Ch. 3 Structure of Interest Rates

Question 1

“Unfavorable” characteristics = _____ VS “Favorable” characteristics = _____

Answer 1

higher yields to attract investors; lower yields since it is safer

Question 2

Lower liquidity = _____ VS Higher liquidity = _____

Answer 2

higher risk premium; lower risk premium

Question 3

Credit (default) Risk

Answer 3

-check the creditworthiness of the security issuer.
-Especially for longer-term securities.
-Treasuries don’t have default risk
-Difference (our debt-treasuries) is called the risk premium

Question 4

Use of Rating Agencies to Assess Credit Risk

Answer 4

-bonds ratings are changes over time, based on the changes in the firm’s financial conditions
-ratings are opinions which not guarantee
-low credit rating bonds default more often compared to high credit rating bonds

Question 5

Financial Reform Act of 2010

Answer 5

-established an Office of Credit Ratings within the SEC (Sec Exch Comm)
-regulate credit agencies
-internal control

Question 6

what are the 2 rating agencies?

Answer 6

Moody
-Ex: Aaa, Aa, A, Baa, Ba, B

S&P
-Ex: AAA, AA, A, BBB, BB, B

Question 7

How does the credit agencies take part in the financial crisis of 2008-2009?

Answer 7

-debt agencies gave the highest rating (AAA) to mortgage loans of homebuyers with bad credit and undocumented income
-all the AAA securities were downgraded to junk rating and written off as losses
-led to the disappearance of major investment banks and Fed Gov. bought billions of bad debt from distressed financial institutions

Question 8

The lower a security’s liquidity = _____ VS The higher a security’s liquidity = _____

Answer 8

the higher the yield preferred by an investor; the lower the yield investor will get

Question 9

what securities and markets have higher liquidity?

Answer 9

Debt securities with a short-term maturity or an active secondary market have greater liquidity.

Question 10

Liquidity

Answer 10

-Investors like liquidity.
-When you need the money will drive your need for liquidity and the returns you are willing to accept.
-MM = very liquid.

Question 11

Pure Expectations Theory

Answer 11

the term structure of interest rates is determined by expectations of interest rates.

Question 12

upward slope = _____

flat = _____

downward slope = _____

Answer 12

higher than today’s interest rate

same as today’s interest rate

lower than today’s interest rate

Question 13

what’s going to happen If investors think rates will go up in the future?

Answer 13

they will prefer the short term now, so they can reinvest for more returns in the future = causing more money supply to go into the short-term securities market = lower interest rate

Question 14

what’s going to happen if corporate borrowers who need to issue debt think rates will go up in the future?

Answer 14

lock in today’s lower rates and pay a lower rate on their debt forever = issuing long term-bonds means There is no demand for short-term funds = D for ST goes down.

Question 15

how’s the sudden decrease in rates going to affect ST and LT?

Answer 15

Supply for LT goes up (you want a higher return longer) = Supply for ST goes down

Demand for LT goes down (I am going to issue debt at lower rates) = Demand for ST goes up

Question 16

Liquidity Premium Theory

Answer 16

-preference for liquid short-term securities = upward pressure on the yield curve
-liquidity is a critical factor for investors and it will change over time

Question 17

what would indicate a recession?

Answer 17

flat or inverted yield curves