Chapter 12: The Risk and Term Structure of Interest Rates

Question 1

risk structure of interest rates

Answer 1

The relationship of bonds with the same term to maturity with different interest rates

risk and liquidity both play a role in determining the risk structure

Question 2

term structure of interest rates

Answer 2

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

A bond’s term to maturity that also affects its interest rate

Question 3

risk of default

Answer 3

influences a bond’s interest rate

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

Question 4

a corporation facing big losses has more or less chances of having bonds that have risk of default?

Answer 4

more

Question 5

why do government bonds usually have no default risk?

Answer 5

the federal government can always increase taxes to pay off its obligations

default-free bonds

Question 6

default-free bonds

Answer 6

bonds that have no default risk

Question 7

bond risk premium

Answer 7

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

indicates how much additional interest people must earn in order to be willing to hold that risky bond

Question 8

what happens to the risk premium of a corporate bond if its default risk increases (because corporation is bugging or something like that)?

why?

Answer 8

an increase in its default risk will raise the risk premium

the expected return on the corporate bond falls relative to the expected return on the default-free government bond while its relative riskiness rises

the corporate bond is less desirable and demand for it will fall (shift to the left)

it will reduce the corporate bond price and raise interest

the expected return on default-free government bonds increases relative to the expected return on corporate bonds while their relative riskiness declines

the demand for government bonds increases (shift to the right)

it will increase the government bond price and decrease interest

the risk premium is the difference between corporate interest (which is now higher) ad the risk free government bods (which is ow lower)

Question 9

a bond with a default risk will always have a positive or negative risk premium?

Answer 9

a bond with default risk will always have a positive risk premium

Question 10

credit-rating agencies

Answer 10

investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default

Question 11

investment-grade securities

Answer 11

Bonds with relatively low risk of default

have a rating of BBB ad above

Question 12

speculative-grade or junk bonds

Answer 12

Bonds with ratings below BBB

have higher default risk

Question 13

why are speculative-grade or junk bonds also referred to as high-yield bonds

Answer 13

Because these bonds always have higher interest rates than investment-grade securities

Question 14

fallen angels

Answer 14

Investment-grade securities whose rating has fallen to junk levels

Question 15

liquid asset

Answer 15

one that can be quickly and cheaply converted into cash if the need arises

Question 16

attributes that influence bond risk structures (the relationship among interest rates on bonds with the same maturity) and interest rates

Answer 16

default risk

liquidity

the income tax treatment of the bond s interest payments

Question 17

true or false

The more liquid an asset is, the more desirable

Answer 17

true

Question 18

which bonds are the most liquid of all long term bonds?

why?

Answer 18

Canada bonds

because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low

Question 19

why are corporate bonds not that liquid?

Answer 19

because fewer bonds for any one corporation are traded

it can be costly to sell these bonds in an emergency because it may be hard to find buyers quickly

Question 20

how does the liquidity of corporate bonds from a company bugging the interest premium? why?

Answer 20

harder to sell them since they lose liquidity

they become less desirable and governments bonds more desirable

corporate bond price will fall ad their interest will rise

government bond prices will rise and their interests will fall

the risk premium will increase

Question 21

why is a risk premium more accurately defined as risk and liquidity premium?

Answer 21

he differences between interest rates on corporate bonds and Canada bonds (that is, the risk premiums) reflect not only the corporate bond’s default risk but its liquidity too

Question 22

in canada, how are coupon payments on fixed-income securities taxed?

Answer 22

are taxed as ordinary income in the year they are received

Question 23

how can taxes influence how desirable a bond can be?

Answer 23

if in canada, you got a bond that has a higher interest than an American one, but after tax its lower, you ill want the American one

Question 24

how can bonds with identical risk, liquidity, and tax characteristics have different interest rates?

Answer 24

because the time remaining to maturity is different

Question 25

yield curve

Answer 25

A graph of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations it describes the term structure of interest rates for particular types of bonds, such as government bonds

Question 26

inverted yield curve

Answer 26

downward- sloping yield curves

Question 27

how can yield curves be classified?

Answer 27

upward-sloping flat downward- sloping

Question 28

what does it mean when yield curves slope upward?

Answer 28

the long-term interest rates are above the short-term interest rates

Question 29

what does it mean when yield curves are flat?

Answer 29

short- and long-term interest rates are the same

Question 30

what does it mean when yield curves are inverted (downward sloping)?

