Risk and Term Structure of Interest Rates

Question 1

Why do bonds with the same maturity have different interest rates?

Answer 1

1. default risk
2. liquidity
3. tax considerations

Question 2

How does default risk vary with interest?

Answer 2

proportional - if there is a higher chance the issuer will default on payments, a higher interest rate will be offered compared to treasury bonds (higher risk premium)

Question 2

How does different interest rates tie in with treasury bonds?

Answer 2

The discrepancy in demand for both is what drives the “interest difference” i.e. premium.

Increase in demand for treasury bonds <=> decrease in demand for corporate bonds

increase in price for treasury bonds, decrease in i/r for treasury <=> decrease in price, increase in i/r for treasury

Question 3

Why doesn’t the expectations theory explain the fact that yield curves almost always slope upward?

Answer 3

expectations theory argues that bonds with different maturities are substitutes of each other i.e. a LT bond is the expected average of many ST bonds

if so, then the yield curve should be a horizontal line

Question 4

Why doesn’t the segmented markets theory explain:
(a) i/r on bonds of different maturities move together over time
(b) when the yield for ST bonds low (high), curve usually slopes upwards (downwards)

Answer 4

segmented markets argues that the i/r determined solely by dd and ss per bond, bonds are not substitutes

(a) if so, then they shouldn’t move together at all
(b) the yield for ST bonds should not affect the yield for LT bonds

Question 5

How is the yield curve affected by market activity and government policy?

Answer 5

price of a bond affected by dd and ss <=> increase (decrease) in price of the bond leads to a decrease (increase) in the yield

different portions of the yield curve can be targeted depending on what is done