ECO 531 - Chapter 4: Structure of Interest Rates Quiz

Bond Interest Rates and Risk

• Different bonds with the same term of maturity earn different interest rates due to varying levels of default risk.
• The spread between the interest rates on bonds with default risk and those without default risk is known as the default risk premium.

Default-Free Bonds

• Treasury bonds are referred to as default-free bonds because they are backed by the credit and taxing power of the government.
• The full faith and credit of the government ensures that treasury bonds are considered to have no default risk.

Factors Influencing Interest Rates

• Default risk is a key factor that influences interest rates, making treasury bonds more desirable than corporate bonds.
• The liquidity premium, which is the extra return required for holding less liquid bonds, also influences interest rates.

The Pure Expectations Theory

• The Pure Expectations Theory explains the term structure of interest rates, which is the relationship between interest rates and bond maturities.
• According to the theory, an upward-sloping yield curve is caused by expectations of rising interest rates in the future.

Municipal Bonds

• The interest rate on municipal bonds is influenced by their tax-exempt status, which makes them more attractive to investors and reduces their interest rate relative to treasury bonds.

Corporate Bonds

• An increase in the liquidity premium of corporate bonds is caused by a decrease in their liquidity, making them less attractive to investors.

Theories of the Yield Curve

• The Segmented Market Theory assumes that the yield curve always slopes upward due to the separate markets for different bond maturities.
• The Liquidity Premium Theory and Preferred Habitat Theories assume that investors demand a liquidity premium for holding less liquid bonds, leading to an upward-sloping yield curve.
• The key assumption of these theories is that investors are not willing to hold bonds with different maturities unless they are compensated with a higher return.

Uses of the Yield Curve

• One of the uses of the yield curve is to forecast future interest rates and economic conditions.
• The Segmented Market Theory explains that the yield curve reflects the relationship between bonds with differing maturities, which are determined by separate market conditions.