week 2b

Question 1

what is expected return

Answer 1

the return expected over the next period on one asset relative to alternative assets.

Question 2

what is wealth

Answer 2

the total resources owned by the individual, including all assets

Question 3

what is liquidity

Answer 3

the ease and speed with which an asset can be turned into cash relative to alternative assets.

Question 4

What determines bond prices and bond yields?

Answer 4

Bond prices and bond yields are determined by the forces of supply and demand in the bond market.

Question 5

What is the bond supply curve?

Answer 5

The bond supply curve represents the relationship between the price of bonds and the quantity of bonds that sellers are willing to supply, holding all other factors constant. It slopes upward, indicating that as bond prices rise, the quantity supplied of bonds also increases.

Question 6

What does the bond demand curve depict?

Answer 6

The bond demand curve illustrates the relationship between the price of bonds and the quantity of bonds that investors are willing to demand, assuming all else remains constant. It slopes downward, indicating that as bond prices decrease, the quantity demanded of bonds increases.

Question 7

What effect does changes in government borrowing have on bond supply?

Answer 7

An increase in the government’s borrowing needs leads to an increase in the quantity of bonds outstanding, shifting the bond supply curve to the right.

Question 8

How do changes in general business conditions impact bond supply?

Answer 8

Improvements in general business conditions can lead to an increase in the supply of bonds, shifting the bond supply curve to the right.

Question 9

What is the relationship between changes in expected inflation and bond supply?

Answer 9

When expected inflation rises, the cost of borrowing falls, prompting an increase in the supply of bonds, which shifts the bond supply curve to the right.

Question 10

what is the relationship between the price and the yield of a bond

Answer 10

they have inverse relationship in order to maintain equilibrium in the bond market

Question 11

How does changes in wealth affect bond demand?

Answer 11

Increases in wealth lead to a rightward shift in the demand for bonds.

Question 12

what impact does expected inflation have on bond demand

Answer 12

Expected inflation can significantly affect bond demand. When inflation is expected to increase, investors demand higher yields to compensate for the loss of purchasing power over time. As a result, the demand for bonds decreases, leading to lower bond prices. Conversely, when inflation expectations decrease, bond demand tends to increase, causing bond prices to rise. Therefore, expected inflation can influence the attractiveness of bonds as an investment relative to other assets.

Question 13

What impact does expected inflation have on bond demand?

Answer 13

Declining inflation increases the value of promised payments, shifting bond demand to the right.

Question 14

How do changes in expected returns and interest rates influence bond demand?

Answer 14

Rising returns on bonds relative to alternative investments or expectations of falling interest rates lead to a rightward shift in bond demand.

Question 15

What role does risk play in bond demand?

Answer 15

If bonds become less risky compared to alternative investments, bond demand increases.

Question 16

How does liquidity affect bond demand?

Answer 16

Greater liquidity in bonds relative to alternatives increases bond demand, leading to a rightward shift in the demand curve.

Question 17

what happens if there is an increase in expected inflation

Answer 17

Supply:

Bonds are typically issued by governments, municipalities, and corporations to raise funds.
An increase in expected inflation might lead entities issuing bonds to demand higher yields to compensate for the expected loss of purchasing power over time.
If entities issue more bonds to meet this demand for higher yields, the supply of bonds increases.
Demand:

Investors demand bonds as part of their investment portfolios.
An increase in expected inflation prompts investors to seek assets that offer protection against inflation erosion.
If bonds fail to offer adequate protection, investors may reduce their demand for bonds, leading to a decrease in demand.

Question 18

what are the the three major risks of defaulting on bonds

Answer 18

• default risk
• inflation risk
• interest rate risk

Question 19

What is interest-rate risk?

Answer 19

Interest-rate risk arises from fluctuations in interest rates and the potential impact on the bond’s value. This risk is particularly relevant when the bondholder’s investment horizon is shorter than the bond’s maturity date.

Question 20

What is default risk?

Answer 20

Default risk refers to the possibility that the issuer of a bond may fail to make the promised interest payments or repay the principal amount at maturity.

Question 21

What is inflation risk?

Answer 21

Inflation risk occurs when investors are uncertain about the future purchasing power of the bond’s interest payments and principal due to changes in the overall price level.

Question 22

What equation can be used to express the interest rate on a non-Treasury security, incorporating the spread?

Answer 22

Interest Rate on Non-Treasury Security

Spread
Interest Rate on Non-Treasury Security=Base Interest Rate+Spread

or equivalently:

Base Interest Rate
+
Risk Premium
Interest Rate on Non-Treasury Security=Base Interest Rate+Risk Premium

Question 23

What is the base interest rate?

Answer 23

The base interest rate is the minimum interest rate or benchmark rate that investors demand for investing in a non-Treasury security. It serves as the reference point for determining the risk premium.

Question 24

what is default risk

Answer 24

The probability that the issuer of the bond is unable or unwilling to make interest
payments or pay off the face value when the bond matures

Question 25

why are UK treasury bonds special

Answer 25

they are considered to be default free bonds

Question 26

what are the three components of interest rate

Answer 26

• the real interest rate
• expected inflation
• compensation for inflation risk - risk premium

Question 27

What is interest-rate risk?

