Interest Rate and Maturity Flashcards
Bonds with the same maturity can have different interest rates due to?
1) Default risk
2) Liquidity
3) Income tax considerations
What is default risk?
Default occurs when the issuer of a bond is unable or unwilling to make interest payments.
Name a default-free bond
Government treasury bonds.
What is the risk premium?
The spread between interest rates on bonds with default risk and interest rates on default-free bonds
What does the risk premium show?
Indicates how much additional interest people must earn to be willing to hold the risky bond.
What are investment-grade securities?
Bonds with relatively low risk of default + have a rating of Baa (or BBB) and above.
What are junk bonds?
High-yield bonds with ratings below Baa (or BBB) that have higher default risk.
Distinguish the liquidity between government and corporate bonds
Government bonds are more liquid than corporate bonds.
Why are treasury bonds highly liquid?
Because they are widely traded, easiest to sell and the cost of selling them is low.
Why do municipal bonds have lower interest than treasury bonds?
Because their interest payments are exempt from federal income taxes.
What is a yield curve?
A plot of the YTM on bonds with different maturity but the same risk, liquidity, and tax considerations
What does an upward sloping yield curve indicate?
Long-term interest rates are above short-term interest rates.
What does a downward sloping yield curve indicate?
Long-term interest rates are below short-term interest rates.
What theories explain the term structure of interest rates?
1) Expectations theory
2) Segmented markets theory
3) Liquidity premium theory
Expectations theory
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.
What are the three key points about the term structure of interest rates?
1) Interest rates move together
2) If short-term is low, upward slope
3) Yield curves tend to be upward
Does the expectation theory satisfy all three points of term structure?
No, only the first and second.
What are the assumptions of the expectation theory?
Investors do not prefer one bond over another (perfect substitutes) + expected return is the same
Segmented market theory
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.
What are the assumptions of the segmented market theory?
Investors have preferences between bonds (there are no substitutes) – short-term bonds with less risk are preferred.
Does the segmented market theory satisfy all three points of term structure?
No, only the last one.
Liquidity premium theory
The interest rate on a long-term bond will equal an average of short-term expected interest rates plus a liquidity premium.
What is a liquidity premium?
A form of additional compensation offered to investors to encourage investment in long-term assets.
What are the assumptions of the liquidity premium theory?
Bonds are imperfect substitutes and investors prefer short-term assets.
Does the liquidity premium theory satisfy all three points of term structure?
Yes.
What is the preferred habitat theory?
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.
