Behaviour Of Interest Rates

Question 1

Determinants of asset demand, and their relationship (4)

Answer 1

Wealth - positive relationship
Expected return - positive rel
Risk - neg rel
Liquidity (relative to other assets) - positive rel

Question 2

What determines bond prices and yields

Answer 2

Supply and demand

Question 3

Factors that shift bond supply (3)

Answer 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)

Question 4

Factors that shift bond demand (6)

(Previous was asset demand, but includes all 4 previous ones)

Answer 4

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)

Question 5

Pg 11 - increase in expected inflation diagram

Answer 5

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

Question 6

Why are bonds risky? (3)

Answer 6

Default risk

Inflation risk - uncertainty over real value of payments

Interest rate risk - investment horizon may be shorter than maturity date

Question 7

Risk premium definition and formula for non-treasury security.

Answer 7

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)

Question 8

Default risk

Answer 8

Probability that the issuer of bond is unable to make interest payments or pay off the face value when the. Bond matures.

Question 9

Interest rate risk - how is there a risk? (2) (same as liquidity premium theory)

Answer 9

Investment period differs from maturity date: Investors don’t know the holding period return of a long-term bond.

1. The longer the term of the bond, the larger the price change for a given change in the interest rate.
2. 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)

Question 10

Risk structure of interest rates:

Why do bonds with same maturity have different interest rates? (3)

Answer 10

Default risk

Liquidity

Tax considerations

Question 11

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)

Answer 11

Bond rating - to evaluate creditworthiness of potential borrowers.

Question 12

Bond rating services - what do they do, how is it scored?

Answer 12

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.

Question 13

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

Answer 13

AAA

Question 14

What are investment grade bonds, and who are they for?

Answer 14

Bonds very low risk of default

(Reserved for most government issuers and corporations that are most financially sound)

Question 15

Speculative grade bonds

Answer 15

Bonds issued by companies/countries that may have difficultly meeting their bond payments, BUT NOT AT RISK OF IMMEDIATE DEFAULT

Question 16

Highly speculative bonds

Answer 16

Bonds that are in serious risk of default (unlike speculative, or investment grade)

Question 17

What are junk / high-yield bonds

Answer 17

Bonds below investment grade

Question 18

Types of junk bonds (2)

Answer 18

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.

Question 19

The lower the bond rating… (on default, price, yield)

Answer 19

Higher risk of default

Lower its price (since unattractive)

and higher its yield. (Since want big return for high risk)

Question 20

What do we compare the bonds to?

Answer 20

benchmarks - treasury issues (since have little default risk)

Then the yields on other bonds are measured in terms of the spread over treasuries

Question 21

If bond ratings properly reflect risk, what would happen to default-risk premium for a bond with a low rating?

Answer 21

Low rating means high risk of default, so risk premium will be higher (want to be compensated more)

Question 22

Liquidity (2nd reason why interest rates vary for bonds with same maturity)

Relationship of liquidity and yield

Answer 22

Greater expected liquidity , the lower yield investors require (more willing to accept lower since less risk, will be paid back more often)

Question 23

What are the most liquid securities

Answer 23

Treasury securities (hence why used as the benchmark!)

Question 24

On-the-run vs off-the run issues

Answer 24

On-the-run - the most recently issued securities

Off-the-run - older securities

Question 25

What are more liquid, and more expensive?

Answer 25

On the run, which investors value. So are more expensive

Question 26

3rd reason why bonds have different interest rates:

Tax considerations; how?

Answer 26

Bondholders must pay tax on the payments they receive.

(Bonds that issued by state/gov are tax exempt tho)

Question 27

Good tax question pg 31

Question 28

Tax-exempt bond yield formula

Answer 28

Tax-exempt bond yield = Taxable bond yield x (1-Tax rate)

Question 29

What can be done alternatively, and what is this called?

Answer 29

We can determine yield that must be offered on a taxable bond to give the same after-tax yield as a tax-exempt bond.

Called the equivalent taxable yield

Question 30

Equivalent taxable yield formula

Answer 30

Equivalent taxable yield = Tax exempt yield / (1-tax rate)