C.6 The Risk and Term Structure of Interest Rates Flashcards
Risk structure of interest rates
The relationship among the interest rates on various bonds with the same term to maturity
Term structure of interest rates
The relationship among interest rates on bonds with different terms to maturity
Default occurs when
the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the FV when it matures
Risk premium
The spread between the interest rate on bonds with default risk and the interest rate on default-free bonds
A bond with default risk will always have a ______ risk premium, and an _____ in its default risk will ______ the risk premium
positive; increase; raise
Bonds with relatively low risk of default are called ______ and have a rating of ______ or higher
investment-grade securities; Baa (BBB)
Junk bonds
Bonds with ratings below Baa (or BBB) that have a high default risk
Fallen angels
Investment-grade securities whose rating has fallen to junk levels
Basis point
One one-hundredth of a percentage point
Which long-term bonds are the most liquid
Canada bonds
Lower liquidity of corporate bonds relative to Canada bonds ______ the spread between the interest rates on these two bonds
increases
Yield curve
A plot of the interest rates for particular types of bonds with different terms to maturity
Inverted yield curve
A yield curve that is downward-sloping
When yield curves slope _____, the long-term interest rates are ______ the short-term interest rates
above
Interest rates on bonds of different maturities _____ over time
move together
When short-term interest rates are low, yield curves are more likely to have an ______ slope
upward
Yield curves almost always slope ______
upward
The three theories to explain the term structure of interest rates
- Expectations theory
- The segmented markets theory
- The liquidity premium theory
Which theory can explain all three empirical facts on the term stricture of interest rates
Liquidity premium theory
Expectations theory
The proposition that 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
Perfect substitutes
Bonds with different maturities must have equal expected returns
Segmented markets theory
A theory of term structure that sees markets for different-maturity bonds as completely separated and segmented such that the interest rate for bonds of a given maturity is solely determined by supply of and demand for bonds of that maturity
Key assumption of segmented markets theory
Bonds of different maturities are not substitutes at all, so they have no effect on each other
Key assumption of expectation theory
Buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity
What is the argument for the assumption in segmented markets theory
Investors have very strong preferences for bonds of one maturity but not for another, so they’ll only be concerned with the expected returns of the maturity they prefer
What can the segmented market theory explain
That the yield curve generally slopes upwards
Liquidity premium theory
The theory 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 positive term (liquidity) premium
Liquidity premium’s key assumption
Bonds of different maturities are substitutes, which means expected return on one bonds will affect the expected return on another bond with a different maturity. It also allows investors to prefer a maturity over another
Investors tend to prefer _____-term bonds because
shorter-term bonds because they have lower interest-rate risk
What does the liquidity premium theory add to the expectations theory and why
A positive liquidity premium to induce investors to hold longer-term bonds since they prefer shorter-term ones
Two facts about the liquidity term premium
Always positive and rises with the term to maturity of the bond, n
Preferred habitat theory
A theory that is closely related to liquidity premium theory, in which interest rate on a long-term bond equals an average of short-term interest rates expected to occur over the life of the long-term bond plus a positive term premium. i.e. if the longer-term bond has a higher expected return then they’ll go against their preference for short-term bonds
