Chapter 5 Market Interest Rates Flashcards
What are the macroeconommic factors that affect interest rates?
- Government Budget
- Federal Reserve Policy
- International Factors
- Business Activities
How does a government budget deficit affect interest rates?
In a government deficit, governments would need to increase borrowings or print more money to pay back the deficit. Hence this increases the interest rates. If the government prints more money, this increase inflation as well which increases the interest rates.
How does international factors affect interest rates?
In a trade deficit, the government owes another country trade amounts. Hence, this increases the tendency for the government to borrow money and therefore increasing interest rates.
How does business activity affect interest rates?
In a recession, there is a TENDENCY FOR INTEREST RATES TO DECLINE.
Explain the concept of flight to quality
Flight to quality is a phenomenon where investors flee riskier investments for safer investments
What is the quoted interest rate?
r = r* (real risk free) + drp (default risk premium) + mrp (maturity risk premium) + IP (inflation premium) + lp (liquidity premium)
What is inflation premium?
Inflation premium (IP) is equal to the AVERAGE expected inflation rate over the life of the security into the rate they charge.
What is the default risk premium?
Default Risk Premium (DRP) is the premium paid to the investor in the event that the borrower will not make scheduled interest or principal payments. The higher the rating of the security, the lower the default risk premium assigned to the security.
What is liquidity premium?
Most securities are highly liquid meaning that they are able to be converted into liquid assets rather than financial assets. Hence, for securities that have trouble turning into liquid assets, they will be given a liquidity risk premium.
What is maturity risk premium?
Maturity Risk Premium (MRP) is a premium that reflects the interest rate risk of the security. Longer the maturity of the security, the higher the MRP.
Higher interest means that you would have earned more money, but since you “locked up” your cash for the financial asset. You are unable to earn the greater interest. Hence, this is the concept of maturity risk premium
What is term structure of interest rates?
It describes the relationship between long term and short term rates. It comprises of risk free rate r* , Inflation Premium, Maturity Risk Premium, Default Risk Premium & Liquidity Premium.
What is the corporate bond yield spread?
DRP + LRP
