24 Questions
What is the term structure of interest rates also known as?
Yield curve
Long term interest rates are typically lower than short term interest rates.
False
What is the main difference between a yield curve and a term structure of interest rates?
The term yield curve is less precise, while term structure of interest rates is a more specific term.
The graph of the term structure of interest rates shows the interest rates for a particular ______________ on a particular day.
counterparty
Match the credit rating categories with their descriptions:
AAA = Best bonds available with very low default risk Investment grade = Above the red line Less credit worthy = Higher interest rate
What happens to the economy when short term interest rates increase fast?
It puts a break on the economy
A credit worthy borrower will have a lower interest rate.
True
What is the main factor that affects the interest rate of a loan?
Credit risk and maturity of the loan
What is the purpose of a credit spread in interest rates?
To compensate for expected credit losses
The credit spread is the same for all maturities and borrower qualities.
False
What is the term structure of nominal rates?
The structure of nominal interest rates that reflects the risk of not getting paid back
A _______________ bond is a type of bond that allows the borrower to stop the deal and return the bond to the lender.
callable
What is the effect of collateral arrangements on interest rates?
Decreases interest rates
Match the following factors with their effects on interest rates:
Expected inflation premium = Increases interest rates Credit spread = Reflects expected credit losses Liquidity premium = Increases interest rates Collateral arrangements = Decreases interest rates
The expected inflation premium is the same for all maturities.
False
What is the purpose of seniority in loan agreements?
To give the lender priority over other creditors in case of default
What happens to interest rates when the credit quality deteriorates?
They increase
A recession is good news for the economy.
False
What is the purpose of a maturity premium?
To compensate lenders for delayed consumption due to a longer maturity of the debt instrument.
The term structure of interest rates is affected by the _______________ premium, which accounts for the uncertainty of purchasing power in the future.
expected inflation
Match the following concepts with their definitions:
Compensation for delayed consumption due to longer debt maturity = Maturity premium Reward for delaying consumption = Short-term risk-free interest rate Extra payment required due to credit risk = Credit premium
What happens to interest rates when demand for credit is high?
They increase
A longer maturity of the debt instrument results in a lower interest rate.
False
The lender faces risks, including credit risk, which requires a _______________ to be added to the interest rate.
premium
Study Notes
Term Structure of Interest Rates
- The term structure of interest rates is a graph that shows the interest rates for different maturities, ranging from 1 day to 30 years, on a particular day.
- It is also known as the yield curve.
Characteristics of the Term Structure of Interest Rates
- The graph typically slopes upwards, indicating that long-term interest rates are higher than short-term interest rates.
- The slope of the curve can be affected by the creditworthiness of the borrower, with less creditworthy borrowers having a higher interest rate.
Credit Rating and Interest Rates
- AAA rated bonds have a lower interest rate due to their low default risk.
- The credit rating of a bond can affect the interest rate, with lower-rated bonds having a higher interest rate.
Monetary Policy and the Term Structure of Interest Rates
- An increase in short-term interest rates can make the curve slope downwards, indicating bad news for the economy.
- This can lead to a decrease in credit demand, which can slow down the economy.
Shapes of the Term Structure of Interest Rates
- The normal shape of the curve is upwards sloping (B).
- A descending curve (C) can indicate bad news for the economy, potentially leading to a recession.
Decomposition of an Interest Rate
- The interest rate can be broken down into three components: the short-term risk-free interest rate, the maturity premium, the expected inflation premium, and the credit spread.
- The short-term risk-free interest rate is determined by the demand and supply for loanable funds.
- The maturity premium is a compensation for the delay in consumption.
- The expected inflation premium is a compensation for the potential loss of purchasing power.
- The credit spread is a compensation for expected credit losses.
Other Factors Affecting Interest Rates
- Special contractual provisions, such as seniority and embedded options, can affect the interest rate.
- Collateral arrangements can make the loan more secure and reduce the interest rate.
- Differential tax treatment can also affect the interest rate.
Learn about the relationship between time to maturity and interest rates, researching the Belgian Government's findings. Discover the graph that results from plotting interest rates against time to maturity.
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