Chapter 6: Risk and Term Structure of Interest Rates
48 Questions
0 Views

Choose a study mode

Play Quiz
Study Flashcards
Spaced Repetition
Chat to Lesson

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What happens to the demand for risky bonds during a recession?

  • It remains unchanged.
  • It fluctuates unpredictably.
  • It increases significantly.
  • It decreases. (correct)

How do credit spreads behave during economic downturns?

  • They tend to narrow.
  • They remain steady.
  • They become unpredictable.
  • They rise. (correct)

What is the impact of increased default risk on the equilibrium price of corporate bonds?

  • It has no effect on the equilibrium price.
  • It causes high volatility in prices.
  • It increases the equilibrium price.
  • It decreases the equilibrium price. (correct)

What effect does a tax-free status have on the demand for municipal bonds?

<p>It shifts demand rightward. (B)</p> Signup and view all the answers

What is the relationship between the interest rates of municipal and Treasury bonds when demand changes?

<p>Municipal bonds will have lower interest rates than Treasury bonds. (D)</p> Signup and view all the answers

What occurs to the interest rates of corporate bonds when their default risk increases?

<p>They increase. (C)</p> Signup and view all the answers

What is indicated by the term 'flight to safety' in an economic downturn?

<p>Investors prefer safer, riskless bonds. (D)</p> Signup and view all the answers

What does the term 'risk premium' on corporate bonds represent?

<p>The difference in interest rates between corporate and riskless bonds. (C)</p> Signup and view all the answers

What does a yield curve represent?

<p>The yield on bonds with differing terms to maturity (D)</p> Signup and view all the answers

Which characteristic describes an upward-sloping yield curve?

<p>Long-term rates are above short-term rates (C)</p> Signup and view all the answers

What happens to the yield curve when short-term interest rates rise?

<p>Yield curves are likely to flatten (A)</p> Signup and view all the answers

Which fact about interest rates on bonds does the theory of term structure explain?

<p>Interest rates on bonds of different maturities move together over time (C)</p> Signup and view all the answers

Which factor is NOT considered when explaining the risk structure of interest rates?

<p>Interest rate perception (B)</p> Signup and view all the answers

What is a key implication of the expectations theory?

<p>It clarifies that shifts in short-term rates impact long-term rates (C)</p> Signup and view all the answers

What does it mean if a yield curve is flat?

<p>Short-term and long-term interest rates are the same (D)</p> Signup and view all the answers

What is the risk premium in relation to interest rates on bonds?

<p>The difference between corporate bond rates and government bond rates (D)</p> Signup and view all the answers

Which type of bonds are generally considered default-free?

<p>Government of Canada bonds (C)</p> Signup and view all the answers

Why do bond prices fluctuate?

<p>As a result of changing interest rates over time (C)</p> Signup and view all the answers

Which scenario is most likely to lead to an inverted yield curve?

<p>When short-term interest rates are higher than long-term rates (A)</p> Signup and view all the answers

Which factor affects the liquidity of a bond?

<p>The ease of converting the bond into cash (A)</p> Signup and view all the answers

Why might interest payments on municipal bonds be attractive to investors in the U.S.?

<p>They are exempt from federal income taxes. (A)</p> Signup and view all the answers

Which of the following is NOT one of the three key factors that affect the yield differences among bonds of the same maturity?

<p>Inflation expectations (C)</p> Signup and view all the answers

How does a bond's liquidity relate to its market?

<p>It increases when there are many buyers and sellers. (C)</p> Signup and view all the answers

Which of the following is an example of how credit-rating agencies impact the risk structure of interest rates?

<p>They assess and rate the riskiness of bond issuers. (D)</p> Signup and view all the answers

What does a steeply rising yield curve signify about future short-term interest rates?

<p>Short-term interest rates are expected to rise in the future. (C)</p> Signup and view all the answers

Which of the following best describes the typical shape of yield curves?

<p>Typically upward-sloping. (A)</p> Signup and view all the answers

What does an inverted yield curve suggest about short-term interest rates?

<p>They are expected to decline sharply. (B)</p> Signup and view all the answers

What factor primarily causes yield curves to be typically upward-sloping?

<p>Increasing liquidity premiums. (C)</p> Signup and view all the answers

In the liquidity premium theory, how is the expected one-year interest rate calculated for the next year based on two-period investments?

