling the average of future short-
term rates expected to occur over the life of the bond is the
A) pure expectations theory.
B) preferred habitat theory.
D) segmented markets theory.
Answer: A
17
64) Of the four theories that explain how interest rates on bonds with different terms to maturity
are related, the one that assumes that bonds of different maturities are not substitutes for one
another is the
A) expectations theory.
B) segmented markets theory.
D) preferred habitat theory.
Answer: B
65) A moderately upward-sloping yield curve indicates that short-term interest rates are expected
to
A) neither rise nor fall in the near future.
B) remain relatively unchanged, but that long-term rates are expected to fall.
C) neither rise nor fall, but that long-term rates are expected to rise moderately.
D) rise moderately in the near future.
Answer: A
66) A steep upward-sloping yield curve indicates that short-term interest rates are expected to
A) neither rise nor fall in the near future.
B) remain relatively unchanged, but that long-term rates are expected to fall.
C) neither rise nor fall, but that long-term rates are expected to rise moderately.
D) rise moderately in the near future.
Answer: D
67) A bond rating of Aa or AA would mean that the quality of the bond is
A) the highest.
B) high.
C) medium grade.
D) speculative.
Answer: B
68) ________ bonds are the most liquid of all long-term bonds.
A) Callable
B) Municipal
C) Corporate Aaa
D) U.S. Treasury
Answer: D
18
69) ________ bonds are exempt from federal income taxes.
A) Corporate Aaa
B) U.S. Treasury
C) Corporate Baa
D) Municipal
Answer: D
70) The risk structure of interest rates is explained by

A) default risk.
B) liquidity.
C) tax considerations.
Answer: D
71) The ________ theory is the most widely accepted theory of the term structure of interest
rates because it explains the major empirical facts about the term structure so well.
A) liquidity premium
B) market segmentation
C) expectations
D) none of the above
Answer: A
72) ________ are investment advisory firms that rate the quality of corporate and municipal
bonds in terms of probability of default.
A) Financial institutions
B) Credit-rating agencies
C) Securities companies
D) none of the above
Answer: B
73) If a bond has a favorable tax treatment, its required interest rate (all else equal)
A) will be higher.
B) will not be affected.
C) will be lower.
D) all of the above could happen.
Answer: C
19
74) Based on the expectations hypothesis, the steep upward sloping yield curve in June of 2013
indicted that short-term rates would ________ in the future.
A) climb
B) fall
C) remain the same
D) change in a random fashion
Answer: A
Question Status: New Question
75) A bond with default risk will always have a ________ risk premium, and an increase in its
default risk will raise the risk premium.
A) positive
B) negative
C) unpredictable
D) minimal
Answer: A
76) Closely related to the ________ is the preferred habitat theory, which takes a somewhat less
direct approach to modifying the expectations hypothesis but comes to a similar conclusion.
A) liquidity premium theory
B) expectations theory
C) market segmentation theory
D) supply theory
Answer: A
5.2 True/False
1) The term structure of interest rates describes how interest rates move over time.
Answer: FALSE
2) The risk structure of interest rates describes the relationship between the interest rates of
different bonds with the same maturities.
Answer: TRUE
20
3) Following the subprime collapse, the spread (difference) between the interest rates on Baa
bonds and Treasury bonds widened.
Answer: TRUE
4) The risk premium on corporate bonds becomes smaller as the liquidity of the bonds falls.
Answer: FALSE
5) An increase in income tax rates will cause the interest rates on tax-exempt municipal bonds to
fall relative to the interest rate on taxable corporate securities.
Answer: TRUE
6) The interest rates on bonds of different maturities tend to move together over time.
Answer: TRUE
7) The expectations theory is able to explain why yield curves are usually upward-sloping.
Answer: FALSE
8) According to the expectations theory, the interest rate on a long-term bond is the average of
the short-term interest rates expected over the life of the long-term bond.
Answer: TRUE
9) The market segmentation theory is able to explain why interest rates on bonds of different
maturities move together over time.
Answer: FALSE
10) Bonds with the lowest risk of default are often referred to as junk bonds.
Answer: FALSE
21
11) A positive liquidity premium indicates that investors prefer long-term bonds over short-term
bonds.
Answer: FALSE
12) A mildly upward-sloping yield curve suggests that the market is predicting constant short-
term interest rates.
Answer: TRUE
13) An increase in the marginal tax rate would likely increase the demand for municipal bonds,
and decrease the demand for U.S. government bonds.
Answer: TRUE
14) When yield curves are downward-sloping, long-term interest rates are above short-term
interest rates.
Answer: FALSE
15) Risk occurs when the issuer of the bond is unable or unwilling to make interest payments
when promised or pay off the face value when the bond matures.
Answer: FALSE
16) The spread between the interest rates on bonds with default risk and default-free bonds is
called the risk premium.
Answer: FALSE
17) With the Obama tax increase that repealed the Bush tax cuts for high-income tax payers in
2013, the after-tax expected return on tax-free municipal bonds relative to Treasury bonds
decreases.
Answer: FALSE
22
18) Risk, liquidity, and income tax rules all play a role in determining the risk structure of
interest rates.
Answer: TRUE
19) During the budget negotiations in Congress in 1995-1996, and then again in 2011-2013, the
Republicans threatened to let Treasury bonds default, and this had an impact on the bond market.
Answer: TRUE
5.3 Essay
1) Contrast the liquidity premium theory to the market segmentation theory of the term structure
of interest rates.
2) Why would an increase in the income tax rate reduce borrowing costs to municipalities?
3) Discuss what is shown by a yield curve.

4) Why is it unlikely that the expectations theory alone is the correct theory for explaining the
yield curve?
5) What is meant by the risk structure of interest rates?

6) How would a severe recession affect the risk premium on corporate bonds?
7) Explain why a flight to quality occurred following the subprime collapse and how this
affected the interest rates on lower-quality corporate bonds and Treasury bonds.
23
8) What do credit-rating agencies do and why is this work important?
9) Explain why the liquidity premium theory is so widely accepted.

10) In 2013, President Obama increased tax by essentially repealing the Bush tax cuts for high-
income
tax payers. How does this affect the after-tax expected return on tax-free municipal bonds
relative to Treasury bonds?
11) What effect did the Bush Tax Cut have on bond interest rates?
12) What are the differences among the expectations, market segmentation, and liquidity
premium theories for the term structure of interest rates?
24

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Solution Manual for Financial Markets and Institutions

8th Edition by Mishkin and Eakins ISBN 013342362X

Full download link at:

Test bank: https://testbankpack.com/p/test-bank-for-financial-markets-and-institutions-8th-edition-by-

Financial Markets and Institutions, 8e (Mishkin)

5.1 Multiple Choice

1) The term structure of interest rates is

2) The risk structure of interest rates is

6) Bonds with relatively low risk of default are called

7) Bonds with relatively high risk of default are called

19) Moody's and Standard and Poor's are agencies that

27) If income tax rates were lowered, then

28) If income tax rates rise, then

31) Which of the following statements are true?

32) Which of the following statements are true?

38) Yield curves can be classified as

39) Typically, yield curves are

40) When yield curves are steeply upward-sloping,

42) According to the expectations theory of the term structure,

43) According to the expectations theory of the term structure,

44) According to the expectations theory of the term structure,

50) According to the market segmentation theory of the term structure,

51) The liquidity premium theory of the term structure

52) The liquidity premium theory of the term structure

54) According to the liquidity premium theory of the term structure,

70) The risk structure of interest rates is explained by

3) Discuss what is shown by a yield curve.

5) What is meant by the risk structure of interest rates?

9) Explain why the liquidity premium theory is so widely accepted.

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