Money & Banking: Chapter 6, Risk and Term structure of Interest Rates

Bonds with the same maturity will have different inter-est rates because of three factors:

default risk, liquidity, and tax considerations.

expectations theory

term structure states the following commonsense proposition: The interest rate on a long-term bond will equal the average of the short-term interest rates that people expect to occur over the life of the long-term bond.

yield curve,

A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a ________ and it describes the term structure of interest rates for particular types of bonds, such as government bonds. generally slopes upwards!!! When yield curves slope upward, which is the most common case, long-term interest rates are above short-term interest rates;

Three theories of the term structure provide explana-tions of how interest rates on bonds with different terms to maturity are related.

The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond. By contrast, the segmented markets theory treats the determination of interest rates for each bond's maturity as the outcome of supply and demand in that market only. Neither of these theories by itself can explain the fact that interest rates on bonds of dif-ferent maturities move together over time and that yield curves usually slope upward.

risk structure of interest rates.

The greater a bond's default risk, the higher its interest rate relative to the interest rates of other bonds; the greater a bond's liquidity, the lower its interest rate; and bonds with tax-exempt status will have lower interest rates than they otherwise would. The relationship among interest rates on bonds with the same maturity that arises because of these three factors is known as the_____________

The liquidity premium (preferred habitat) theory com-bines the features of the other two theories, and by so doing is able to explain the facts just mentioned.

The liquidity premium (preferred habitat) theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. The liquidity premium (preferred habitat) theory allows us to infer the market's expectations about the movement of future short-term interest rates from the yield curve. A steeply upward-sloping curve indicates that future short-term rates are expected to rise; a mildly upward-sloping curve, that short-term rates are expected to stay the same; a flat curve, that short-term rates are expected to decline slightly; and an inverted yield curve, that a substantial decline in short-term rates is expected in the future.

risk premium

The spread between interest rates on bonds with default risk and interest rates on default-free bonds, both of the same maturity, is called the ____

Default

occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures.

segmented markets theory

of the term structure sees markets for different-maturity bonds as completely separate and segmented. The inter-est rate on a bond of a particular maturity is then determined by the supply of and demand for that bond and is not affected by expected returns on other bonds with other maturities

liquidity premium theory

of the term structure states that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.

inverted yield curve

upward-sloping, flat, or downward-sloping (the last sort is often referred to as an