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15 Cards in this Set

  • Front
  • Back
A bond with default risk will always have a ____ risk premium, and an increase in its default risk will _____ the risk premium
positive, raise
credit-rating agencies
investment advisory firms that rate the quality of corporate and municipal bonds in terms of prob. of default
Investment grade
low risk of default; Baa or BBB and above
Junk bonds
high default risk and ratings below Baa or BB; always have higher interest rates; high-yield bonds
as a bond's default risk increases, the risk premium on that bond ____
rises
• Yield curve
a plot of the yield on bonds with differing terms to maturity but the same risk,
liquidity and tax considerations
+ Upward-sloping: LT rates are above short-term rates
+Flat: ST and LT rates are the same
+Inverted: LT rates are below ST rates
Interest rates on bonds of different maturities move ____ over time
together
When ST interest rates are low, yield curves are more likely to have an___ slope; when ST rates are high, yield curves are more likely to
slope ______ and be ______
upward
downward
inverted
Yield curves almost always slope _____
upward
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
• Buyers of bonds do not prefer bonds of one maturity over another.
• Bonds are considered to be perfect substitutes
expected return for holding a 2pd bond for 2weeks
for 2 1pd bonds
2i2t
it+ie(1+t)
or
i2t=it+ie(1+t)/2
Segmented markets theory
•Key Assumption: Bonds of different maturities are not
substitutes at all.
•Implication: Markets are completely segmented: interest
rates at different maturities are determined separately.
•Explanation of Fact 3: Typical preference for higher liquidity and lower risk
•Typical preference for short holding periods
•demand for short-term bonds is higher
•short term bonds have higher prices and lower interest rates
Liquidity preference theory
The interest rate on a LT bond will= an avg of ST interest
rates expected to occur over the life of the LT bond plus a liquidity premium that responds to supply and demand conditions for that bond
• Bonds of different maturities are substitutes but not perfect substitutes
Liquidity premium theory equation
int = it + iet+1 + iet+2 + iet-n/n + lnt
add liquidity premium for the n-pd bond at time t; always pos and rises with the term to maturity of the bond, n
preferred habit theory
Investors have a preference for bonds of one maturity over another
• They will be willing to buy bonds of different maturities only if they earn a
somewhat higher expected return
• Investors are likely to prefer short-term
bonds over longer-term bonds