C.6 The Risk and Term Structure of Interest Rates

Question 1

Risk structure of interest rates

Answer 1

The relationship among the interest rates on various bonds with the same term to maturity

Question 2

Term structure of interest rates

Answer 2

The relationship among interest rates on bonds with different terms to maturity

Question 3

Default occurs when

Answer 3

the issuer of the bond is unable or unwilling to make interest payments when promised or to pay off the FV when it matures

Question 4

Risk premium

Answer 4

The spread between the interest rate on bonds with default risk and the interest rate on default-free bonds

Question 5

A bond with default risk will always have a ______ risk premium, and an _____ in its default risk will ______ the risk premium

Answer 5

positive; increase; raise

Question 6

Bonds with relatively low risk of default are called ______ and have a rating of ______ or higher

Answer 6

investment-grade securities; Baa (BBB)

Question 7

Junk bonds

Answer 7

Bonds with ratings below Baa (or BBB) that have a high default risk

Question 8

Fallen angels

Answer 8

Investment-grade securities whose rating has fallen to junk levels

Question 9

Basis point

Answer 9

One one-hundredth of a percentage point

Question 10

Which long-term bonds are the most liquid

Answer 10

Canada bonds

Question 11

Lower liquidity of corporate bonds relative to Canada bonds ______ the spread between the interest rates on these two bonds

Answer 11

increases

Question 12

Yield curve

Answer 12

A plot of the interest rates for particular types of bonds with different terms to maturity

Question 13

Inverted yield curve

Answer 13

A yield curve that is downward-sloping

Question 14

When yield curves slope _____, the long-term interest rates are ______ the short-term interest rates

Answer 14

above

Question 15

Interest rates on bonds of different maturities _____ over time

Answer 15

move together

Question 16

When short-term interest rates are low, yield curves are more likely to have an ______ slope

Answer 16

upward

Question 17

Yield curves almost always slope ______

Answer 17

upward

Question 18

The three theories to explain the term structure of interest rates

Answer 18

1. Expectations theory
2. The segmented markets theory
3. The liquidity premium theory

Question 19

Which theory can explain all three empirical facts on the term stricture of interest rates

Answer 19

Liquidity premium theory

Question 20

Expectations theory

Answer 20

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

Question 21

Perfect substitutes

Answer 21

Bonds with different maturities must have equal expected returns

Question 22

Segmented markets theory

Answer 22

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

Question 23

Key assumption of segmented markets theory

Answer 23

Bonds of different maturities are not substitutes at all, so they have no effect on each other

Question 24

Key assumption of expectation theory

Answer 24

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

Question 25

What is the argument for the assumption in segmented markets theory

Answer 25

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

Question 26

What can the segmented market theory explain

Answer 26

That the yield curve generally slopes upwards

Question 27

Liquidity premium theory

Answer 27

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

Question 28

Liquidity premium’s key assumption

Answer 28

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

Question 29

Investors tend to prefer _____-term bonds because

Answer 29

shorter-term bonds because they have lower interest-rate risk

Question 30

What does the liquidity premium theory add to the expectations theory and why

Answer 30

A positive liquidity premium to induce investors to hold longer-term bonds since they prefer shorter-term ones

Question 31

Two facts about the liquidity term premium

Answer 31

Always positive and rises with the term to maturity of the bond, n

Question 32

Preferred habitat theory

Answer 32

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