Answer 30

long-term interest rates are below short-term interest rates

Question 31

three important empirical facts of the term structure of interest rates

Answer 31

1. interest rates on bonds of different maturities move together over time 2. When short-term interest rates are low, yield curves are more likely to have an upward slope when short-term interest rates are high, yield curves are more likely to slope downward and be inverted 3. Yield curves almost always slope upward

Question 32

Four theories have put forward to explain the term structure of interest rates

Answer 32

(1) the expectations theory (2) the segmented markets theory (3) the liquidity premium theory (4) the preferred habitat theory

Question 33

which facts does expectations theory explain

Answer 33

1. interest rates on bonds of different maturities move together over time 2. When short-term interest rates are low, yield curves are more likely to have an upward slope when short-term interest rates are high, yield curves are more likely to slope downward and be inverted vags on the third empirical fact

Question 34

which facts does the segmented markets theory explain

Answer 34

can explain fact 3 (Yield curves almost always slope upward) does not explain the other two empirical facts

Question 35

which theories explain all three of the empirical rules of the term structure of interest rates

Answer 35

the liquidity premium theory preferred habitat theory

Question 36

The expectations theory of the term structure

Answer 36

the interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond r example, if people expect that short-term interest rates will be 10% on average over the coming five years, the expectations theory predicts that the interest rate on bonds with five years to maturity will be 10% too

Question 37

perfect substitute bonds

Answer 37

bonds with different maturities are perfect substitutes, the expected return on these bonds must be equal

Question 38

what is the key assumption behind the expectations theory?

Answer 38

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

Question 39

what are is the formula for the yields of bonds that don't have the same maturity under the expectations theory? the formula for the term structure of bonds under the expectations theory what does it explain?

Answer 39

i_n = ie_+(n-1) n is the amount of periods the n-period interest rate equals the average of the one-period interest rates expected to occur over the n-period life of the bond

Question 40

segmented markets theory of the term structure

Answer 40

sees markets for different maturity bonds as completely separate and segmented

Question 41

under the segmented markets theory, how is the interest rate for each bond with a different maturity determined?

Answer 41

by the supply of and demand for that bond with no effects from expected returns on other bonds with other maturities

Question 42

what is the key assumption in the segmented markets theory?

Answer 42

bonds of different maturities are not substitutes at all the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity

Question 43

how would you compare the expectations theory and the segmented markets theory?

Answer 43

as complete opposites

Question 44

how does the segmented markets theory explain that bonds of different maturities are not substitutes?

Answer 44

investors have very strong preferences for bonds of one maturity but not for another they will be concerned with the expected returns only for bonds of the maturity they prefer

Question 45

how is the return of a bond when the holding period equals the term to maturity?

Answer 45

the return is known for certain because it equals the yield exactly there is no interest-rate risk

Question 46

how does the segmented markets theory explain the third empirical fact?

Answer 46

investors generally prefer bonds with shorter maturities that have less interest-rate risk the demand for long-term bonds is relatively lower than that for short-term bonds, long-term bonds will have lower prices and higher interest rates hence the yield curve will typically slope upward

Question 47

how does the the segmented markets theory fail to explain empirical facts 1 and 2?

Answer 47

Because it views the market for bonds of different maturities as completely segmented, there is no reason for a rise in interest rates on a bond of one maturity to affect the interest rate on a bond of another maturity Therefore, it cannot explain why interest rates on bonds of different maturities tend to move together (fact 1) the theory cannot explain why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high (fact 2) because it is not clear how demand and supply for short- versus long-term bonds change with the level of short-term interest rates

Question 48

The liquidity premium theory of the term structure

Answer 48

states 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 liquidity premium that responds to supply and demand conditions for that bond liquidity premium also referred to as a term premium

Question 49

The liquidity premium theory's key assumption

Answer 49

bonds of different maturities are substitutes this means that the expected return on one bond does influence the expected return on a bond of a different maturity it also allows investors to prefer one bond maturity over another In other words, bonds of different maturities are assumed to be substitutes but not perfect substitutes

Question 50

The liquidity premium theory

Answer 50

induces investors to hold longer-term bonds because they tend to prefer shorter-term

Question 51

The liquidity premium theory formula

Answer 51

i_nt = i_t+(n-1) + l_nt l_nt = the liquidity (term) premium for the n-period bond at time t l_nt is always positive and rises with the term to maturity of the bond n = the term to maturity of the bond

Question 52

the preferred habitat theory

Answer 52

assumes that investors have a preference for bonds of one maturity over another a particular bond maturity (preferred) in which they prefer to invest

Question 53

the preferred habitat theory, when will investors invest in a bond that does not have the preferred maturity (habitat)?

