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15 Cards in this Set
- Front
- Back
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A bond with default risk will always have a ____ risk premium, and an increase in its default risk will _____ the risk premium
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positive, raise
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credit-rating agencies
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investment advisory firms that rate the quality of corporate and municipal bonds in terms of prob. of default
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Investment grade
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low risk of default; Baa or BBB and above
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Junk bonds
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high default risk and ratings below Baa or BB; always have higher interest rates; high-yield bonds
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as a bond's default risk increases, the risk premium on that bond ____
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rises
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• Yield curve
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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 |
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Interest rates on bonds of different maturities move ____ over time
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together
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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 |
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Yield curves almost always slope _____
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upward
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expectations theory
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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 |
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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 |
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Segmented markets theory
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•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 |
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Liquidity preference theory
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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 |
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Liquidity premium theory equation
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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 |
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preferred habit theory
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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 |
