Chapter 5 Flashcards
Credit rating agencies
agencies rating bond quality
Default
not being able to pay back loan
Default free bonds
bonds that cannot go default and 100% ensures you the final payment
Expectations theory
states the following commonsense
proposition: The interest rate on a long-term bond will equal an average of the shortterm interest rates that people expect to occur over the life of the long-term bond. For 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.
The key assumption behind this theory is that buyers of bonds do not prefer
bonds of one maturity over another, so they will not hold any quantity of a bond if
its expected return is less than that of another bond with a different maturity.
Forward rate
the one-period interest
rate that the pure expectations theory of the term structure indicates is expected
to prevail one period in the future.
Inverted yield curve
downward-sloping yield curve, indicating that long-term interest rates are below short-term interest rates
Junk bonds
Bonds with ratings below
Baa (or BBB) have higher default risk
Liquidity premium theory
states that bonds of different maturities are substitutes, which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows investors
to prefer one bond maturity over another. In other words, bonds of different maturities are assumed to be substitutes, but not perfect substitute
Market segmentation theory
sees markets for different-maturity bonds as completely separate and segmented.
bonds of different
maturities are not substitutes at all, so the expected return from holding a bond of
one maturity has no effect on the demand for a bond of another maturity. This
theory of the term structure is at the opposite extreme to the expectations theory,
which assumes that bonds of different maturities are perfect substitutes.
Preferred habitat theory
A theory that assumes that
investors have a preference for bonds of one
maturity over another, a particular bond maturity (preferred habitat) in which they prefer to
invest
Risk premiun
The spread between the interest rate
on bonds with default risk and the interest rate
on default-free bonds.
Risk structure of interest rates
The relationship among
the various interest rates on bonds with the same
term to maturity
Spot rate
:The interest rate at a given moment.
Term structure of interest rates
