Topic 5 – Term and Risk Structures of Interest Rates

Question 1

Yield on bond

Answer 1

return on bond when the bond is held until maturity.

the total return on an investment, comprising interest received, and any capital gain (or loss).

Question 2

Interest rate (coupon rate)

Answer 2

on bond to maturity is known when issued but yield on bond may not be known because it depends on future interest rates

Question 3

Bond sold before maturity date may incur

Answer 3

capital gain or loss.

Question 4

Term Structure of Interest Rates

Answer 4

The relationship between interest rates and terms to maturity for debt instruments in the same risk class

Question 5

Yield Curve

Answer 5

is a graph, at a point in time, of yields on an identical security with different terms to maturity

Question 6

RISK STRUCTURE OF INTEREST RATES

Answer 6

The relationship between interest rates and default risk for debt instruments in the same maturities

Question 7

There are four types of Yield Curves

Answer 7

Normal / Positive
Inverse / Negative
Humped
Flat

Question 8

Normal / Positive Yield Curve

Answer 8

Long-term interest rates are higher than short-term rates

Upward Sloping

Question 9

Inverse (Negative) Yield Curve

Answer 9

Long-term interest rates are lower than short-term rates
Downward Sloping

Possible in periods of tight liquidity or contractionary monetary policy

Question 10

Flat Yield Curve

Answer 10

A flat yield curve means that the yield to maturity on all debt instruments (for example, govt securities) is the same.

Question 11

Humped Yield Curve

Answer 11

The shape of the yield curve changes over time from being a normal curve to being an inverse curve.

i - Short-term bond with lower interest rate (high demand for short-term bond);
ii - Medium-term bond with higher interest rate;
iii - Long-term bond with lower interest rate (higher demand for long-term bond).

Question 12

The fact that the shape of the yield curve changes over time suggests that

Answer 12

monetary policy interest rate changes are not the only factor affecting interest rates.

Question 13

There are three theories that explain the term structure of interest rates

Answer 13

The Expectation Theory
The Segmented Markets Theory
The Liquidity Premium Theory

Question 14

Expectations Theory

Answer 14

A theory that explains the shape of a yield curve through current and future short term interest rates.

Question 15

Assumptions of the Expectations Theory

Answer 15

1 - Large number of financial investors with homogenous expectations about future values of short term interest rates;
2 - No transaction costs;
3 - No impediments;
4 - Bonds with different maturities are PERFECT SUBSTITUTES.

Question 16

The Expectation Theory: Shapes of Yield Curves (normal_

Answer 16

result from expectations that future short-term rates will be higher than current short-term rates.

Question 17

The Expectation Theory: Shapes of Yield Curves (inverse)

Answer 17

Will result if the market expects future short-term rates to be lower than current short-term rates.

Question 18

The Expectation Theory: Shapes of Yield Curves (humped)

Answer 18

Investors expect short-term rates to rise in the future but to fall in subsequent periods.

Question 19

The Segmented Markets Theory

Answer 19

All bonds are not perfect substitutes; investor have preferences when investing in short or longer term bonds

Question 20

The Segmented Markets Theory (Assumptions)

Answer 20

1. Bonds of different maturities are not substitutes at all.

2. Bonds may only be substitutes within certain time frames

Question 21

How does the segmented markets theory reject the expectations theory

Answer 21

Rejects the expectations theory assumption that all bonds are perfect substitutes, or that investors are indifferent between holding short-term and longer-term securities

Question 22

Implication of Segmented Markets Theory

Answer 22

Markets are completely segmented - Interest rate at each maturity are determined separately.

The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond with no effects from expected returns on other bonds with other maturities.

Question 23

Implication of Segmented Markets Theory Assumptions

Answer 23

• Investors have particular holding period in their mind.
• If they match the maturity of the bond to the desired holding period, they can obtain a certain return with reduced risk.

Question 24

Segmented Markets Theory: Yield Curve slopes up

Answer 24

because demand for short-term (ST) bonds is relatively higher than long-term (LT) bonds

Question 25

Segmented Markets Theory: Yield Curve slopes down

Answer 25

would indicate that the demand for LT bonds is relatively higher, thus lower yield.

Question 26

Suppose the Central Bank sold Treasury bonds with one-year to maturity in the market.
What would be the outcome under this theory?

Answer 26

• The price of short-term bonds would decline and the yield curve would lift.
• Since short-term bonds are not substitutes of medium to long-term bonds, the yield of medium to long-term bonds will not be affected according to this theory.

Question 27

The Liquidity Premium Theory

Answer 27

Investors prefer short term securities; investors prefer short term securities and therefore require compensation to invest longer term

Question 28

Liquidity Premium Theory Key Assumption

Answer 28

Bonds of different maturities are substitutes, but are not perfect substitutes!

Question 29

Liquidity Premium Theory Implication

Answer 29

• Modifies Expectations Hypothesis with features of Segmented Markets Theory.
• Investors prefer short rather than long-term bonds and must be paid positive term premium, to hold long-term bonds.

Question 30

Liquidity Premium Theory Equation

Answer 30

𝟎𝒊𝟐 =((𝟎𝒊𝟏 +𝑬𝟏𝒊𝟏+𝑳))/𝟐

Where:
0𝑖2 denotes rate on a two-year investment commencing today.
0𝑖1 denotes rate on a one-year investment commencing today.
𝐸1𝑖1 is expected rate that would prevail in one years time on a one-year instrument.
𝐿 denotes liquidity premium for long term securities.

Question 31

Risk Structure of Interest Rates

Answer 31

Measures the perceived difference in credit quality amongst securities.

• Government securities are regarded as default risk free (treasury notes and treasury bonds).
• All other securities have a risk premium added above the risk-free rate.

Question 32

Default Risk

Answer 32

Default occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures.