Module 1.3

Question 1

Why Debt Security Yields Vary (1 of 7)

Answer 1

The yields on debt securities are affected:
Credit (default) risk
Liquidity
Tax status
Term to maturity

Question 2

Credit (default) Risk

Answer 2

Investors must consider the creditworthiness of
the security issuer.
▪ All else being equal, securities with a higher
degree of default risk must offer higher yields.
▪ Especially relevant for longer term securities.

Question 3

Credit (default) Risk (cont.)

Answer 3

In general, securities with a higher degree of default
risk offer higher yields.
▪ Rating Agencies — Rating agencies charge the issuers of debt securities a
fee for assessing default risk. (Exhibit 3.1).
▪ Accuracy of Credit Ratings — The ratings issued by the agencies are
useful indicators of default risk but they are opinions, not guarantees.
▪ Oversight of Credit Rating Agencies — The Financial Reform Act of
2010 established an Office of Credit Ratings within the Securities and
Exchange Commission in order to regulate credit rating agencies. Rating
agencies must establish internal controls.

Question 4

Liquidity

Answer 4

The lower a security’s liquidity, the higher the
yield preferred by an investor.
▪ Debt securities with a short-term maturity or an
active secondary market have greater liquidity.

Question 5

Tax Status (Exhibit 3.2)

Answer 5

Investors are more concerned with after-tax
income.
▪ Taxable securities must offer a higher before-tax
yield.

Question 6

Computing the Equivalent Before-Tax Yield:

Answer 6

Yat=Ybt(1-T)
Yat=after tax yield
Ybt=before Tax Yield
T=investor’s marginal tax rate

Ybt=Yat/(1-T)

Question 7

Term to Maturity (Exhibit 3.3)

Answer 7

Maturity dates will differ between debt
securities.
▪ The term structure of interest rates defines the
relationship between term to maturity and the
annualized yield

Question 8

Explaining Actual Yield Differentials (1 of 3)

Answer 8

Small yield differentials can be relevant.
▪ The yield differential is the difference between
the yield offered on a security and the yield on
the risk-free rate.
▪ They are sometimes measured in basis points
where 1bp = 0.01%

Question 9

Yield Differentials on Money Market Securities

Answer 9

Yields on commercial paper and negotiable
CDs are only slightly higher than T-bill rates to
compensate for lower liquidity and higher
default risk.
▪ Market forces cause the yields on all securities
to move in the same direction.

Question 10

Yield Differentials on Capital Market Securities

Exhibit 3.4

Answer 10

Municipal bonds have the lowest before-tax yield
but their after-tax yields are typically higher than
Treasury bonds.
▪ Treasury bonds have the lowest yield because of
their low default risk and high liquidity

Question 11

Estimating the Appropriate Yield

Answer 11

Yn = Rf,n + DP + LP + TA
where:
Yn
= yield of an n-day debt security
Rf,n
= yield of an n-day Treasury (risk-free) security
DP = default premium to compensate for credit risk
LP = liquidity premium to compensate for less liquidity
TA = adjustment due to difference in tax status

Question 12

A Closer Look at the Term Structure (1 of 5)

Answer 12

Pure Expectations Theory: Term structure
reflected in the shape of the yield curve is
determined solely by the expectations of interest
rates.
▪ Impact of an Expected Increase in Rates leads
to an upward sloping yield curve. (Exhibit 3.5)
▪ Impact of an expected Decline in Rates leads
to a downward sloping yield curve.

Question 13

Pure Expectations Theory

Answer 13

Algebraic Presentation:
(1+tI2^)2=(1+tI1)^2*(1+t=1F1)
where
tI2=known annualized interest rate of a 2 year security at time t
tI1=known annualized interest rate of a 1 year security at time t

Question 14

Liquidity Premium Theory:

Answer 14

Investors prefer
short-term liquid securities but will be willing to
invest in long-term securities if compensated with
a premium for lower liquidity. (Exhibit 3.6)
▪ Estimation of Forward Rates Based on
Liquidity Premium
(1 + ti2)^2 = (1 + ti1)(1 + t+1r1) + LP2
where LP2
is the liquidity premium on the 2 year security

Question 15

Segmented Markets Theory

Answer 15

Investors choose
securities with maturities that satisfy their
forecasted cash needs.
▪ Limitation of the Theory:
▪ Some borrowers and savers have the flexibility to choose
among various maturities.
▪ Implications: Preferred Habitat Theory
▪ Although investors and borrowers may normally
concentrate on a particular maturity market, certain
events may cause them to wander from their “natural” or
preferred market.

