Ch. 6 Flashcards
risk structure of interest rates
the relationship among bonds withe same term to maturity that have different interest rates. this includes risk, liquidity and income tax rules.
default risk
occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures.
default-free bonds
bonds with no default risk such as us treasury bonds; b/c the federal gov’t can always raise taxes or print money to pay off its obligations
risk premium
the spread between interest rates on bonds with default res and interest rates on default-free bonds, both of the same maturity; indicates how much additional interest people must earn to be willing to hold the risky bond.
a bond with default risk will always have a POSITIVE/NEGATIVE risk premium, and an increase in its default risk will LOWER/RAISE the risk premium.
positive; raise
investment advisory firms that rate the quality of corporate and municipal bonds in terms of their probability of default.
credit-rating agencies
3 largest credit rating agencies
Moody’s, S&P, Fitch
junk bonds
have higher default risk but have higher interest rates making them high-yield bonds.
liquidity
the more liquid an asset, the more desirable it is; US treasury bonds are most liquid of all long-term bonds b/c they are easiest to sell quickly and the cost to sell is low. liquidity is included in the risk premium along with the default risk.
interest payment on municipal bonds are TAXED OR TAX FREE; this causes the demand for municipal bonds to be HIGHER/LOWER than US treasury bonds even though municipal bonds have lower interest rates and are consider to have a higher default risk.
tax free; higher
term structure of interest rates
the relationship among bonds with different terms to maturity
yield curve
plots the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations
which theory? the interest rate on long-term bonds will equal the average of the short-term interest rates that people expect to occur over the life of the long-term bond.
expectations theory
which theory? sees markets for different-maturity bonds as completely separate and segmented. The interest rate on a bond of a particular maturity is then determined but he supply and demand for that bond, and is not affected by expected returns on other bonds with other maturities.
segmented markets theory
which theory? states the interest rate on 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 liquidity premium.
liquidity premium theory
