class 4

Question 1

what is the risk structure of interest rates?

Answer 1

the relationships among interest rates on bonds with the same term to maturity

Question 2

what is the term structure of interest rates?

Answer 2

the relationship among interest rates on bonds with different terms to maturity

Question 3

what is a term?

Answer 3

the horizon of an investment or loan

Question 4

do bond yields differ across bonds with similar maturity?

Answer 4

yes

Question 5

what are the 3 factors that affect bond yield?

Answer 5

risk default
liquidity
tax considerations

Question 6

over time how have the prices of federal bonds, provincial bonds and corporate bonds ranked in price and interest rate?

Answer 6

federal bonds normally have high price and low interest rate

provincial bonds normally have higher prices and lower interest rates than corporate bonds but not the same as federal bonds

corporate bonds normally have lower prices with higher interest rates

Question 7

what is default risk?

Answer 7

the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

Question 8

are government of canada bonds considered default free bonds?

Answer 8

yes

Question 9

what is risk premium?

Answer 9

the spread between the interest rate on bonds with default risk and the interest rates on same maturity Canada bonds

Question 10

what are credit rating agencies?

Answer 10

agencies that assess and grade bond risk

Question 11

what grades are investment grade bonds?

Answer 11

bonds with ratings AAA to BBB (Baa)

Question 12

what grades are speculative bonds (junk bonds or high-yield bonds)?

Answer 12

bonds with ratings of BBB (Baa) or below

Question 13

what is liquidity?

Answer 13

the ease with which an asset can be converted into cash

Question 14

what are the 2 things that liquidity depends on?

Answer 14

cost of selling a bond
number of buyers/ sellers in a bond market

Question 15

what are tax considerations?

Answer 15

wither a the interest payments of a bond is taxed or not, in the states interest payments on municipal bonds are. exempt from federal income taxes and in Canada they are taxed

Question 16

how could risk of default impact the bonds yield?

Answer 16

if the risk is higher on a bond the price will be lower and the interest rate will be higher and vice versa for lower risk bonds

Question 17

how could liquidity impact the bonds yield?

Answer 17

if it it hard to sell bonds and the liquidity is low than the interest rate would have to be higher to attract customers and vice versa for a easily liquid bond

Question 18

how could tax considerations impact the bonds yield?

Answer 18

if the interest payments are taxed the interest rate would have to be higher to make up for the loss to attract people to buy it

Question 19

what does risk structure of bonds look at?

Answer 19

they look at multiple bonds with the same maturity at different risk and interest rates

Question 20

what is yield curve?

Answer 20

a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations

(the relationship between the term of the bond and the yield to maturity)

Question 21

what are the 3 kinds of yield curves?

Answer 21

upward sloping
flat
inverted

Question 22

explain an upward sloping yield curve?

Answer 22

longterm rates (higher yield) are above short-term rates (less yield)

Question 23

explain a flat yield curve?

Answer 23

short and long term rates are the same

Question 24

explain an inverted yield curve?

Answer 24

longterm rates are below (less yield) short-term rates (higher yield)

Question 25

what are the 3 facts that the theory of the term structure of interest rates must explain?

Answer 25

1) interest rates on bonds of different maturities move together over time

2) when short-term interest rates are low, yield curves are more likely to have an upward slope, when short term rates are high, yield curves are more likely to slope downward and be inverted

3) yield curves usually slope upward

Question 26

what are the 3 theories that explain yield curve?

Answer 26

expectations theory
segmented markets theory
liquidity premium theory

Question 27

what is the expectations theory?

Answer 27

it predicts that the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long term bond

Question 28

what is a key assumption of the expectations theory?

Answer 28

bond holders consider bonds with different maturities to be perfect substitutes

Question 29

what is an example of the expectations theory?

Answer 29

if the current rate of a one year bond to be 6% and you expect the interest rate on a one-year bond to be 8% next year

the average interest rate one two one-year bonds are 7%

the interest rate on a two-year bond today will be 7%

Question 30

what are the 2 strategies that can be used in the expectations theory?

Answer 30

strategy 1: expected return over two periods from investing 1$ in the two-period bond and holding it for two periods

strategy 2: invest 1 dollar to buy a one period (one-year) bond; when it matures, buy another one-year bond

Question 31

what are the 3 things that the expectations theory can explain?

Answer 31

explains why the term structure of interest rates changes at different times

explains why interest rates on bonds with different maturities move together overtime (fact 1)

explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high (fact 2)

Question 32

what does the expectation theory not explain?

Answer 32

cannot explain why yield curves usually slope upwards

Question 33

what is the segmented market theory?

Answer 33

states that bonds of different maturities are not substitutes at all and that investors have preferences for bonds of one maturity over another one

Question 34

how are interest rates of bond determined in the segmented market theory?

Answer 34

the interest rate for each bond with a different maturity is determined by the demand for and supply of that bond

Question 35

what fact does the segmented market threoy explain?

Answer 35

if investors generally prefer bonds with shorter maturities that have less interest rate risk, then this explains why yield curves usually slope upwards (fact 3)

Question 36

what is the liquidity premium theory?

Answer 36

the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond

Question 37

what is a liquidity premium?

Answer 37

the amount by which the yield on a long-term bond is greater then the yield on a shorter-term bond ( if the long term interest rate is 6% and short-term is 4%, the liquidity premium is 2%)

Question 38

what is another term for liquidity premium?

Answer 38

term premium

Question 39

what does the liquidity premium theory say about bond being substitutes?

Answer 39

bonds of different maturities are partial (not perfect)
substitutes

Question 40

what are 3 things explained by the liquidity premium?

Answer 40

interest rates on different bonds move together

yield curves slope upward when short-term rates are low and downward when short term rates are high

yield curves typically slope upwards

Question 41

what are the application of using the term structure?

Answer 41

using it to forecast interest rates

Question 42

what are the 2 ways how the term structure can help forecast interest rates?

Answer 42

the yield curve shows the spot rates of interest available (at a point in time) from investing in different securities with different terms to maturity

it can be used to forecast future short-term interest rate