Term Structure of Interest Rates

Question 1

Why would interest rates vary holding risk, liquidity and tax characteristics constant?

Answer 1

Differing times to maturity

Question 2

Interest rates on bonds with different maturities move ______ over time.

Answer 2

together

Question 3

Yield curves are almost always

Answer 3

upward sloping

Question 4

Name the three markets theories:

Answer 4

• Segmented Markets Theory
• Pure Expectations Theory
• Premium Theory

Question 5

Segmented Markets Theory:

are bonds with different maturities substitutes?

Answer 5

No - If you want an 18 yr bond, your only option is to buy an 18 year bond

Question 6

Segmented Markets Theory:

How are interest rates determined?

Answer 6

By supply and demand for a given bond

Question 7

Segmented Markets Theory:

Do investors have preference for bonds with one maturity over another? Why?

Answer 7

Yes - lenders match maturity dates with known payments

Question 8

Segmented Markets Theory:

Do changes in one market have effects on other markets?

Answer 8

No - a change in one market will have 0 change in all other markets

Question 9

Segmented Markets Theory:

If conditions are favorable, what would we expect market yields to do in longer markets?

Answer 9

We would expect market yields to increase in each longer market resulting in an upward sloping yield curve

Question 10

Segmented Markets Theory:

Why does this theory work?

Answer 10

because of the effects on premiums for market risk - longer maturities have more risk

Question 11

Pure Expectations Theory:

How are long-term interest rates determined?

Answer 11

the average of the short term interest rates that are expected to occur over the life of the long-term bond

Question 12

Pure Expectations Theory:

Do buyers have preference over bonds with different maturities? Why?

Answer 12

No - they will not hold any quantity of a bond if its expected return is less than another bond with a different maturity date

Question 13

Pure Expectations Theory:

Are bonds substitutes?

Answer 13

Yes - bonds under the Pure Expectations theory are considered perfect substitutues

Question 14

Pure Expectations Theory:

Do lenders have maturity preferences?

Answer 14

Yes - lenders still have preferences however they will buy a combination of different maturitites as they are perfect substitutes

Question 15

Pure Expectations Theory:

Under what conditions would lenders be indifferent between different bond combinations?

Answer 15

If the expected yields are identical at the end of the time horizon

Question 16

Liquidity Premium and Preferred Habitat:

How does this theory differ from expectations theory?

Answer 16

same as expectations theory (long term rates equal average of short term) + a premium that responds to S/D conditions for that bond

Question 17

Liquidity Premium and Preferred Habitat:

are bond with different maturities substitutes?

Answer 17

Yes - but they are not perfect substitutes (hence the additional premium)

Question 18

Preferred Habitat Hypothesis:

what is it?

Answer 18

Different maturity debt instruments have different investors (preferred habitats) - investors must be induced to move from their preferred habitat.

Everybody is impatient, we need to be compensated to wait

Question 19

Preferred Habitat Hypothesis:

Liquidity Premium vs Habitat Premium

Answer 19

Liquidity: designed to combat market risk
Habitat: designed to combat human impatience

In reality, any premium is a combination of both