<p>Solving the equilibrium of expected returns from different bonds. (B)</p> Signup and view all the answers

If the current short-term interest rate ($i_t$) is 5% and the two-period interest rate ($i_{2t}$) is 5.5%, what is the expected one-year interest rate for next year ($i_{t+1}^e$)?

<p>6% (B)</p> Signup and view all the answers

When would yield curves tend to be inverted?

<p>When short-term rates are high with lower expected future rates. (A)</p> Signup and view all the answers

What trend does a flat yield curve indicate regarding short-term interest rates?

<p>Short-term rates are expected to fall moderately. (D)</p> Signup and view all the answers

What is the formula to calculate the expected 1-year interest rate n years hence?

<p>$(1 + in+1,t)^{n+1} - 1$ (D)</p> Signup and view all the answers

Which component is added to the formula when considering the liquidity premium?

<p>$</p> <ul> <li>ℓnt$ (B)</li> </ul> Signup and view all the answers

If it = 5% and i2t = 5.75%, what is the expected 1-year interest rate one year from now if ℓ1t = 0?

<p>6.0% (A)</p> Signup and view all the answers

What does the term $ i_{e, t+n}$$ represent in the context of interest rates?

<p>The market's forecast of future interest rates (D)</p> Signup and view all the answers

In the given context, what type of interest rates do financial institutions typically focus on forecasting?

<p>Long-term and risky interest rates (A)</p> Signup and view all the answers

What does the Segmented Markets Theory suggest about bond demand across different maturities?

<p>Investors have specific preferences for bonds of various maturities. (B)</p> Signup and view all the answers

In Liquidity Premium Theory, what does the liquidity premium generally signify?

<p>An average of short-term interest rates. (B)</p> Signup and view all the answers

What is the significance of the liquidity premium $ ℓ_{nt}$ in interest rate forecasting?

<p>It compensates for the risk of holding illiquid assets (C)</p> Signup and view all the answers

Which of the following does NOT reflect a primary focus of conventional monetary policy?

<p>Targeting long-term interest rates (C)</p> Signup and view all the answers

How does Preferred Habitat Theory relate to investor behavior regarding bond maturities?

<p>Investors will only buy longer-term bonds if they anticipate higher returns. (C)</p> Signup and view all the answers

What is the final form of the equation when including liquidity premiums for the expected interest rate?

<p>$(1 + in+1,t - ℓn+1,t)^{n+1} / (1 + int - ℓnt)^{n}$ (D)</p> Signup and view all the answers

What is the implication of a yield curve according to Liquidity Premium and Preferred Habitat theories?

<p>The yield curve will be above the expectations theory and steeper. (B)</p> Signup and view all the answers

According to the Liquidity Premium Theory, what happens to the liquidity premium as the term to maturity increases?

<p>It is positive and typically increases. (C)</p> Signup and view all the answers

How does Segmented Markets Theory explain the typical upward slope of yield curves?

<p>Investors prefer shorter maturities to avoid interest-rate risk. (A)</p> Signup and view all the answers

What does the expression for interest rate in Liquidity Premium Theory convey?

<p>It averages expected future short-term rates and includes a liquidity premium. (C)</p> Signup and view all the answers

What factor primarily influences the slope of the yield curve according to liquidity theories?

<p>Investor demand and supply dynamics for different maturities. (D)</p> Signup and view all the answers

Flashcards

Countercyclical Default Risk

The tendency for default risk on bonds to increase during economic recessions.

Flight to Safety

A phenomenon where investors shift their investments away from risky assets like corporate bonds and towards safer assets like government bonds, typically during periods of economic uncertainty or recession.

Credit Spread

The difference in interest rates between risky bonds and safer bonds, reflecting the additional risk associated with the risky bonds.

Term Spread

The spread in interest rates between bonds with different maturities, reflecting the difference in risk and liquidity associated with different maturities.

Signup and view all the flashcards

Inverse Relationship between Bond Prices and Interest Rates

The relationship between bond prices and interest rates where an increase in interest rates leads to a decrease in bond prices, and vice versa.

Signup and view all the flashcards

Risk Structure of Interest Rates

A type of analysis that compares the interest rates of bonds with the same maturity but different levels of risk, typically focused on the default risk of the issuer.

