fin 350 ch 6

T/FHigher inflation expectations increase the nominal interest rate demanded by investors.

true

Suppose the real risk-free rate and inflation rate are expected to remain at their current levels throughout the foreseeable future. what will the yield curve look like?

upward slope/normal

what is considered a normal yield curve?

upward sloping yield curve

a graph showing the relationship between bond yields and maturities

yield curve

the relationship between bond yields and maturities

term structure of interest rates

T/F we generally assume that default risk premium on treasury securities is 0.

true

default risk premium symbol

DRP

T/F When the economy is weakening, the Fed is likely to increase short-term interest rates.

False

A yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities.

Humped Yield Curve

Inflation premium symbol

IP

liquidity risk premium

LP

maturity risk premium symbol

MRP

A premium that reflects interest rate risk. Higher the greater the years to maturity.

Maturity Risk Premium (MRP)

A theory that states that the shape of the yield curve depends on investors' expectations about future interest rates.

Pure Expectations Theory

why would a firm that needs to borrow money would borrow at long-term rates when short-terms rates are lower than long-term rates?

The use of short-term financing over long-term financing for a long-term project will increase the risk of the firm.

T/F Countries with strong balance sheets and declining budget deficits tend to have lower interest rates.

True

T/F During recessions, short-term interest rates decline more sharply than long-term interest rates.

True

T/F The yield curve for a BBB-rated corporate bond is expected to be above the US Treasury bond yield curve.

True

T/F Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets.

True

want to expand business when economy is booming. when businesses demand for money is up, interest rates go up.

business activity

production opportunities time preferences for consumption risk expected inflation

cost of money 4 fundamental factors

It is based on the bond's rating; the higher the rating, the lower the premium added, thus lowering the interest rate.

default risk premium

what would the yield curve look like when short-term rates are higher than long-term rates?

downward sloping

what has an especially important effect on the yield curves shape, especially US treasury securities?

expected inflation

T/F The default risk on Walmart's short-term debt will be higher than the default risk on its long-term debt.

false

a deficit casuses an increasing demand for money the larger the federal deficit, the higher the level of interest rates

federal budget deficit or surpluses

should we lower or raise interest rates? if lower interest rates and increase money supply, the price of the item goes down

federal reserve policy

_____________ is the amount by which prices increase over time.

inflation

Over the past several years, Germany, Japan, and Switzerland have had lower interest rates than the United States due to lower values of this premium.

inflation rate premium

all long term bonds, even treasury bonds, have a an element of risk called ____________________

interest rate risk

the risk of capital losses to which investors are exposed because of changing interest rates

interest rate risk

what do you call a downward sloping yield curve?

inverted or "abnormal" yield curve

This is the premium added to the equilibrium interest rate on a security that cannot be bought or sold quickly enough to prevent or minimize loss.

liquidity risk premium

This is the premium that reflects the risk associated with changes in interest rates for a long-term security.

maturity risk premium

a corporations short-term bonds are usually ______ liquid and have _______ liquidity premiums than its long-term bonds.

more & lower

This is the rate on a Treasury bill or a Treasury bond.

nominal risk free rate

any nominal rate

r

nominal risk free rate symbol

r RF

represents the rate of interest on Treasury securities

r RF

real risk-free rate symbol

r*

represents the "real" risk-free rate of interest. Like a T bill rate, if there was no inflation. typically ranges from 1%-4% per year.

r*

This is the rate on short-term US Treasury securities, assuming there is no inflation.

real risk free rate

the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested

reinvestment rate risk

the _________ the corporation, the __________ the yield curve

risker & higher

which tend to be more volatile? short term or long term interest rates?

short term interest rates

why do long term interest rates tend to be more smoother than short term interest rates?

short term interest rates reflect the current market and they fluctuate more often/ easily. Long term interest rates reflect long run expectations of inflation. Therefore they are usually more smoother

federal reserve policy example

there's many pizza places on main street of Kutztown. The demand for pizza is lower because there's so many options. The price of pizza is so low for this reason.

corporate yield curves would have the same general slope as __________________________.

treasury curves

T/F If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the Treasury yield curve is downward sloping. (Assume MRP = 0.)

true

T/F The pure expectations theory assumes that investors do not consider long-term bonds to be riskier than short-term bonds.

true

T/F When the economy is weakening, the Fed is likely to decrease short-term interest rates.

true

T/F the interest income on short term T-bills is less stable than long term bonds.

true