Interest Rate and Maturity

Question 1

Bonds with the same maturity can have different interest rates due to?

Answer 1

1) Default risk
2) Liquidity
3) Income tax considerations

Question 2

What is default risk?

Answer 2

Default occurs when the issuer of a bond is unable or unwilling to make interest payments.

Question 3

Name a default-free bond

Answer 3

Government treasury bonds.

Question 4

What is the risk premium?

Answer 4

The spread between interest rates on bonds with default risk and interest rates on default-free bonds

Question 5

What does the risk premium show?

Answer 5

Indicates how much additional interest people must earn to be willing to hold the risky bond.

Question 6

What are investment-grade securities?

Answer 6

Bonds with relatively low risk of default + have a rating of Baa (or BBB) and above.

Question 7

What are junk bonds?

Answer 7

High-yield bonds with ratings below Baa (or BBB) that have higher default risk.

Question 8

Distinguish the liquidity between government and corporate bonds

Answer 8

Government bonds are more liquid than corporate bonds.

Question 9

Why are treasury bonds highly liquid?

Answer 9

Because they are widely traded, easiest to sell and the cost of selling them is low.

Question 10

Why do municipal bonds have lower interest than treasury bonds?

Answer 10

Because their interest payments are exempt from federal income taxes.

Question 11

What is a yield curve?

Answer 11

A plot of the YTM on bonds with different maturity but the same risk, liquidity, and tax considerations

Question 12

What does an upward sloping yield curve indicate?

Answer 12

Long-term interest rates are above short-term interest rates.

Question 13

What does a downward sloping yield curve indicate?

Answer 13

Long-term interest rates are below short-term interest rates.

Question 14

What theories explain the term structure of interest rates?

Answer 14

1) Expectations theory
2) Segmented markets theory
3) Liquidity premium theory

Question 15

Expectations theory

Answer 15

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

Question 16

What are the three key points about the term structure of interest rates?

Answer 16

1) Interest rates move together
2) If short-term is low, upward slope
3) Yield curves tend to be upward

Question 17

Does the expectation theory satisfy all three points of term structure?

Answer 17

No, only the first and second.

Question 18

What are the assumptions of the expectation theory?

Answer 18

Investors do not prefer one bond over another (perfect substitutes) + expected return is the same

Question 19

Segmented market theory

Answer 19

Sees markets for different maturity bonds as completely separate and segmented → the interest rate on a bond is determined only by the supply and demand of that bond.

Question 20

What are the assumptions of the segmented market theory?

Answer 20

Investors have preferences between bonds (there are no substitutes) – short-term bonds with less risk are preferred.

Question 21

Does the segmented market theory satisfy all three points of term structure?

Answer 21

No, only the last one.

Question 22

Liquidity premium theory

Answer 22

The interest rate on a long-term bond will equal an average of short-term expected interest rates plus a liquidity premium.

Question 23

What is a liquidity premium?

Answer 23

A form of additional compensation offered to investors to encourage investment in long-term assets.

Question 24

What are the assumptions of the liquidity premium theory?

Answer 24

Bonds are imperfect substitutes and investors prefer short-term assets.

Question 25

Does the liquidity premium theory satisfy all three points of term structure?

Answer 25

Yes.

Question 26

What is the preferred habitat theory?

Answer 26

Assumes investors have a preference for bonds of different maturity: investors will buy bonds that do not have the preferred maturity only if they earn a higher return.