Chapter 6: bond valuation and interest rates part 4

Question 1

what are the 3 theories of the term structure of interest rates

Answer 1

1. liquidity preference theory
2. expectations theory
3. market segmentation theory

Question 2

what is the liquid preference theory

Answer 2

refers to the demand for money, considered as liquidity
posits that investors must be paid a liquid premium in order to be compensated for the interest rate risk inherent in holding less liquid, longer-term debt

Question 3

what is the expectations theory

Answer 3

suggests that longer-term interest rates are the result of expectations of future short-term interest rates or

in other words, the interest rates of various maturities are dependant on each other

Question 4

what is market segmentation theory

Answer 4

suggest that different markets exist for securities of different maturities that therefore the two ends of the yield curve can have different factors affecting them

Question 5

what are risk premiums

Answer 5

more risky bonds

Question 6

what would a BBB- rate corporate bond show

Answer 6

will have their own yield curve
- will plot at higher YTM at every maturity than government bonds
because of the additional default risk that BBBs carry

Question 7

the yield spread is what

Answer 7

the difference between the YTM on a BB-rated corporate bond and the government of Canada bond of the same maturity

Question 8

what does the yield spread represent

Answer 8

the default risk premium investors demand for investing in more risky corporate bonds

Question 9

when does the yield spread widen

Answer 9

during recessions

Question 10

when does the yield spread narrow

Answer 10

during times of economic expansion

Question 11

what is RF

Answer 11

is the risk-free rate

Question 12

more here page 9

Answer 12

page 9

Question 13

what are debt ratings

Answer 13

risk agencies, such as the dominion bond rating service (DBRS), standard and poors (S&P) and MOddy’s assign all publicly traded bonds a risk rating

Question 14

what are the interest rate determinants

Answer 14

risk, liquidity and bond features

Question 15

the greater the default risk

Answer 15

the higher the required YTM

Question 16

the less liquid the bond

Answer 16

the higher the required YTM

Question 17

call features do what to the YTM

Answer 17

generally increase the required YTM

Question 18

extendable bonds do what to the YTM

Answer 18

generally have lower required YTMs

Question 19

Retractable bonds do what to the YTM

Answer 19

generally have lower required YTMs

Question 20

what are T-bills

Answer 20

short-term obligations of the government

Question 21

what are the characteristics of T-bills

Answer 21

1. initial term to maturity of one year or less
2. issued at a discount to face value
   
   • face value being paid at maturity
3. the difference between the discounted issue price and the face value is treated as interest income

Question 22

what is the equation for T-bills

Answer 22

see page 11

Question 23

what are zero coupon bonds

Answer 23

bonds issued at a discount which pay no coupons and mature at par or face value

Question 24

what is a good feature about zero coupon bonds

Answer 24

since no coupons are paid, there is no reinvestment rate risk

Question 25

what is the formula for zero coupon bonds

Answer 25

see 12

Question 26

what are floating rate bonds

Answer 26

have coupon rates that float with some reference rate such as
1. the yield on treasury bills

since the coupon rate floats, or is variable, the market will typically be close to the bond’s face value

Question 27

what are real return bonds

Answer 27

are issued by the gov. of Canada to protect investors against unexpected inflation

Question 28

what are some characteristics of real return bonds

Answer 28

each period the face value is gorse dup by the inflation rate
- the coupon is then paid on the grossed up face value

Question 29

what are Canada savings bonds (CSBs)

Answer 29

issued by the government of Canada as either

1. regular interest bonds (interest paid annually)
2. compound interest bonds (interest compounds over the life of the bond)

Question 30

is there a secondary market for Canada savings bonds?

Answer 30

no,

instead they are redeemable at any chartered bank in Canada at their face value

Question 31

what is the interest rate parity

Answer 31

demonstrates why differences in interest rates between countries should be offset by forward exchange rates

Question 32

in interest rate parity if no arbitrage opportunities exist, what equation should be used

Answer 32

F / S = 1 + K (domestic) / 1 + K foreign

F = current forward exchange rate (domestic units for foreign units)
S = current spot exchange rate
K domestic = domestic interest rate
K foreign = foreign interest rate

Question 33

more information on interet rate praitiy

Answer 33

get more info