Behaviour Of Interest Rates Flashcards
Determinants of asset demand, and their relationship (4)
Wealth - positive relationship
Expected return - positive rel
Risk - neg rel
Liquidity (relative to other assets) - positive rel
What determines bond prices and yields
Supply and demand
Factors that shift bond supply (3)
Government borrowing (increase in borrowing, so fund by supplying more bonds so price of bonds fall, interest rates rise)
General business conditions (better conditions, firms invest more, so borrow money by supplying their bonds)
Expected inflation - an increase makes cost of borrowing falls, so they borrow more by supplying more)
Factors that shift bond demand (6)
(Previous was asset demand, but includes all 4 previous ones)
Wealth - pos rel
Expected returns - pos rel
Risk relative to alternatives - neg rel
Liquidity relative to alternatives - pos rel
Expected interest rates - neg rel (expected fall means expected prices rise (price yield relationship), so demand now!
Expected inflation - neg rel - an increase causes a fall in demand. (Since promised payments are worth less, so less attractive)
Pg 11 - increase in expected inflation diagram
Fall in demand (lower return on lending)
and increase in supply (reduces cost of borrowing)
Overall just results in a fall in the price of bond
Why are bonds risky? (3)
Default risk
Inflation risk - uncertainty over real value of payments
Interest rate risk - investment horizon may be shorter than maturity date
Risk premium definition and formula for non-treasury security.
The spread between interest rates on bonds with default risk and the interest rates on treasury bonds
Base interest rate + risk premium
(Base interest rate is the minimum rate investors will demand for investing in a non-treasury security)
Default risk
Probability that the issuer of bond is unable to make interest payments or pay off the face value when the. Bond matures.
Interest rate risk - how is there a risk? (2) (same as liquidity premium theory)
Investment period differs from maturity date: Investors don’t know the holding period return of a long-term bond.
- The longer the term of the bond, the larger the price change for a given change in the interest rate.
- Investors that plan to sell before maturity, changes in interest rate create risk via capital gains/losses. (They want low interest so price is high when they sell)
Risk structure of interest rates:
Why do bonds with same maturity have different interest rates? (3)
Default risk
Liquidity
Tax considerations
1st reason why bonds with same maturity have different interest rates: Default risk.
Default is one of the biggest risks bondholders faces.
How to mitigate this issue (from lender perspective)
Bond rating - to evaluate creditworthiness of potential borrowers.
Bond rating services - what do they do, how is it scored?
They monitor the status of individual bond issuers and assess the likelihood a lender will be repaid by the bond issuer.
A high rating suggests that a bond issuer will have little problem meeting a bond’s payment obligations.
Firms or governments with an exceptionally strong financial position carry the highest ratings and are able to issue the highest-rated bonds.
What are they called
AAA
What are investment grade bonds, and who are they for?
Bonds very low risk of default
(Reserved for most government issuers and corporations that are most financially sound)
Speculative grade bonds
Bonds issued by companies/countries that may have difficultly meeting their bond payments, BUT NOT AT RISK OF IMMEDIATE DEFAULT
Highly speculative bonds
Bonds that are in serious risk of default (unlike speculative, or investment grade)
What are junk / high-yield bonds
Bonds below investment grade
Types of junk bonds (2)
Fallen angels - once investment grade, but issuers fell on hard times, so harder for them to make bond payments.
Bonds where there is little known.
The lower the bond rating… (on default, price, yield)
Higher risk of default
Lower its price (since unattractive)
and higher its yield. (Since want big return for high risk)
What do we compare the bonds to?
benchmarks - treasury issues (since have little default risk)
Then the yields on other bonds are measured in terms of the spread over treasuries
If bond ratings properly reflect risk, what would happen to default-risk premium for a bond with a low rating?
Low rating means high risk of default, so risk premium will be higher (want to be compensated more)
Liquidity (2nd reason why interest rates vary for bonds with same maturity)
Relationship of liquidity and yield
Greater expected liquidity , the lower yield investors require (more willing to accept lower since less risk, will be paid back more often)
What are the most liquid securities
Treasury securities (hence why used as the benchmark!)
On-the-run vs off-the run issues
On-the-run - the most recently issued securities
Off-the-run - older securities
