Chapter 6: bond valuation and interest rates part 4 Flashcards
what are the 3 theories of the term structure of interest rates
- liquidity preference theory
- expectations theory
- market segmentation theory
what is the liquid preference theory
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
what is the expectations theory
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
what is market segmentation theory
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
what are risk premiums
more risky bonds
what would a BBB- rate corporate bond show
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
the yield spread is what
the difference between the YTM on a BB-rated corporate bond and the government of Canada bond of the same maturity
what does the yield spread represent
the default risk premium investors demand for investing in more risky corporate bonds
when does the yield spread widen
during recessions
when does the yield spread narrow
during times of economic expansion
what is RF
is the risk-free rate
more here page 9
page 9
what are debt ratings
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
what are the interest rate determinants
risk, liquidity and bond features
the greater the default risk
the higher the required YTM
the less liquid the bond
the higher the required YTM
call features do what to the YTM
generally increase the required YTM
extendable bonds do what to the YTM
generally have lower required YTMs
Retractable bonds do what to the YTM
generally have lower required YTMs
what are T-bills
short-term obligations of the government
what are the characteristics of T-bills
- initial term to maturity of one year or less
- issued at a discount to face value
- face value being paid at maturity
- the difference between the discounted issue price and the face value is treated as interest income
what is the equation for T-bills
see page 11
what are zero coupon bonds
bonds issued at a discount which pay no coupons and mature at par or face value
what is a good feature about zero coupon bonds
since no coupons are paid, there is no reinvestment rate risk
what is the formula for zero coupon bonds
see 12
what are floating rate bonds
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
what are real return bonds
are issued by the gov. of Canada to protect investors against unexpected inflation
what are some characteristics of real return bonds
each period the face value is gorse dup by the inflation rate
- the coupon is then paid on the grossed up face value
what are Canada savings bonds (CSBs)
issued by the government of Canada as either
- regular interest bonds (interest paid annually)
- compound interest bonds (interest compounds over the life of the bond)
is there a secondary market for Canada savings bonds?
no,
instead they are redeemable at any chartered bank in Canada at their face value
what is the interest rate parity
demonstrates why differences in interest rates between countries should be offset by forward exchange rates
in interest rate parity if no arbitrage opportunities exist, what equation should be used
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
more information on interet rate praitiy
get more info
