Financial Markets and Institutions - Structure of Interest Rates

Flashcards covering key concepts related to the structure of interest rates, including factors affecting debt security yields, rating agencies, yield differentials, and various theories explaining the term structure of interest rates.

Term Structure of Interest Rates

The relationship between the term to maturity and the yield of securities.

Credit (Default) Risk

The risk that a security issuer will not be able to make promised payments, requiring higher yields for investors.

Liquidity (Debt Security)

The ease with which a security can be converted to cash without a loss in value; lower liquidity results in higher preferred yields.

Tax Status (Debt Security)

How the income generated by a debt security is treated for tax purposes, affecting the before-tax yield required by investors.

Rating Agencies

Organizations that assess the default risk of debt securities, charging issuers a fee for this service.

Financial Reform Act of 2010

Legislation that established an Office of Credit Ratings within the Securities and Exchange Commission to regulate credit rating agencies.

Yield Differential

The difference between the yield offered on a security and the yield on the risk-free rate.

Basis Point (bp)

A unit of measure for interest rates, equal to 0.01%.

Risk-free Rate (Rf,n)

The yield of an n-day Treasury security, representing the return with no default risk.

Default Premium (DP)

A component of a security's yield that compensates investors for credit risk.

Liquidity Premium (LP)

A component of a security's yield that compensates investors for less liquidity.

Tax Adjustment (TA)

A component of a security's yield that accounts for differences in tax status.

Pure Expectations Theory

A theory that the term structure of interest rates is determined solely by investors' expectations of future interest rates.

Upward Sloping Yield Curve

A yield curve shape indicating that longer-term securities have higher yields, often due to expectations of rising interest rates.

Downward Sloping Yield Curve (Inverted Yield Curve)

A yield curve shape indicating that shorter-term securities have higher annualized yields than longer-term securities, often signaling an expected decline in rates or a potential recession.

Liquidity Premium Theory

A theory suggesting investors prefer short-term liquid securities and demand a premium to invest in longer-term, less liquid securities.

Segmented Markets Theory

A theory stating that investors choose securities with maturities that satisfy their specific forecasted cash needs, leading to distinct markets for different maturities.

Preferred Habitat Theory

An extension of the segmented markets theory, suggesting investors and borrowers may concentrate on a particular maturity market but can be flexible to wander to other maturities if conditions warrant.

Forecasting Recessions (Yield Curve)

The use of flat or inverted yield curves by analysts as indicators of a potential recession in the near future.