Answer 53

only if they earn a somewhat higher expected return

Question 54

under the preferred habitat theory, when will investors invest in a long term bond? why'

Answer 54

only if they have higher expected returns because investors are likely to prefer the habitat of short-term bonds to that of longer-term bonds

Question 55

why is the yield curve implied by the liquidity premium and preferred habitat theories always above the yield curve implied by the expectations theory and why does it have a steeper slope?

Answer 55

because the liquidity premium is always positive and typically grows as the term to maturity increases

Question 56

how do the liquidity premium and preferred habitat theories explain fact 1 (that interest rates on different-maturity bonds move together over time)

Answer 56

a rise in short-term interest rates indicates that short-term interest rates will, on average, be higher in the future i_nt = i_t+(n-1) + l_nt i_t+(n-1) implies that long-term interest rates will rise along with them

Question 57

how do the liquidity premium and preferred habitat theories explain fact 2 (yield curves tend to have an especially steep upward slope when short-term interest rates are low and to be inverted when short-term rates are high)

Answer 57

Because investors generally expect short-term interest rates to rise to some normal level when they are low, the average of future expected short-term rates will be high relative to the current short-term rate long-term interest rates will be substantially above current short-term rates, and the yield curve would then have a steep upward slope with the additional boost of a positive liquidity premium if short-term rates are high, people usually expect them to come back down Long-term rates would then drop below short-term rates because the average of expected future short-term rates would be so far below current short-term rates that despite positive liquidity premiums, the yield curve would slope downward

Question 58

how do the liquidity premium and preferred habitat theories explain fact 3 (yield curves typically slope upward)

Answer 58

it recognizes that the liquidity premium rises with a bond s maturity because of investors preferences for short-term bonds even if short-term interest rates are expected to stay the same on average in the future, long-term interest rates will be above short-term interest rates, and yield curves will typically slope upward

Question 59

How can the liquidity premium and preferred habitat theories explain the occasional appearance of inverted yield curves if the liquidity premium is positive?

Answer 59

at times short-term interest rates are expected to fall so much in the future that the average of the expected short-term rates is well below the current short-term rate Even when the positive liquidity premium is added to this average, the resulting long-term rate will still be below the current short-term interest rate

Question 60

according to the liquidity premium and preferred habitat theories, what does a steeply rising yield curve indicate?

Answer 60

indicates that short-term interest rates are expected to rise in the future

Question 61

according to the liquidity premium and preferred habitat theories, what does a moderately steep rising yield curve indicate?

Answer 61

indicates that short-term interest rates are not expected to rise or fall much in the future

Question 62

according to the liquidity premium and preferred habitat theories, what does a flat yield curve indicate?

Answer 62

indicates that short-term rates are expected to fall moderately in the future

Question 63

according to the liquidity premium and preferred habitat theories, what does an inverted yield curve indicate?

Answer 63

indicates that short-term interest rates | are expected to fall sharply in the future

Question 64

why should yield curves also forecast inflation and real output fluctuations? how?

Answer 64

Because the yield curve contains information about future expected interest rates the yield curve contains information not only about the future path of nominal interest rates, but about future inflation as well

Question 65

what are rising interest rates associated with? economic booms or recessions

Answer 65

economic booms

Question 66

what are falling interest rates associated with? economic booms or recessions

Answer 66

recessions

Question 67

what does a lat or negatively sloped yield curve indicate when talking about inflation and economic situation?

Answer 67

the economy is more likely to enter a recession a future fall in inflation

Question 68

the forward rate

Answer 68

ie_+1 the one-period interest rate that the pure expectations theory of the term structure indicates is expected to prevail one period in the future the settlement price of a transaction that will not take place until a predetermined date it is forward-looking

Question 69

spot rates

Answer 69

the price for a commodity being traded immediately, or "on the spot" the current market value of an asset at the moment of the quote

Question 70

adjusted forward-rate forecast

Answer 70

ie_t+n this is the equivalent to the formula to allow for liquidity premiums

Question 71

The difference between the expectations and liquidity premium theories’ formulas

Answer 71

They are practically the same, but the liquidity premium theory adds l_nt l_nt is the liquidity premium for the n period bond at time t (when you buy it) l_nt is always positive and increases the longer the term to maturity

Question 72

Why is the yield curve implied by the liquidity premium theory always steeper than the expectations theory?

Answer 72

Because of the former’s liquidity premium, which only grows the longer the term to maturity of the bond