ECON 2411 - Ch. 6 The Risk and Term Structure of Interest Rates

If the yield on a 10-year T-note is 4%, what is the risk premium on bond #4? The risk premium is ____. What is a likely range of yields for a 10-year corporate bond with a Ba rating? The minimum yield is ____ and the maximum yield is _____.

0.60% 7.45% ; 7.75%

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Answer: As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt. (Risk premiums will fall in an economic expansion as business revenue and profits improve, making it easier for borrowers to make scheduled interest payments on their debt and increasing the likelihood that the business will repay the principle of that debt.)

Given the market activity shown in the diagrams above, the risk premium is ______. Based on this information, it is more likely that the economy is entering _____.

Answer: Decreasing an expansion

If a yield curve looks like the one show in the diagram to the right, what is the market predicting about the movement of future short-term interest rates? The market is predicting that short-term interest rates will______. What might the yield curve indicate about the market's predictions for the inflation rate in the future? The market's prediction indicate that inflation will _______.

Answer: Increase int he near term, then decrease in the long term. Increase in the near term, then decrease in the long term.

Prior to 2008, mortgage lenders required a house inspection to assess its value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?

Answer: Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.

What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected by the tax rate change?

Answer: Interest rates would rise because the reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable and reduce the demand for municipal bonds. Yes, because the reduction in the tax-exempt privilege in municipal bonds would raise the relative value of Treasury securities, making Treasury securities more desirable.

What would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market?

Answer: Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand, which would lower the risk premium.

Consider the following two bonds: Bond A and Bond B are considered to be close substitute. Bond A is a one-year instrument and Bond B is a two-year instrument. Currently, the following yields exist on these bonds: Bond A - 4.5% yield ; Bond B 4.75% yield. If investors expect one-year rates next year to be higher at 5.50%, are they more likely to buy or sell two-year bonds today? Investors are most likely to _____ two-year bonds today. How will this affect two-year bond rates? The yield on two-year bonds will ______.

Answer: Sell Increase

During 2008, the difference in yield (the yield spread) between 3-month AA-rated financial commercial paper and 3-month AA-rated non-financial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at it peak in October 2008. Which of the following explains this sudden increase?

Answer: The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.

In 2010 and 2011, the government of Greece risked defaulting on its debt due to a sever budget crisis. Using bond market graphs, determine how default would affect the risk premium between U.S. Treasury debt and Greek debt with comparable maturity. In the case of default, what would happen to the risk premium between U.S. Treasury debt and comparable maturity Greek debt?

Answer: The risk premium would increase, which corresponds to segment B on the graph above.

Assume the segmented markets theory of the term structure holds. If bond investors decide that 30-year bonds are no longer as desirable an investment, the yield curve would:

Answer: result in a jump in the 30-year rate, with the remainder of the yield curve unchanged.

Which of the following statements are true?

Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates were low, they had higher interest rate than U.S. government bonds before the World War II.

According to the liquidity premium theory, a yield curve that is flat means that ...

Bond purchasers expect interest rates to fall in the future.

If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would ______.

Increase.

According to the expectations theory of the term structure

Interest rates on bonds of different maturities move together over time.

According to the liquidity premium theory of the term structure, a slightly upward sloping yield curve indicates that short-term interest rates are expected to

Remain unchanged in the future.

When yield curves are downward sloping.

Short-term interest rates are above long-term interest rates.

The U.S. Treasury offers some of 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 much smaller scale than nominal U.S. Treasury bonds of equivalent maturity. What can you conclude about the liquidity premium between TIPS and 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.

Why do U.S. Treasury bills have lower interests rates than large-denomination negotiable bank CDs?

Treasuries are considered to be risk-free debt instruments.

A plot of the interest rates on default - free government bond with different terms to maturity is called

a yield curve.