Chap 11 Flashcards
The required return on a bond can be expressed as:
ri = r* IP + RP
Yield spreads
differences in interest rates between the various market sectors.
For bonds, the risk premium addresses:
the default (credit) risk of the issuer, liquidity and call risks.
The risk-free rate
it accounts for interest rate and purchasing power risk
real rate of return plus expected inflation premium
Important subjects in the Market Interest Rates : (general info)
The bond market is not a single market, but consists of many different sectors:
- U.S. Treasury issues
- Municipal bond issues
- Corporate bond issues
There is no single interest rate that applies to all the segments of the bond market.
Municipal bond rates are usually 20-30% lower than corporate bond rates due to their tax-exempt feature.
Revenue bonds pay higher rates than general obligation bonds due to higher risk.
Treasury bonds have lower rates than corporate bonds due to no default risk and exemption from state income taxes.
The lower the credit rating (and higher the risk), the higher the interest rate.
Bonds with longer maturities generally provide higher yields than short-term issues (not ALWAYS the case).
Freely callable bonds generally pay higher interest rates than noncallable bonds.
What Causes Rates to Move?
- Inflation
- Money supply
- Federal budget (goverment)
- Economic activity
- Reserves policies
- Foreign interest rate
When money supply change, what happens with the interest rate ?
- Slow increase ——> decrease
- Slow decrease ——> increase
- Fast increase ——>increase
- Fast decrease —–>decrease
When federal budget change, what happens with the interest rate ?
- Deficit ———> increase
- surplus =====> decrease
When economic activity change, what happens with the interest rate ?
- Recession ——-> decrease
- Expansion =====> increase
Term structure of interest rates
the relationship between interest rates (yield) and time to maturity for any class of similar-risk securities.
Yield curve graph
a graph that depicts the Term structure of interest rates
Types of Yield Curves
- Most common type is upward-sloping
- Occasionally, the yield curve becomes inverted
- Flat: rates for short- and long-term debt are essentially the same.
- Humped: when intermediate rates are the highest.
Reason for the use of treasury security (bill, bonds and notes):
Treasury securities have no risk of default.
They are actively traded, so their prices and yields are easy to observe.
They are relatively homogeneous with regard to quality and other issue characteristics.
Can also construct yield curves with other classes of debt securities, such as A-rated municipal bonds, Aa-rated corporate bonds, and even certificates of deposit.
theories to explain reasons for the general shape of the yield curve:
Expectations hypothesis
Liquidity preference theory
Market segmentation theory
Expectations Hypothesis
The yield curve reflects investor expectations about the future behavior of interest rates.
- When investors expect interest rates to go up, they will only purchase long-term bonds if those bonds offer higher yields than short-term bonds; hence the yield curve will be upward sloping.
- When investors expect interest rates to go down, they will only purchase short-term bonds if those bonds offer higher yields than long-term bonds; hence the yield curve will be downward sloping.
Liquidity Preference Theory
long-term bond rates should be higher than short-term rates because of the added risks involved with the longer maturities.
- Investors may view long-term bonds as being riskier because long-term bonds are less liquid and are subject to greater interest rate risk.
- Borrowers will also pay a premium to obtain long-term funds. Borrowers thus assure themselves that funds will be available and avoid having to roll over short-term debt at unknown and possibly unfavorable rates.
