Econ 4200 Quiz 2
Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?
Baa bonds have lower probability of default than a bond with C rating. The lower default risk requires a lower premium to compensate investors. (trade-off theory)
The U.S. Treasury offers some its debt as Treasury Inflation Protected Securities, or TIPS, in which the price of bonds is adjusted for inflation over the life of the debt instrument. TIPS bonds are traded on a smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premiums of TIPS versus nominal U.S. bonds?
The liquidity premium for a TIPS bonds is usually smaller than inflation compensations in nominal U.S. bond yields of equal maturity.
Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to five years, and plot the resulting yield curves for the following paths of one-year interest rates over the next five years: (a) 5%, 7%, 7%, 7%, 7% (b) 5%, 4%, 4%, 4%, 4% How would your yield curves change if people preferred shorter-term bonds to longer- term bonds?
(answers for 5,6,7,6,5 and 5,4,3,4,5) (a) The yield to maturity would be 5% for a one-year bond, 5.5% for a two-year bond, 6% for a three-year bond, 6% for a four-year bond, and 5.8% for a five-year bond; (b) the yieldto maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4% for a three-year bond, 4% for a four-year bond, and 4.2% for a five-year bond. The upward- and then downward-sloping yield curve in (a) would tend to be even more upward sloping if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward- and then upward-sloping yield curve in (b) also would tend to be more upward sloping because of the positive risk premium for long-term bonds.
If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?
Abolishing the tax-exemption would decrease the desirability of municipal bonds versus Treasury bonds. The demand for municipal bonds would decrease and demand would increase for Treasury bonds. This would raise the interest rates on municipal bonds and lower interest rates on Treasury bonds.
Risk premiums on corporate bonds are usually anticycli- cal (or countercyclical); that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. or As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt.
An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?
From the above diagrams(in screenshots), when the Federal Reserve sells bonds, the supply of bonds increases leading to a shift to the right of the bond supply curve. This is illustrated in the diagram to the left. This results in a decrease in the bond price or a rise in the bond interest rate ()12ii. But when the Federal Reserve sells bonds, it leads to a decrease in the money supply. In the liquidity preference model (Keynes model), the supply of money shifts to the left, leading to an increase in the interest rate in the money market. The rise in the interest rate is consistent in the bond market and the liquidity preference model following the Federal Reserve's action.
In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable- maturity Greek debt.
If the Greek government bonds become riskier, the demand for those bonds will fall. This leads to a decrease in Greek bond price correspondingly increasing the interest rates paid on them. On the other end, an increase in the riskiness in Greek government bonds means that nervous investors will switch to buying U.S. government bonds, propping up their prices and correspondingly reducing the interest rates paid on them. This will increase the risk premium as shown in the figure above. (graph in screenshots)
If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?
If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the pure expectations theory.
Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?
In the bond supply and demand analysis, the increased riskiness of bonds lowers the demand for bonds. The demand curveB d shifts to the left, and the equilibrium interest rate rises. The same answer is found in the liquidity preference framework. The increased riskiness of bonds relative to money increases the demand for money. The money demand curve M d shifts to the right, and the equilibrium interest rate rise
Using both the liquidity preference frame- work and the supply and demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).
In the loan able funds framework, when the economy booms, the demand for bonds increases: the public's income and wealth rises while the supply of bonds also increase, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the dmand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the interest rate falls. The conclusion is that interest rates rise during booms and fall during recessions: that is, interest rates are procyclical. The same answer is found with the liquidity preference framework. When the economy booms, the demand for money increases: people need more money to carry out an increased amount of transactions and also because their wealth has risen. The demand curve, Md, thus shifts to the right, raising the equilibrium interest rate. When the economy enters a recession, the demand for money falls and the demand curve shifts to the left, lowering the equilibrium interest rate. Again, interest rates are seen to be procyclical.
In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?
Initially default risk increases, yield increases, price of AIG decreases • After government intervention, default decreases, yield decreases, price of AIG increases
Explain what effect a large federal deficit might have on interest rates?
