Week 6 - Term/Risk Structure of Interest Rates

Question 1

What is the name for the relationship between yield and term to maturity for securities that differ only in length of time to maturity?

Answer 1

The Term structure of interest rates.

Question 2

When does an ascending yield curve develop?

Answer 2

When interest rates are lowest on short term securities

Question 3

Which yield curve is most commonly observed?

Answer 3

The ascending yield curve

Question 4

What does a flat yield curve indicate?

Answer 4

A ‘soft landing’ for the economy following a period of boom or growth.

Question 5

What does a descending yield curve indicate?

Answer 5

Beginning of a recession.

Question 6

What is the expectation theory of yield curves?

Answer 6

That the shape of the yield curve is determined by investors expectations of future interest rate movements. Changes in these expectations change the shape of the curve.

Question 7

What are the assumptions of the expectation theory? (2)

Answer 7

1) Investors are profit maximisers

2) Investors have no preference between holding a long term maturity or a series of short term maturities

Question 8

What is the term structure formula?

Answer 8

(1 + tRn) = [(1 + tR1)(1 + t+1f1)(1 + t+2f1) … (1 + t+n-1f1)] ^ (1/n)
Where:
R = the observed market rate (spot)
f = the forward/future rate
t = time period for which the rate is applicable
n = the bond’s maturity

i.e. The geometric average.

Question 9

Describe the liquidity premium

Answer 9

The liquidity premium is the extra return derived from a security of longer term given as consideration for the risk of price fluctuations and reduced marketability.

Question 10

Which have greater marketability, short or long term securities?

Answer 10

Short term securities, which informs liquidity premiums.

Question 11

What is the market segmentation theory?

Answer 11

That investors have a strong preference for securities with a particular maturity. As such, the yield curve is determined by supply and demand of these securities.

Question 12

What makes the market segmentation theory extreme?

Answer 12

It assumes that certain investors are almost completely risk averse.

Question 13

What is the preferred habitat theory?

Answer 13

Extends the market segmentation theory and explains discontinuities in the curve. Investors will invest in securities with different maturities but must be compensated with a risk premium.

Question 14

What yield curve is generally preferable for financial institutions and why?

Answer 14

An upward sloping curve, as they generally borrow in the short term and lend in the long term.

Question 15

How do financial intermediaries react to flat yield curves?

Answer 15

By cutting costs as profits are squeezed.

Question 16

How do financial intermediaries react to downward sloping yield curves?

Answer 16

By trying to reduce the maturity of their liabilities and trying to lock in the current lending rates with those borrowing from them for as long as possible.

Question 17

What is default risk?

Answer 17

The risk premium paid on a security to account for the possibility that the repayments are not made. Can be calculated as the difference between the rate on a risky security and the rate on a risk free security.

Question 18

What is the name for bonds rated between AAA and BBB?

Answer 18

Investment-grade bonds

Question 19

What is the name for bonds rated below BBB?

Answer 19

Speculative grade bonds or junk bonds

Question 20

What 5 things are considered when formulating credit ratings?

Answer 20

1) The background and history of the company
2) Corporate strategy and philosophy
3) The operating position
4) Financial Management and accounting policies
5) Other topics such as derivatives usage, regulatory developments, major litigation etc.

Question 21

What is a call option and what is a put option?

Answer 21

A call option gives the holder the right to buy the underlying security while a put option gives the holder the right to sell the underlying security.

Question 22

What is a conversions option?

Answer 22

A conversion option gives the holder the option to change the security into another type of security.

Question 23

Bonds that contain a call option for the issuer sell at a …. yield. Because …

Fill in the two blanks

Answer 23

Higher, because the call option works to the benefit of the issuer (borrower) and to the detriment of investors. I.e. if interest rates decline below the coupon rate the issuer can call (retire the bond and issue new ones in its place)

Question 24

Bonds that contain a put option for the investors sell at a …. yield. Because ….

Fill in the two blanks

Answer 24

Lower, because the put option works to the benefit of the investor and to the detriment of the issuer (borrower). In essence, it places a floor on the minimum price for a bond.

Question 25

Bonds that contain a conversion option for the investors sell at a …. yield. Because …

Fill in the two blanks

Answer 25

Lower, because the conversion option works to the benefit of the investor and to the detriment of the issuer (borrower). In essence, it gives a second option in the event prices change (most usually the conversion to the issuer’s shares.