Chapter 6: The Risk and Term Structure of Interest Rates

What is the key assumption of the segmented markets theory?

Bonds of different maturities are not substitutes at all.

What is the key assumption of the liquidity premium and preferred habitat theories?

Bonds of different maturities are partial (not perfect) substitutes (allows investors to prefer one bond maturity over another)

Segmented markets theory: What do investors have preferences for?

Bonds of one maturity over another

What are junk bonds?

Bonds with higher default risk and ratings below Baa (or BBB); aka speculative grade bonds, or high yield bonds

What are investment grade securities?

Bonds with relatively low risk of defaults; rating of Baa (or BBB) and above

What is the preferred habitat theory?

Takes a less direct approach to modifying the expectations hypothesis but comes to a similar conclusion as the liquidity premium theory; assumes that investors have a preference for bonds of one maturity over another—a particular bond maturity ("preferred habitat") in which they prefer to invest

What does the expectations theory predict?

That interest rates on bonds of different maturities differ because short term interest rates are expected to have different values at future dates

What does the expectations theory suggest when the curve is upward sloping?

That short term interest rates are expected to rise in the future

Expectations theory: Only when the yield curve is flat does the theory suggest what?

That short term interest rates are not expected to change, on average, in the future

What does bonds of different maturities are partial (not perfect) substitutes mean?

That the expected return on one bond does influence the expected return on a bond of a different maturity

Expectations theory: When the long term rate is higher than the short term rate, the average of future short term rates is expected to be what?

Higher than the current short term rate, which can occur only if short term interest rates are expected to rise

What is a more accurate term for a risk premium?

Risk and liquidity premium

What plays a role in determining the risk structure?

Risk, liquidity, and income tax

What theory explains the third fact of the term structure of interest rates?

Segmented markets theory

Preferred habitat theory: What are investors likely to prefer?

Short term bonds over longer term bonds

Yield curves: Describe flat

Short- and long-term rates are the same

Liquidity premium and preferred habitat theories: Yield curves typically slope upward, explained by what?

A larger liquidity premium as the term to maturity lengthens

What is the yield curve?

A plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations

Liquidity premium theory: What must investors be offered to induce them to hold longer term bonds?

A positive liquidity premium

What is the scale for credit rating agencies?

AAA-D, from best to worst

What are the key assumptions for the expectations theory?

Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity / bond holders consider bonds with different maturities to be perfect substitutes

Liquidity premium theory: How is the expectations theory modified?

By adding a positive liquidity premium to the equation that describes the relationship between long and short-term interest rates

Segmented markets theory: How is the interest rate for each bond with a different maturity determined?

By the demand for and supply of that bond (not affected by expected returns on other bonds with other maturities)

What does liquidity depend on?

Cost of selling a bond and the number of buyers/sellers in a bond market

Bonds with the same maturity have different interest rates due to what?

Default risk, income tax considerations, liquidity

How does the segmented markets theory explain fact three?

Demand for long term bonds is typically relatively lower than that for short term bonds, long term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slope upward

What theory explains the first two facts of the term structure of interest rates?

Expectations theory

Expectations theory: What does bond holders consider bonds with different maturities to be perfect substitutes mean?

If bonds with different maturities are perfect substitutes, then the expected returns on those bonds must be equal

What does the segmented markets theory explain and how?

If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3).

A bond's term to maturity also affects its _______, and the relationship among interest rates on bonds with different terms to maturity is called the _______

Interest rate; term structure of interest rates

The theory of the term structure of interest rates must explain what facts?

Interest rates on bonds of different maturities move together over time / when short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted / yield curves almost always slope upward.

What is the liquidity premium theory?

Investors tend to prefer shorter term bonds because these bonds earn less interest rate risk

What theory explains all three fact of the term structure of interest rates by combining the other two theories?

Liquidity premium theory

Yield curves: Describe inverted or downward sloping

Long-term rates are below short-term rates

What does the segmented markets theory see?

Markets for different maturity bonds as completely separate and segmented

What are the largest credit rating agencies?

Moody's Investor Service, Standard and Poor's Corporation, and Fitch Ratings

Yield curves: Describe upward sloping

Most common classification; long-term rates are above short-term rates

Describe municipal bonds

Not default free; not as liquid as US treasury bonds; lower interest rates on these bonds than US Treasury bonds (because interest payments are exempt from federal income taxes)

What does the differences between interest rates on corporate bonds and Treasury bonds (the risk premiums) reflect?

Not only the corporate bond's default risk, but also its lesser liquidity

A bond with default risk will always have a _______, and an increase in its _______ will raise the risk premium

Positive risk premium; default risk

What is default risk?

Probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

What is the risk structure of interest rates?

Relationship among bonds with the same term to maturity but different interest rates

What does the expectations theory suggest when the curve is inverted?

The average of future short term interest rates is expected to be lower than the current short term rate, implying that short term interest rates are expected to fall, on average, in the future

What is liquidity?

The relative ease with which an asset can be converted into cash

Liquidity premium and preferred habitat theories: Interest rates on different maturity bonds move together over time, explained by what?

The first term in the equation

What is the liquidity premium and preferred habitat theories?

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 (aka term premium) that responds to supply and demand conditions for that bond.

What is the expectations theory?

The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.

Liquidity premium and preferred habitat theories: Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high, explained by what?

The liquidity premium term in the first case and by a low expected average in the second case

What is the risk premium?

The spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds

Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because of what?

The time remaining to maturity is different

Credit rating agencies rate the quality of corporate and municipal bonds in terms of what?

Their probability of default

Preferred habitat theory: People will be willing to buy bonds of different maturities only if what happens?

They earn a somewhat higher expected return

What are default free bonds?

U.S. Treasury bonds (government can raise taxes)

What are the classifications of yield curves?

Upward sloping, flat, downward sloping (can change shape between the three)

When does default occur?

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

What does the expectations theory explain for fact 1?

Why interest rates on bonds with different maturities move together over time

What does the expectations theory explain in general?

Why the term structure of interest rates changes at different times

What does the expectations theory explain for fact 2?

Why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high

What can't the expectations theory explain?

Why yield curves usually slope upward (fact 3)