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### 15 Cards in this Set

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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 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