Chapter 6: Risk and Term Structure of Interest Rates

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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?

It shifts demand rightward. Signup and view all the answers

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

Municipal bonds will have lower interest rates than Treasury bonds. Signup and view all the answers

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

They increase. Signup and view all the answers

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

Investors prefer safer, riskless bonds. Signup and view all the answers

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

The difference in interest rates between corporate and riskless bonds. Signup and view all the answers

What does a yield curve represent?

The yield on bonds with differing terms to maturity Signup and view all the answers

Which characteristic describes an upward-sloping yield curve?

Long-term rates are above short-term rates Signup and view all the answers

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

Yield curves are likely to flatten Signup and view all the answers

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

Interest rates on bonds of different maturities move together over time Signup and view all the answers

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

Interest rate perception Signup and view all the answers

What is a key implication of the expectations theory?

It clarifies that shifts in short-term rates impact long-term rates Signup and view all the answers

What does it mean if a yield curve is flat?

Short-term and long-term interest rates are the same Signup and view all the answers

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

The difference between corporate bond rates and government bond rates Signup and view all the answers

Which type of bonds are generally considered default-free?

Government of Canada bonds Signup and view all the answers

Why do bond prices fluctuate?

As a result of changing interest rates over time Signup and view all the answers

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

When short-term interest rates are higher than long-term rates Signup and view all the answers

Which factor affects the liquidity of a bond?

The ease of converting the bond into cash Signup and view all the answers

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

They are exempt from federal income taxes. 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?

Inflation expectations Signup and view all the answers

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

It increases when there are many buyers and sellers. 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?

They assess and rate the riskiness of bond issuers. Signup and view all the answers

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

Short-term interest rates are expected to rise in the future. Signup and view all the answers

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

Typically upward-sloping. Signup and view all the answers

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

They are expected to decline sharply. Signup and view all the answers

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

Increasing liquidity premiums. 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?

Solving the equilibrium of expected returns from different bonds. 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 ($i_{t+1}^e$)?

6% Signup and view all the answers

When would yield curves tend to be inverted?

When short-term rates are high with lower expected future rates. Signup and view all the answers

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

Short-term rates are expected to fall moderately. Signup and view all the answers

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

$(1 + in+1,t)^{n+1} - 1$ Signup and view all the answers

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

$ <ul> <li>ℓnt$</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?

6.0% Signup and view all the answers

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

The market's forecast of future interest rates Signup and view all the answers

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

Long-term and risky interest rates Signup and view all the answers

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

Investors have specific preferences for bonds of various maturities. Signup and view all the answers

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

An average of short-term interest rates. Signup and view all the answers

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

It compensates for the risk of holding illiquid assets Signup and view all the answers

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

Targeting long-term interest rates Signup and view all the answers

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

Investors will only buy longer-term bonds if they anticipate higher returns. Signup and view all the answers

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

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

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

The yield curve will be above the expectations theory and steeper. Signup and view all the answers

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

It is positive and typically increases. Signup and view all the answers

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

Investors prefer shorter maturities to avoid interest-rate risk. Signup and view all the answers

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

It averages expected future short-term rates and includes a liquidity premium. Signup and view all the answers

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

Investor demand and supply dynamics for different maturities. Signup and view all the answers

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.

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.