chapter 12 theoretical questions Flashcards
If junk bonds are “junk,” then why do investors buy them?
Junk bonds are referred to as “junk” in that they are very risky investments but provide high yields to investors who buy them at very low prices
they are therefore compensated with a high-risk premium
Do you think that a Canadian Treasury bill will have a risk premium that is higher than, lower than, or the same as that of a similar security (in terms of maturity and liquidity) issued by the government of Colombia?
Canadian government-issued securities are usually considered to be default free
However, securities issued by other governments usually have a positive risk premium, depending in general on the fiscal imbalances that each country exhibits at a given point in time
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business-cycle expansions and increase during recessions.
Why is this so?
During business-cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium
during recessions, default risk on corporate bonds increases and their risk premium increases
The Canadian government offers some of its debt as Real Return Bonds, in which the price of bonds is adjusted for inflation over the life of the debt instrument. Real Return Bonds are traded on a much smaller scale than nominal Canada bonds of equivalent maturity.
What can you conclude about the liquidity premiums of Real Return Bonds versus nominal Canada bonds?
Since Real Return Bonds are traded much more lightly than their nominal counterparts, demand for these bonds is somewhat lower than comparable Canada bonds
the higher yield (controlling for the effects of inflation) represents a liquidity premium
because this liquidity effect is relatively small, inflation compensation will generally be larger than the liquidity premium, implying that nominal bond yields overall will be higher than Real Return Bonds of comparable maturity
Predict what would happen to the risk premiums of corporate bonds if brokerage commissions were lower in the corporate bond market.
Risk premiums of corporate bonds would fall.
If the income tax exemption on U.S. municipal bonds were abolished, what would happen to the interest rates on these bonds?
What effect would the change have on interest rates on U.S. Treasury securities?
Abolishing the tax-exempt feature of U.S. municipal bonds would make them less desirable relative to Treasury bonds
The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall
“According to the expectations theory of the term structure, it is better to invest in one- year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years.” Is this statement true, false, or uncertain?
False
The expectations theory of the term structure implies that, with a $1 investment in one- period bonds over two years, the expected return is given as i_t + i_t+1 , which equals 2i_t assuming that one-period bond rates are expected to be the same across both periods
With a $1 investment in a two-period bond, the expected return is 2i_2t . Thus, only if the (expected) one-period bond rate for both periods is greater than the expected two-period bond rate will
one-period bonds be a better investment
Suppose the interest rates on 1-, 5-, and 10-year Canada bonds are currently 3%, 6%, and 6%, respectively
Investor A chooses to hold only 1-year bonds, and Investor B is indifferent with regard to holding 5- and 10-year bonds
How can you explain the behaviour of Investors A and B?
Investor A, even though she receives a lower expected return, clearly prefers to hold short- term debt, perhaps because it is more liquid
Investor A’s preferences are consistent with the segmented markets theory
Investor B is apparently maximizing expected return, but since he is indifferent between the 5- and 10-year bonds, Investor B doesn’t appear to favour any particular maturity and so views the 5- and 10-year bonds as essentially perfect substitutes
this is an assumption consistent with the expectations theory of the term structure
If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?
You would raise your predictions of future interest rates, because the higher long-term rates imply that the average of the expected future short-term rates is higher
Suppose that the Bank of Canada made an announcement that it would purchase up to $300 billion of longer-term Canada securities over the following six months.
What effect might this policy have on the yield curve?
If the Bank of Canada purchases a significant amount of longer-term government debt, this will reduce the effective supply of bonds of those particular maturities, resulting in a higher price and lower yield
This should have the effect of lowering the “long end” of the curve, decreasing medium and longer-term yields.
In other words, the yield curve will shift down, but mostly on medium- and long-term maturities
