Ch. 6: Interest Rates

The interest rate on debt, r, is ALSO equal to:

the nominal risk-free rate + a default risk premium + a liquidity premium + a maturity risk premium.

The interest rate on debt, r, is equal to:

the real risk-free rate + an inflation premium + a default risk premium + a liquidity premium + a maturity risk premium.

Assets with higher trading volume are generally ______ liquid. The average liquidity premium varies over time.

more

Because of their additional default and liquidity risk, corporate bonds yield ______ Treasury bonds with the same maturity.

more than

Interest Rate is...

...the price that lenders receive and borrowers pay for debt capital.

If the entire population was living at the subsistence level, time preferences for current consumption would be_______ , savings would be______ , interest rates would be______ , and capital formation would be______.

1. high 2. low 3. high 4. difficult

In addition, ______ risk and ______ inflation lead to higher interest rates.

1. higher 2. higher

Federal Reserve factor: To stimulate the economy, the Fed ______ the money supply. The initial effect would be to cause short-term rates to decline; however, a ______ money supply might lead to an increase in expected future inflation, which would cause long-term rates to rise even as short-term rates fell. The reverse is true when the Fed ______ the money supply.

1. increases 2. larger 3. tightens

Because interest rates can and do occasionally rise, all long-term bonds, even Treasury bonds, have an element of risk called ______ rate risk. Therefore, a ______ risk premium, which is higher the longer the term of the bond, is included in the required interest rate.

1. interest 2. maturity

While long-term bonds are heavily exposed to ______ rate risk, short-term bills are heavily exposed to ______ risk. Although investing in short-term T-bills preserves one's ______ , the interest income provided by short-term T-bills is ______ stable than the interest income on long-term bonds.

1. interest 2. reinvestment 3. principal 4. less

The yield spread between corporate and Treasury bonds is ______ the longer the maturity. This occurs because longer-term corporate bonds have ______ default and liquidity risk than shorter-term bonds, and both of these premiums are ______ in Treasury bonds.

1. larger 2. more 3. absent

The 4 fundamental factors that affect the supply of, and demand for investment capital are:

1. production opportunities 2. time preferences for consumption 3. risk 4. inflation

Level of Business Activity factor: During a ______ , the demand for money and the inflation rate tend to fall and the Fed tends to ______ the money supply to stimulate the economy. As a result, there is a tendency for interest rates to decline during ______ . During ______ , short-term rates decline more sharply than long-term rates because (1) the Fed operates mainly in the short-term sector, so the Fed's intervention has the strongest effect there; (2) Long-term rates reflect the average expected inflation rate over the next 20 to 30 years and this expectation doesn't change much due to the level of current inflation. So, short-term rates are ______ volatile than long-term rates.

1. recession 2. increase 3. recessions 4. recessions 5. more

It is logical for a firm to finance current assets with ______ debt and to finance fixed assets with ______ -term debt.

1. short-term 2. long

Producers' expected returns on their business investments set a(n) ______ limit on how much they can pay for savings, while consumers' time preferences for consumption establish how much consumption they are willing to delay, and, consequently, how much they will ______ at different interest rates.

1. upper 2. save

The prices of long-term bonds ______ whenever interest rates rise.

decline

Macroeconomic factors that effect the level of interest rates and the shape of the yield curve are:

1. Federal Reserve policy 2. The federal budget deficit or surplus 3. International factors like the foreign trade balance and interest rates abroad 4. The level of business activity.

Federal Budget factor: If the government spends more than it takes in as taxes, it runs a ______ , which must be covered by additional borrowing or by printing money. If the government borrows money, this ______ the demand for funds and ______ interest rates. If the government prints money, the result will be ______ inflation, which will ______ interest rates. So, the larger the federal ______ , other things held constant, the ______ the level of interest rates.

1. deficit 2. increases 3. increases 4. increased 5. increase 6. deficit 7. higher

International factors: If U.S. businesses and individuals buy more goods from abroad than they sell (more imports than exports), the U.S. is running a foreign trade ______ , which must be financed. This generally means that the U.S. borrows from nations with export ______ . The larger the trade ______ , the higher the tendency to borrow, so U.S. interest rates become highly dependent on interest rate levels abroad. Consequently, this interdependency ______ the Fed's ability to use monetary policy to control U.S. economic activity.

1. deficit 2. surpluses 3. deficit 4. constraints

The ______ the bond's risk of default, the higher the market rate. The average default risk premium varies over time, and it tends to get ______ when the economy is weaker and borrowers are more likely to have a hard time paying off their debts.

1. greater 2. larger

Abnormal Yield Curve

A(n) ______ is downward sloping and indicates that investors expect inflation to decrease.

Normal Yield Curve

A(n) ______ is upward sloping because investors charge higher rates on longer-term bonds, even when inflation is expected to remain constant.

Humped Yield Curve

A(n) ______ occurs when interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities.

Default Risk Premium (DRP)

means that a borrower will not make scheduled interest or principal payments, and it affects the market interest rate on a bond.

Two main ways companies raise capital

debt and equity

If the demand for funds decline, which typically happens during a recession, interest rates will...

decline

T/F Government policy doesn't influence the allocation of capital and the level of interest rates.

false

T/F There is a price for each type of capital; however, the price remains constant due to foreign investment.

false

If the Federal Reserve tightens credit, which decreases the supply of funds, interest rates will...

increase

Real assets are generally ______ liquid than financial assets, but different financial assets vary in their liquidity.

less

The firm's optimal financial policy depends on the nature of the firm's assets—the easier its assets can be sold, the more feasible it is for the firm to use ______ debt.

short-term

The real risk-free rate of interest may be thought of as the interest rate on ______ U.S. Treasury securities in an inflation-free world.

short-term

T/F Short-term TIPS are free of default, maturity, and liquidity risks and of risk due to changes in the general level of interest rates.

true

T/F The inflation premium is equal to the average expected inflation rate over the life of the security.

true

T/F The interest rate in each market is the point where the supply and demand curves for capital intersect.

true

T/F The supply curve in each market is upward sloping, which indicates that investors are willing to supply more capital the higher the interest rate they receive on their capital.

true