Week 6 - Term/Risk Structure of Interest Rates Flashcards
What is the name for the relationship between yield and term to maturity for securities that differ only in length of time to maturity?
The Term structure of interest rates.
When does an ascending yield curve develop?
When interest rates are lowest on short term securities
Which yield curve is most commonly observed?
The ascending yield curve
What does a flat yield curve indicate?
A ‘soft landing’ for the economy following a period of boom or growth.
What does a descending yield curve indicate?
Beginning of a recession.
What is the expectation theory of yield curves?
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.
What are the assumptions of the expectation theory? (2)
1) Investors are profit maximisers
2) Investors have no preference between holding a long term maturity or a series of short term maturities
What is the term structure formula?
(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.
Describe the liquidity premium
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.
Which have greater marketability, short or long term securities?
Short term securities, which informs liquidity premiums.
What is the market segmentation theory?
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.
What makes the market segmentation theory extreme?
It assumes that certain investors are almost completely risk averse.
What is the preferred habitat theory?
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.
What yield curve is generally preferable for financial institutions and why?
An upward sloping curve, as they generally borrow in the short term and lend in the long term.
How do financial intermediaries react to flat yield curves?
By cutting costs as profits are squeezed.
How do financial intermediaries react to downward sloping yield curves?
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.
What is default risk?
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.
What is the name for bonds rated between AAA and BBB?
Investment-grade bonds
What is the name for bonds rated below BBB?
Speculative grade bonds or junk bonds
What 5 things are considered when formulating credit ratings?
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.
What is a call option and what is a put option?
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.
What is a conversions option?
A conversion option gives the holder the option to change the security into another type of security.
Bonds that contain a call option for the issuer sell at a …. yield. Because …
Fill in the two blanks
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)
Bonds that contain a put option for the investors sell at a …. yield. Because ….
Fill in the two blanks
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.
