Chapter 6 Flashcards
What is default risk?
One attribute of a bond that influences its interest rate is its risk of default. Occurs when issuer is unable/unwilling to make interest payments when promised or pay off face value when bond matures
What are default free bonds?
Bonds with no default risk. (i.e. US Treasury bonds since government can always increase taxes or print money)
What is risk premium?
the spread between interest rates on bonds with default risk and interest rates on default free bonds, both with the same maturity. Indicates how much additional interest people must earn to be willing to hold the risky bond
What can we conclude about a bond with default risk?
A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium.
Who are credit rating agencies?
investment advisory firms that rate the quality of corporate and municipal bonds in terms of their probability of default.
i.e Standard and Poor’s , Moody’s
Why are municipal bonds not as liquid as US Treasury bonds?
Municipal Bonds have lower interest rates and interest payments on these bonds are exempt from federal income tax.
This factor has the same effect on their demand as an increase in their expected return.
What is a Yield Curve?
A plot of yields on bonds with differing terms to maturity but the same risk, liquidity and tax considerations.
Describes the term structure of interest rates for particular types of bonds
Yield curve movements and interest rates?
- interest rates on bonds of different maturities move together over time
- When short term interest rates are low, yield curves are more likely to have an upward slope
- when short term interest rates are high, yield curves are more likely to slope downward and be inverted
- Yield curves almost always slope upwards.
What is expectations theory?
The interest rate on a long term bond will equal the average of the short term interest rates that people expect to occur over the life of the long term bond.
What are perfect substitutes?
Bonds with different maturities are perfect substitutes when the expected return on those bonds are equal.
What is segmented market theory?
sees markets for different maturity bonds as completely separate and segmented
key assumption is that bonds of different maturities are not substitutes at all, and so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity.
What can expectations theory not explain?
Yield curves almost always slope upwards. typical upward slope implies that short term interest rates are usually expected to rise in the future. In practice, short term interest rates are just as likely to fall as they are to rise, and so the expectations theory suggests that the typical yield curve should be flat rather than upward sloping.
What 2 things can segmented market theory not explain?
Firstly, as it views market for bonds of different maturities as completely segmented, there is no reason that a rise in the interest on a bond of one maturity would affect the interest rate of another. Therefore cannot explain why interest rates on bonds of different maturities tend to move together.
Secondly, because supply and demand of short versus long is unclear with change of level of short term interest rates. The theory does not explain why yield curves tend to slope upward when short term interest rates are low and to be inverted when short term interest rates are high.
What is liquidity premium theory?
states that the interest rate on a long term bond will equal an average of short term interest rates expected to occur over the life of the long term bond plus a liquidity premium that responds to supply and demand conditions for that bond.
What is the key assumption of liquidity premium theory?
bonds of different maturities are substitutes, meaning expected return on one bond does influence the expected return on a bond of a different maturity.
Bonds if different maturities are assumed to be substitutes, but not perfect substitutes.
