Risk Free Rates, Required Return, Risk Premiums
2 characteristics of risk premiums
1 - hard to quantify 2 - change over time
two types of bond ratings
1 - investment grade 2 - junk, speculative, high-yield (risky)
For debt securities other than U.S. Treasuries, the liquidity premium is greater (less liquid) when... (2)
1 - longer time until maturity 2 - smaller issuers (companies) than larger
The market price of long-term U.S. Treasuries ___(is/is not)____ affected by changes in the market rate of interest.
IS if interest rates rise, you'll get less if you try to sell it later
2 ratings agencies
Moody's Standard & Poor's (S&P)
do US treasuries have default risk?
NO - safest investment default risk premium = 0
___ real risk-free rate = interest rate on a risk-less security, including a premium for inflation
NOMINAL
___ real risk-free rate = interest rate on a risk-less security, assuming NO inflation
REAL
S&P stands for...
Standard & Poor's
___ are considered the safest investments in the
US Treasury securities
___ > ___ negative real rate of interest
inflation > interest
____ = the possibility of loss of purchasing power due to rising prices
inflation risk
___ > ___ positive real rate of interest
interest > inflation
The market price of a short-term bond _____________ affected by changes in the market rate of interest.
is not/is less
who pays the rating agencies to have their bonds rated
issuers!
the rate on t-bonds is the ___-term ___ risk-free rate
long nominal
Maturity risk premium: The relationship (b/w interest rates and bond value) is stronger the __________________ the time remaining until the bond matures.
longer/more
the higher the bond rating, the ___ the default risk
lower
2 types of debt securities
money market securities/instruments (short term) bonds (long term)
interest rates on bonds & advertised by banks are __ interest rates
nominal
rates advertised by banks are __ interest rates
nominal
3 terms for opposite of "real"
nominal stated quoted
required return = ___ risk-free rate + risk ___
nominal ... premium
r
nominal risk-free rate
liquidity premium for US treasuries:
none, 0
default defn.
possibility the borrower can't repay interest and/or principal as required
maturity risk premium is the inverse relationship between the market price of a ___ and changes in the market ___
price of a bond market rate of interest
nominal risk-free rate =
r* + IP
r* meaning and defn.
real risk-free interest rate investors desired profit above inflation
the Fed sets __ term interest rates
short
the rate on t-bills is the ___-term ___ risk-free rate
short nominal
3 types of US treasury securities
t bills, t notes, t bonds
US Treasury securities are backed by "the full faith and credit of the US government", aka...
taxing authority
___ sets short term interest rates
the Fed
____ borrows money by issuing Treasury securities
the US government
long term interest rate set by: based on:
the bond market investors expectations for inflation in the future
US Treasury securities are backed by " "
the full faith and credit of the US government
you can earn the nominal risk-free rate on an investment in ______________ which are debt securities
the interest rate on US Treasury securities
expectations theory defn. implications?
the market's expectations about future interest rates (incorporating expectations about future inflation) shapes the yield curve US treasuries have no maturity risk premium, other debt securities do
required return defn based on:
the minimum acceptable potential* return the investment risks
inflation risk defn.
the possibility of loss of purchasing power due to rising prices investors want compensation for it
what is default risk?
the possibility that the borrower will be unable to pay the interest on the loan and/or repay the loan principal
TIPS means... the interest rate on TIPS is real or nominal? the ___ on TIPS adjusts annually for ___
treasury inflation protected security real principal ... inflation
ratings agencies are for profit corporations? t/f
true
the rate on ___ is the nominal risk free rate
us treasuries
are US treasuries liquid
yes, extremely!
inflation premium defn.
expected inflation average projected annual inflation rate over the life of the investment
opposite of liquid
illiquid
required interest rate equation =
expected inflation + desired profit above inflation inflation premium + real risk-free inflation
bond ratings can't be changed after bond's issued. t/f?
false can have rating upgrade or downgrade
rating between __ and __
BBB- and BB+
premium defn
additional potential return due to presence of risk
"real" defn
after inflation effects removed
default risk aka..
credit risk
bond ratings indicate...
default risk
___ is the possibility that the borrower will be unable to pay the interest on the loan and/or repay the loan principal
default/credit risk
liquid defn
easily convertible into cash