Answer 27

Interest-rate risk arises from uncertainty about the future direction of interest rates, leading to potential fluctuations in the value of bonds. The longer the term of the bond, the greater the potential price change for a given change in interest rates.

Question 28

How does the term of a bond affect interest-rate risk?

Answer 28

The longer the term of the bond, the larger the potential price change for a given change in interest rates, increasing interest-rate risk.

Question 29

What factors contribute to the risk structure of interest rates?

Answer 29

Bonds with the same maturity may have different interest rates due to factors such as default risk, liquidity, and tax considerations.

Question 30

How do independent companies assess default risk?

Answer 30

Independent rating agencies evaluate the creditworthiness of potential borrowers by estimating the likelihood that the borrower will fulfil the bond’s promised payments. These agencies play a crucial role in assessing default risk for investors.

Question 31

What are the main bond rating agencies?

Answer 31

he best-known bond rating services include Moody’s, Standard & Poor’s, and Fitch. These agencies evaluate the creditworthiness of bond issuers and assess the likelihood of repayment.

Question 32

What does a high bond rating indicate?

Answer 32

A high bond rating suggests that a bond issuer has a strong financial position and is likely to meet its payment obligations without difficulty.

Question 33

What are investment-grade bonds?

Answer 33

Investment-grade bonds are bonds with a very low risk of default. They are typically issued by financially sound government entities and corporations and are considered suitable for most investors.

Question 34

Why is the distinction between investment-grade and speculative-grade bonds important?

Answer 34

The distinction is crucial because many regulated institutional investors are restricted from investing in bonds rated below investment grade due to their higher risk of default.

Question 35

What are speculative-grade bonds?

Answer 35

Speculative-grade bonds, also known as junk bonds or high-yield bonds, are issued by companies or countries that may have difficulty meeting their bond payments but are not at immediate risk of default.

Question 36

What are fallen angels in the context of junk bonds?

Answer 36

Fallen angels are bonds that were once considered investment-grade but have been downgraded to junk status due to financial difficulties experienced by their issuers.

Question 37

What are bonds issued by issuers with little known about them referred to as?

Answer 37

junk bonds. These bonds carry higher risk due to the lack of information available to investors.

Question 38

How do material changes in a firm’s or government’s financial condition affect debt ratings?

Answer 38

changes in their debt ratings. A ratings downgrade lowers an issuer’s bond rating, while a ratings upgrade increases it.

Question 39

What is the impact of bond ratings on yields?

Answer 39

Bond ratings are designed to reflect default risk. The lower the rating, the higher the risk of default, resulting in a lower bond price and higher yield to compensate investors for the increased risk.

Question 40

Why are Treasury bonds used as benchmark bonds?

Answer 40

Treasury bonds are considered to have little default risk, making them suitable as benchmark bonds. Yields on other bonds are measured in terms of the spread over Treasury yields.

Question 41

What is liquidity in the context of bond trading?

Answer 41

Liquidity refers to the ease with which a bond can be bought or sold in the market. Bonds with greater expected liquidity typically offer lower yields, as investors are willing to accept lower returns for the ease of trading.

Question 42

What is the relationship between liquidity and bond yields?

Answer 42

The greater the expected liquidity of a bond, the lower the yield investors require. Treasury securities are highly liquid, leading to lower yields compared to non-Treasury securities, which may have lower liquidity.

Question 43

Why are Treasury securities considered the most liquid securities?

Answer 43

Treasury securities are considered the most liquid securities because they are backed by the U.S. government and are actively traded in the market, making them highly desirable and easy to buy and sell.

Question 44

What is the impact of liquidity on Treasury bonds?

Answer 44

Within the Treasury market, on-the-run issues (most recently issued) have greater liquidity than off-the-run issues (previously issued), leading to differences in yields between these securities.

Question 45

How do income tax considerations affect bond yields?

Answer 45

Income tax considerations are important in determining bond yields. Bondholders must pay income tax on interest income received from privately issued bonds (taxable bonds), whereas coupon payments on municipal bonds (tax-exempt bonds) are exempt from federal income tax.

Question 46

How is the difference in yield between tax-exempt and Treasury securities typically measured?

Answer 46

The difference in yield between tax-exempt securities and Treasury securities is typically measured in percentage terms.

Question 47

What is the formula to calculate the yield on a taxable bond after income taxes are paid?

Answer 47

The yield on a taxable bond after income taxes are paid can be calculated using the formula: Tax-Exempt Bond Yield = (Taxable Bond Yield) × (1 − Tax Rate).

Question 48

What is the equivalent taxable yield?

Answer 48

The equivalent taxable yield is the yield that must be offered on a taxable bond issue to provide the same after-tax yield as a tax-exempt issue. It is calculated using the formula: Equivalent Taxable Yield = Tax-Exempt Yield / (1 − Tax Rate).

Question 49

How does the tax rate affect the gap between yields on taxable and tax-exempt bonds?

Answer 49

The higher the tax rate, the wider the gap between the yields on taxable and tax-exempt bonds. This is because higher tax rates result in greater tax savings for investors in tax-exempt bonds, making them relatively more attractive.