Chapter 6 Flashcards
Interest rates can be thought of as the ___1___ of ___2____. They are ultimately determined by the forces of _____3_____ and ___4___ for __5__ funds.
- Price
- Money
- Supply
- Demand
- Loanable
The main factor that influences a business’ willingness to borrow is______________________.
The three factors that influence potential lenders to provide funds are: 1, 2, 3.
Business Prospects and their returns.
1) Time preference for spending
2) Perceived risk of business prospects
3) Expected Inflation
All else remaining the same, if businesses have a desire to borrow more, interest rates will ____________.
Increase
All else remaining the same, if lenders become less willing to provide funds, interest rates will _____________.
Increase
When interest rates rise, the value of financial assets (such as bonds) ____1______. Because of a negative _____2___ effect, this will likely lead to ___3_____ consumer spending. If this happens, the profitability of businesses ____4____, and businesses tend to___5___, leading also to less consumer spending.
- decrease
- wealth
- reduced
- declines
- downsize
Interest rates vary by the terms (time to maturity) of financial assets such as bonds. These three basic terms are:
- Short Term
- Intermediate Term
- Long Term
Interest rates vary by the terms (time to maturity) of financial assets such as bonds. One of the three basic terms, [Short Term] definition is
Maturity less than 1 year
Interest rates vary by the terms (time to maturity) of financial assets such as bonds. One of the three basic terms, [Intermediate Term] definition is
Maturity between 1 and 10 years
Interest rates vary by the terms (time to maturity) of financial assets such as bonds. One of the three basic terms, [Long Term] definition is
Maturity more than 10 years
Interest rates tend to __1__ during recessions, and __2__ during business expansions. Also, short term rates are more ___3__ than long term interest rates.
- decline
- increase
- volatile
Something called the ___1___ rate of interest is equal to nominal interest rates minus ________2____________.
- real
2. the inflation rate
r* can be defined as the ____1_______.
When analyzing interest rates, this is the lowest possible rate to which we add various __2___ to compensate lenders for various risks.
- real, risk free rate of return
2. Risk Premiums
There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. These are:
- IP
- DRP
- LP
- MRP
There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “IP” what it stands for and what it compensates for
stands for:
Inflation
Premium
compensates for:
Inflation, reduction in purchasing
power
There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “DRP” what it stands for and what it compensates for
stands for:
Default risk
premium
compensates for:
The risk that the borrower may not
be able to make interest payments
or repay the bond principal
There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “LP” what it stands for and what it compensates for
stands for:
Liquidity
Premium
compensates for:
The risk that you may not be able
to dispose of a bond when you
need to.
There are four possible additions (called Risk Premiums) to r* that serve to compensate lenders for risks. One These is “MRP” what it stands for and what it compensates for
stands for:
Maturity Risk
Premium
compensates for: The risk that, during a bond’s term, market interest rates might rise, and thus the value of your bond decline.
When the term ‘risk-free rate’ is used, it normally refers to ___ + ___, and is labeled Rrf.
( r* + IP ) = Real, risk free rate of return + Inflation premium
Which of the 4 Risk Premiums vary directly with the years to maturity (term) of bonds?
DRP - Default Risk Premium
LP - Liquidity Premium
MRP - Maturity Risk Premium
What are the two main classifications of bonds in respect to their ratings by Standard & Poor’s? At what rating does the higher (less risky) of the two classifications end?
Investment Grade Bonds & Junk Bonds
Investment Grade Bond classification ends at BBB (BB is Junk)
What is the normal slope of a Yield Curve, and why?
Upward Sloping due to risks such as DRP, LP, and MRP.
Why might a Yield Curve be inverted?
If inflation rates are expected to decrease in the future.
How would you compare the Yield Curve for Corporate Bonds to a Yield Curve for a U.S. Treasury Bonds (all else the same)? What differences should exist?
The Yield Curve for Corporate Bonds would lie above the Yield Curve for Treasuries. This would imply
higher interest rates, which compensate for higher risks
How would a Federal Government budget deficit impact market interest rates?
A Federal Deficit leads to more Federal Government borrowing. This increases the demand for loan-able
funds, and increases interest rates.
Which of the Risk Premiums has the largest impact on the slope of (any) Yield Curve, and why?
Expected inflation (Inflation Premium)
Corp Bond yield
Quoted interest rate =
r = r* + IP + DRP + LP + MRP
U.S Treasury Bond yield =
r* + IP + MRP
