class 4 Flashcards
what is the risk structure of interest rates?
the relationships among interest rates on bonds with the same term to maturity
what is the term structure of interest rates?
the relationship among interest rates on bonds with different terms to maturity
what is a term?
the horizon of an investment or loan
do bond yields differ across bonds with similar maturity?
yes
what are the 3 factors that affect bond yield?
risk default
liquidity
tax considerations
over time how have the prices of federal bonds, provincial bonds and corporate bonds ranked in price and interest rate?
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
what is default risk?
the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value
are government of canada bonds considered default free bonds?
yes
what is risk premium?
the spread between the interest rate on bonds with default risk and the interest rates on same maturity Canada bonds
what are credit rating agencies?
agencies that assess and grade bond risk
what grades are investment grade bonds?
bonds with ratings AAA to BBB (Baa)
what grades are speculative bonds (junk bonds or high-yield bonds)?
bonds with ratings of BBB (Baa) or below
what is liquidity?
the ease with which an asset can be converted into cash
what are the 2 things that liquidity depends on?
cost of selling a bond
number of buyers/ sellers in a bond market
what are tax considerations?
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
how could risk of default impact the bonds yield?
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
how could liquidity impact the bonds yield?
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
how could tax considerations impact the bonds yield?
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
what does risk structure of bonds look at?
they look at multiple bonds with the same maturity at different risk and interest rates
what is yield curve?
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)
what are the 3 kinds of yield curves?
upward sloping
flat
inverted
explain an upward sloping yield curve?
longterm rates (higher yield) are above short-term rates (less yield)
explain a flat yield curve?
short and long term rates are the same
explain an inverted yield curve?
longterm rates are below (less yield) short-term rates (higher yield)
what are the 3 facts that the theory of the term structure of interest rates must explain?
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
what are the 3 theories that explain yield curve?
expectations theory
segmented markets theory
liquidity premium theory
what is the expectations theory?
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
what is a key assumption of the expectations theory?
bond holders consider bonds with different maturities to be perfect substitutes
what is an example of the expectations theory?
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%
what are the 2 strategies that can be used in the expectations theory?
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
what are the 3 things that the expectations theory can explain?
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)
what does the expectation theory not explain?
cannot explain why yield curves usually slope upwards
what is the segmented market theory?
states that bonds of different maturities are not substitutes at all and that investors have preferences for bonds of one maturity over another one
how are interest rates of bond determined in the segmented market theory?
the interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
what fact does the segmented market threoy explain?
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)
what is the liquidity premium theory?
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
what is a liquidity premium?
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%)
what is another term for liquidity premium?
term premium
what does the liquidity premium theory say about bond being substitutes?
bonds of different maturities are partial (not perfect)
substitutes
what are 3 things explained by the liquidity premium?
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
what are the application of using the term structure?
using it to forecast interest rates
what are the 2 ways how the term structure can help forecast interest rates?
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
