Finance Chapter 3

Characteristics That Affect Security Yields. Identify the relevant characteristics of any security that can affect the security's yield.

- Default risk - liquidity - tax status - maturity

Tax Effects on Yields. Do investors in high tax brackets or those in low tax brackets benefit more from tax-exempt securities? Why? Do municipal bonds or corporate bonds offer a higher before-tax yield at a given point in time? Why? Which has the higher after-tax yield? If taxes did not exist, would Treasury bonds offer a higher or lower yield than municipal bonds with the same maturity? Why?

-High-tax bracket investors benefit more from tax-exempt securities because their tax savings from avoiding taxes is greater. -Corporate bonds offer a higher before-tax yield, since they are taxable by the federal government. The municipal bonds may have a higher tax yield for investors subject to a high tax rate. For low-tax bracket investors, the corporate bonds would likely have a higher after-tax yield. -If taxes did not exist, Treasury bonds would offer a lower yield than municipal bonds because they are perceived to be risk-free. Thus, the required return on Treasury bonds would be lower than on municipal bonds.

Segmented Markets Theory. If a downward-sloping yield curve is mainly attributed to segmented markets theory, what does that suggest about the demand for and supply of funds in the short-term and long-term maturity markets?

A downward-sloped yield curve suggests that the demand for short-term funds is high relative to the supply of short-term funds, causing a high yield. In addition, the demand for long-term funds is low relative to the supply of long-term funds, causing a low yield.

Segmented Markets Theory. If the segmented markets theory causes an upward-sloping yield curve, what does this imply? If markets are not completely segmented, should we dismiss the segmented markets theory as even a partial explanation for the term structure of interest rates? Explain.

An upward-sloped yield curve caused by segmented markets implies that the demand for short-term funds is low relative to the supply of short-term funds. In addition, the demand for long-term funds is high relative to the supply of long-term funds -Even if markets are not completely segmented, investors and borrowers may prefer a particular maturity market. Therefore, they may only switch to a different maturity if there is sufficient compensation (such as a higher return for investors or a lower cost of borrowing for borrowers).

Liquidity Premium Theory. Explain the liquidity premium theory

If investors believe that securities with larger maturities are less liquid, they will require a premium when investing in such securities to compensate. This theory can be combined with the other theories to explain the shape of a yield curve.

Impact of Credit Risk on Yield. What effect does a high credit risk have on securities?

Investors require a higher risk premium on securities with a high default risk

Pure Expectations Theory. Assume there is a sudden expectation of lower interest rates in the future. What would be the effect on the shape of the yield curve? Explain.

The demand for short-term securities would decrease, placing downward (upward) pressure on their prices (yields). The demand for long-term securities would increase, placing upward (downward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now be more horizontal (less steep). If it was downward sloped, it would now be more steep.

Pure Expectations Theory. Explain how a yield curve would shift in response to a sudden expectation of rising interest rates, according to the pure expectations theory.

The demand for short-term securities would increase, placing upward (downward) pressure on their prices (yields). The demand for long-term securities would decrease, placing downward (upward) pressure on their prices (yields). If the yield curve was originally upward sloped, it would now have a steeper slope as a result of the expectation. If it was originally downward sloped, it would now be more horizontal (less steep), or may have even become upward sloping

Forward Rate. What is the meaning of the forward rate in the context of the term structure of interest rates? Why might forward rates consistently overestimate future interest rates? How could such a bias be avoided?

The forward rate is the expected interest rate at a future point in time -If forward rates are estimated without considering the liquidity premium, it may overestimate the future interest rates. If a liquidity premium is accounted for when estimating the forward rate, the bias can be eliminated.

Impact of Liquidity on Yield. Discuss the relationship between the yield and liquidity of securities.

The greater the liquidity of a security, the lower is the yield, other things being equal.

Preferred Habitat Theory. Explain the preferred habitat theory

The preferred habitat theory suggests that while investors and borrowers may prefer a natural maturity, they may wander from that maturity under conditions where they can benefit from selecting a different maturity.

Yield Curve. What factors influence the shape of the yield curve? Describe how financial market participants use the yield curve.

The yield curve's shape is affected by the demand and supply conditions for securities in various maturity markets. Expectations of interest rates, the desire for liquidity, and the desire by investors or borrowers for a specific maturity will influence the demand and supply conditions. -The yield curve can be used to determine the market's expectations of future interest rates. Market participants can compare their own expectations to the market's expectations in order to determine their borrowing or investing decisions.

Impact of Liquidity Premium on Forward Rate. Explain how consideration of a liquidity premium affects the estimate of a forward interest rate.

When considering a liquidity premium, the estimate of a forward interest rate will be reduced.