Interest rates might rise. The large federal deficits require the Treasury to issue more bonds; thus the supply of bonds increases. The supply curve, B-s, shifts to the right and the equilibrium bond price falls and the interest rate rises. Some economists believe that when the Treasury issues more bonds, the demand for bonds increases because the issue of bonds increases the public's wealth. In this case, the demand curve, B-d, also shifts to the right, and it is no longer clear that the equilibrium bond price or interest rate will rise. Thus there is some ambiguity in the answer to this question.
.Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices?
Interest rates will rise. The expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds falls. The demand curve, Bd, shift to the left and the equilibrium bond price falls and the interest rate rises.
Predict what will happen to interest rates if prices in the bond market become more volatile.
Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand for bonds will fall. The demand curve Bd will shift to the left, and the equilibrium bond price falls and the interest rate will rise
How might a sudden increase in people's expectations of future real estate prices affect interest rates?
Interest rates would rise. A sudden increase in people's expectations of future real estate prices raises the expected return on real estate relative to bonds, so the demand for bonds falls. The demand curve B-d shifts to the left, and the equilibrium bond price falls, so the interest rate rises.
Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?
Purchase of long term maturities make the price rise and the yield fall. The yield curve will become flatter or possibly inverted.
During 2008, the difference in yield (the yield spread) between three-month AA-rated financial commercial paper and three-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage points at its peak in October 2008. What explains this sudden increase?
The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the soundness of the financial system, and doubt about the soundness of even the most healthy banks and financial companies. As a result, there was a sharp decrease in demand for financial commercial paper relative to the seemingly safer nonfinancial commercial paper. This resulted in a spike in the yield spread between the two, reflecting the greater risk of financial company investment
Predict what will happen to interest rates on a corpo- ration's bonds if the federal government guarantees that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?
The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
The liquidity premium for a given year is the current rate on a multi-year horizon bond minus the average of expected one year interest rates over that horizon. Thus, the liquidity premiums for each year are given as:0%. l21 = 3 - (3 + 2)/2 = 0.5%. l31 = 5 - (4 + 3 + 2)/3 = 2%. l41 = 6 - (6 + 4 + 3 + 2)/4 = 2.25%. l51 = 8 - (7 + 6 + 4 + 3 + 2)/5 = 3.6%.
Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs?
Treasuries are considered to be risk-free debt instruments
Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: (a) Your wealth falls. (b) You expect the stock to appreciate in value. (c) The bond market becomes more liquid. (d) You expect gold to appreciate in value. (e) Prices in the bond market become more volatile.
a) less because your wealth has declined b) more bc it's relative expected return has risen c) less bc it has become less liquid relative to bonds d) less bc it's expected return has fallen relative to gold e) more bc it has become less risky relative to bonds
Explain why you would be more or less willing to buy long-term AT&T bonds under the following circumstances: (a) Trading in these bonds increases, making them easier to sell. (b) You expect a bear market in stocks (stock prices are expected to decline). (c) Brokerage commissions on stocks fall. (d) You expect interest rates to rise. (e) Brokerage commissions on bonds fall.
a) more because the bonds have become more liquid b) more bc their expected return has risen relative to stocks c) less bc they have become less liquid relative to stocks d) less bc their expected return has fallen e) more, bc they have become more liquid
What effect will a sudden increase in the volatility of gold prices have on interest rates?
interest rates fall. The increased volatility of gold prices makes bonds relatively less risky relative to gold and causes the demand for bonds to increase. The demand curve, Bd, shifts to the right and the equilibrium interest rate falls.
If expectations of future short-term interest rates sud- denly fell, what would happen to the slope of the yield curve?
the yield curve would become flatter
In the aftermath of the global economic crisis that started to take hold in 2008, U.S. government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for some time. Does this make sense? Why or why not?
yes, the decrease in investment opportunities and increase in perceived risk factors resulted in a larger increase in demand than the increase in supply due to government deficit spending
If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?
you would raise your prediction. When the yield curve becomes steeper, it means that long-term bonds pay more than short-term bonds, and the interest rate on short-term bonds is expected to go up