Chapter 3 Flashcards
Credit (Default) Risk
Investors must consider the creditworthiness of the security issuer.
Securities with a higher degree of default risk must offer higher yields.
Rating Agencies
Can change bond ratings over time in response to changes in the issuing firm’s financial condition.
The ratings issued by the agencies are opinions, not guarantees.
Bonds that are assigned a low credit rating experience default more frequently than bonds with a high credit rating.
Liquidity
The lower a security’s liquidity, the higher the yield preferred by an investor.
Debt securities with a short-term maturity or an active secondary market have greater liquidity.
Tax Status
Investors are more concerned with after-tax income.
Taxable securities must offer a higher before-tax yield.
Yat = Ybt(1-T)
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Ybt = Yat / (1-T)
Term to Maturity
The term structure of interest rates defines the relationship between possible terms to maturity an the annualized yield for a debt security at a specific moment in time while holding other factors constant.
Modeling the Yield
Yn = Rf,n + CP + LP + TA
Yn = yield of an n-year debt security
Rf,n = annualized return of an n-year risk-free security with the same term to maturity as the debt security of concern
CP = credit risk premium to compensate for credit risk
LP = liquidity premium to compensate for less liquidity
TA = adjustment due to difference in tax status
Pure Expectations Theory
The term structure of interest rates is determined solely by expectations of interest rates.
A one-year investment followed by a two-year investment should offer the same annualized yield over the three-year horizon as a three-year security that could be purchased today.
(1+i3)^3 = (1+i1) * (1+i2)^2
Liquidity Premium Theory
The preference for the more liquid short-term securities places upward pressure on the slope of a yield curve.
(1+i2)^2 = (1+i1) * (1+r1) + LP2
LP2 = the liquidity premium on a two-year security.
Segmented Markets Theory
Investors choose securities with maturities that satisfy their forecasted cash needs.
Some borrowers and savers have the flexibility to choose among various maturity markets.
Integrating the Term Structure Theories
Investors and borrowers who select security maturities based on anticipated interest rate movements currently expect interest rates to rise.
Most borrowers are in need of long-term funds, whereas most investors have only short-term funds to invest.
Investors prefer more liquidity to less.
These all place upward pressure on long-term yields relative to short-term yields leading to upward sloping yield curve.
Use of the Term Structure
Forecasting interest rates.
Forecasting recessions - flat or inverted yield curves may indicate a recession in the near future.
Making investment and financing decisions - upward sloping yield curves may lead investors to attempt to benefit from long-term securities even with only short-term funds.
International Structure of Interest Rates
Interest rate movements across countries tend to be positively correlated as a result of internationally integrated financial markets.
Actual interest rates may vary significantly across countries.