Signup and view all the flashcards

Municipal-Treasury Bond Spread

The difference in interest rates between tax-exempt municipal bonds and taxable Treasury bonds, arising from the tax advantage of municipal bonds.

Signup and view all the flashcards

Term Structure of Interest Rates

The relationship between interest rates and bond maturities, showing how interest rates vary across different maturities at a given point in time.

Signup and view all the flashcards

Default Risk

The probability that the issuer of a bond will be unable or unwilling to make interest payments or repay the face value.

Signup and view all the flashcards

Risk Premium

The spread between the interest rates on corporate bonds and government bonds with the same maturity.

Signup and view all the flashcards

Liquidity

The ease with which an asset can be converted into cash.

Signup and view all the flashcards

Yield Spread

The spread in interest rates on different types of bonds of the same maturity. It reflects the different levels of risk associated with each bond.

Signup and view all the flashcards

Credit Rating

The degree to which a bond issuer's financial health and ability to meet its obligations are assessed. This assessment helps investors understand the risk associated with investing in a particular bond.

Signup and view all the flashcards

Tax Considerations

The difference in yields between bonds of similar maturity due to tax considerations. For example, municipal bonds in the U.S. are tax-exempt, making them attractive to investors.

Signup and view all the flashcards

Government Bonds (Default-free)

Bonds issued by national governments, generally considered to have the lowest default risk because governments can raise taxes or print money to repay their debts.

Signup and view all the flashcards

Yield Curve

A graphical representation of the relationship between the yield (interest rate) of bonds and their time to maturity.

Signup and view all the flashcards

Upward-sloping yield curve

When long-term interest rates are higher than short-term interest rates.

Signup and view all the flashcards

Flat yield curve

When short-term and long-term interest rates are similar.

Signup and view all the flashcards

Inverted yield curve

When long-term interest rates are lower than short-term interest rates.

Signup and view all the flashcards

Expectations Theory

The theory that the shape of the yield curve is determined by investors' expectations of future interest rates.

Signup and view all the flashcards

Why bonds have different interest rates

Bonds with the same risk, liquidity, and tax considerations but different maturities usually have different interest rates.

Signup and view all the flashcards

Fact 1: Interest rate movements

Interest rates on bonds with different maturities tend to move together over time.

Signup and view all the flashcards

Fact 2: Short-term rates and yield curve shape

When short-term rates are low, curves usually slope upwards. When they are high, curves tend to slope downwards and may become inverted.

Signup and view all the flashcards

Segmented Markets Theory

Each maturity's interest rate is decided solely by its own demand and supply, independent of other maturities.

Signup and view all the flashcards

Preference for Maturities (Segmented Markets Theory)

Investors prefer bonds of one maturity over another, influencing yield curve slopes.

Signup and view all the flashcards

Liquidity Premium Theory

The interest rate on a long-term bond is the average of short-term rates expected over its life, plus a premium due to supply and demand.

Signup and view all the flashcards

Partial Substitutability (Liquidity Premium)

Bonds of different maturities are partially substitutable, meaning they can be swapped to some extent.

Signup and view all the flashcards

Liquidity Premium (ℓnt)

A positive premium added to the average expected short-term rate to reflect the liquidity of a long-term bond.

Signup and view all the flashcards

Preferred Habitat Theory (PHT)

Investors have a preference for specific bond maturities and require a higher return for bonds outside their preferred habitat.

Signup and view all the flashcards

PHT Prediction

The PHT predicts upward sloping yield curves when most investors favor short-term bonds over long-term bonds.

Signup and view all the flashcards

PHT vs. Expectations Theory

The yield curve based on the liquidity premium/PHT is above the yield curve based on the expectations theory and has a steeper slope.

Signup and view all the flashcards

Liquidity Premium

The premium investors demand for holding longer-maturity bonds due to their lower liquidity compared to shorter-maturity bonds.

Signup and view all the flashcards

Liquidity Premium (Preferred Habitat) Theory

The theory describes the shape of the yield curve based on market expectations of future short-term interest rates and the liquidity premium offered on bonds with different maturities.

Signup and view all the flashcards

Forward Interest Rate (iet+1)

The expected interest rate on a one-year bond one year from now. This is used to forecast future interest rates.