Question 16

Research on the Term Structure Theories

Answer 16

Interest rate expectations have a strong influence on the
term structure of interest rates.
▪ However, the forward rate derived from a yield curve
does not accurately predict future interest rates, and this
suggests that other factors may be relevant.
▪ General Research Implications — Although the results
differ, there is evidence that expectations, liquidity
premium, and segmented markets theories all have
some validity.

Question 17

Integrating the Theories of the Term Structure (1 of 4)

Answer 17

If we assume the following conditions:
▪ Investors and borrowers currently expect interest rates to
rise.
▪ Most borrowers need long-term funds, while most
investors have only short-term funds to invest.
▪ Investors prefer more liquidity to less.
▪ Then all three conditions place upward
pressure on long-term yields relative to short
term yields leading to upward sloping yield
curve. (Exhibit 3.7)

Question 18

Use of the Term Structure

Answer 18

Forecasting Interest Rates
▪ The shape of the yield curve can be used to assess the
general expectations of investors and borrowers about future
interest rates.
▪ The curve’s shape should provide a reasonable indication
(especially once the liquidity premium effect is accounted
for) of the market’s expectations about future interest rates.
▪ Forecasting Recessions — Some analysts believe
that flat or inverted yield curves indicate a recession in
the near future

Question 19

Making Investment Decisions

Answer 19

If the yield curve is
upward sloping, some investors may attempt to benefit
from the higher yields on longer-term securities even
though they have funds to invest for only a short
period of time.

Question 20

Making Decisions about Financing

Answer 20

— Firms can
estimate the rates to be paid on bonds with different
maturities. This may enable them to determine the
maturity of the bonds they issue.

Question 21

Why the Slope of the Yield Curve Changes

Answer 21

Conditions may cause short-term yields to change

in a manner that differs from the change in longterm yields. (Exhibit 3.8)

Question 22

How the Yield Curve Has Changed over Time

Answer 22

Yield curves at various dates are illustrated in

Exhibit 3.9.

Question 23

International Structure of Interest Rates (1 of 2)

Answer 23

Factors that affect the shape of the yield curve
can vary among countries, and the yield curve’s
shape at any given time also varies among
countries.
▪ Interest rate movements across countries tend to
be positively correlated as a result of
internationally integrated financial markets. Actual
interest rates may vary significantly across
countries at a given point in time.

Question 24

International Structure of Interest Rates (2 of 2)

Answer 24

This implies that the difference in interest rates is
attributable primarily to general supply and
demand conditions across countries and less so
to differences in default risk premiums, liquidity
premiums, or other characteristics of the individual
securities.

Question 25

SUMMARY (1 of 2)

Answer 25

Quoted yields of debt securities at any given time may
vary for the following reasons. First, securities with
higher credit (default) risk must offer a higher yield.
Second, securities that are less liquid must offer a
higher yield. Third, taxable securities must offer a
higher before-tax yield than do tax-exempt securities.
Fourth, securities with longer maturities offer a
different yield (not consistently higher or lower) than
securities with shorter maturities.   

The appropriate yield for any particular debt security
can be estimated by first determining the risk-free
yield that is currently offered by a Treasury security
with a similar maturity. Then adjustments are made
that account for credit risk, liquidity, tax status, and
other provisions.

Question 26

SUMMARY (2 of 2)

Answer 26

The term structure of interest rates can be explained
by three theories. The pure expectations theory
suggests that the shape of the yield curve is dictated
by interest rate expectations. The liquidity premium
theory suggests that securities with shorter maturities
have greater liquidity and therefore should not have to
offer as high a yield as securities with longer terms to
maturity. The segmented markets theory suggests that
investors and borrowers have different needs that
cause the demand and supply conditions to vary
across different maturities. Consolidating the theories
suggests that the term structure of interest rates
depends on interest rate expectations, investor
preferences for liquidity, and the unique needs of
investors and borrowers in each maturity market.