Chapter 6

Question 1

Define default risk

Answer 1

Default Risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

Question 2

Define risk premium.

Answer 2

Risk Premium: the spread between the interest rates on corporate bonds and Canada bonds (that have the same maturity)

Question 2

Who creates default-free bonds?

Answer 2

Government of Canada bonds are considered default-free bonds (while default is not impossible, the government can raise taxes or print money to repay)

Question 3

What does a credit-rating agency do?

Answer 3

Credit-rating agencies assess and rate riskiness

Question 4

What are the key factors explaining the difference in yields of bonds of similar maturity

Answer 4

Key factors explaining the difference in yields of bonds of similar maturity:
1. Risk of default
2. Liquidity
3. Tax considerations

Question 5

Explain the liquidity difference leading to different yields on bonds and give two examples

Answer 5

the ease with which an asset can be converted into money (“cash”)

1. cost of selling a bond
2. number of buyers/sellers in a bond market

Question 6

Give an example of how tax considerations affect the yield on bonds with similar maturities

Answer 6

Example: in the U.S. interest payments on municipal bonds are exempt from federal income taxes

Question 7

Facts That the Theory of the Term Structure of Interest Rates Must Explain

Question 8

What is a yield curve?

Answer 8

Yield Curve: a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations

Graphical representation of the term structure

Question 8

Slide 7