Signup and view all the flashcards

Forward Interest Rate (iet+2)

The expected interest rate on a one-year bond two years from now. It's derived using the relationship between current and future interest rates for different maturities.

Signup and view all the flashcards

Forward Interest Rate (iet+n)

The expected interest rate on a one-year bond n years from now. It's calculated using the current and future interest rates for different maturities and time horizons.

Signup and view all the flashcards

Interest Rate Forecasting Formula

The formula used by financial institutions to forecast future interest rates. It incorporates current and future interest rates, as well as the liquidity premium.

Signup and view all the flashcards

Conventional Monetary Policy

The practice of using monetary policy tools to influence economic activity, focusing on short-term and risk-free interest rates.

Signup and view all the flashcards

Unconventional Monetary Policy

The practice of using unconventional methods to stimulate the economy, often involving actions beyond traditional interest rate adjustments.

Signup and view all the flashcards

Quantitative Easing

A type of unconventional monetary policy where central banks purchase long-term assets, aiming to lower long-term interest rates and stimulate the economy.

Signup and view all the flashcards

Study Notes

Chapter 6: The Risk and Term Structure of Interest Rates

  • Interest rates on different bonds of the same maturity can vary significantly
  • Key factors affecting bond yields of similar maturity include default risk, liquidity, and tax considerations
  • Default risk is the probability the issuer can't or won't make interest payments or repay the principal
  • Government of Canada bonds are considered default-free
  • Risk premium is the difference between interest rates on corporate bonds and Canada bonds of the same maturity
  • Credit rating agencies assess and rate bond riskiness
  • Liquidity refers to the ease with which an asset can be converted into cash
  • Factors affecting liquidity include cost of selling a bond, and the number of buyers/sellers in the bond market
  • Income tax considerations, such as U.S. municipal bonds exempt from federal income taxes, can also affect bond yields
  • Credit spreads tend to rise during recessions, a countercyclical relationship
  • Term spreads (difference between long-term and short-term rates) are also countercyclical and lagging

Term Structure of Interest Rates

  • Risk structure examines multiple bonds of the same maturity
  • Term structure examines a single bond type with differing maturity dates
  • Example: Canada bonds have different interest rates based on time to maturity
  • Yield curve: graphical representation of the term structure, plotting yields of bonds with different maturity but the same risk, liquidity and tax considerations
  • Yield curves can be upward-sloping (long-term rates higher than short-term rates), flat (short- & long-term rates the same), or inverted (long-term rates lower than short-term rates)

Theories Explaining Term Structure Facts

  • Expectations theory: long-term interest rate equals the average of expected future short-term interest rates over the life of the bond
  • Segmented markets theory: separate markets for bonds with different maturities. Bond investors may have preferences for one maturity over another.
  • Liquidity premium theory: long-term interest rate is the average of expected short-term interest rates plus a liquidity premium, which is dependent on supply and demand

Application of the Theories

  • Forecasting interest rates: Understanding expected future short-term rates can be used to forecast interest rates at different maturities
  • Policy in normal times: Lowering short-term rates is expected to lower longer-term rates as well, assuming the other factors remain constant
  • Conventional monetary policy impacts short-term interest rates
  • Unconventional monetary policy, such as quantitative easing (raising demand for longer term debt through purchases), influences the market's expectations of future interest rates

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Quiz Team

Related Documents

The Economics of Money, Banking, and Financial Markets 8th Canadian Edition, Chapter 6, Risk and Term Structure of Interest Rates PDF

Description

Explore the complexities of interest rates in different bonds with a focus on default risk, liquidity, and tax implications. This quiz delves into how these factors influence bond yields, including the comparison between government bonds and corporate bonds. Test your understanding of the term structure and the dynamics affecting bond market performance.

More Like This

Bond Pricing Relationship Quiz
2 questions

Bond Pricing Relationship Quiz

MesmerizingPlutonium avatar
MesmerizingPlutonium
Understanding Yields and Market Conditions
53 questions

Understanding Yields and Market Conditions

TopQualityErbium avatar
TopQualityErbium
Bond Valuation and Pricing Concepts
57 questions

Bond Valuation and Pricing Concepts

ReputableComet avatar
ReputableComet
Use Quizgecko on...
Browser
Open
Browser
Browser