Chapter 12 Flashcards
What are the key factors that determine the different bond yields across bonds of similar maturity?
Risk of default
Liquidity
Tax considerations
What is default risk?
It is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
What is risk premium?
It is the spread between the interest rates on bonds with default risk and the interest rates on Canada bonds
What doe credit-rating agencies do?
They assess and grade risk
What is liquidity?
The ease with which an asset can be converted into cash
What are income tax considerations?
They are interest payments on municipal bonds which are exempt from federal income taxes
How can bonds with identical risk, liquidity and tax characteristics differ?
They can have different interest rates because the time remaining to maturity is different
What is the yield curve?
It is a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
What does an upward-sloping yield curve tell us?
That long-term rates are above short-term rates
What does a flat yield curve tell us?
That short-term and long-term rates are the same
What does an inverted yield curve tell us?
That long-term rates are below short-term rates
What are the three facts that the theory of the term structure of interest rates must explain?
- Interest rates on bonds of different maturities move together over time
- When short-term interest rates are low, yield curves are more likely to have an upward slope; when short term rates are high, yield curves are more likely to slope downward and be inverted
- Yield curves almost always slope upward
What does the expectations theory describe?
The interest rate on a long term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond
Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity
Bond holders consider bonds with different maturities to be perfect substitutes
What does the segmented markets theory describe?
Bonds of different maturities are not substitutes at all
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
Investors have preferences for bonds of one maturity over another
If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward
What does the liquidity premium theory describe?
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 liquidity premium that responds to supply and demand conditions for that bond
Liquidity premium also referred to as a term premium
Bonds of different maturities are partial (not perfect) substitutes
What does the preferred habitat theory describe?
Closely related to the liquidity premium theory
Investors have a preference for bonds of one maturity over another
They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return
Investors are likely to prefer short-term bonds over longer-term bonds
What do the liquidity premium and preferred habitat theory describe together?
Interest rates on different bonds move together
Yield curves slope upward when short-term rates are low and downward when short-term rates are high
Yield curves typically slope upward
