Risk Free Rates, Required Return, Risk Premiums

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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


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