EC 303 - The Risk And Term Structure Notes

EC 303 - JSU - The Risk And Term Structure Notes

Default Risk

probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

default free

U.S. Treasury bonds are considered ___________ (government can raise taxes)

Risk Premium

the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds

risk premium

A way to assess the default risk on a given bond is to calculate the _____________.

positive

A bond with default risk will always have a (negative/positive) risk premium.

risk premium.

An increase in the default risk will raise the _______________.

increase

An _______ in the default risk will raise the risk premium

default risk

An increase in the ______________ will raise the risk premium.

credit-rating agencies

Firms called ___________ rate debt based on the probability of default.

default

Firms called credit-rating agencies rate debt based on the probability of ________.

issuer

Bond rating agencies are paid by the ________ of the bond.

Liquidity

The relative ease with which an asset can be converted into cash

higher

The lower the cost associates with the selling of the bond, the ______ the liquidity.

more

The larger the bond market, the ______ liquid.

1- The market is larger
2- Transaction costs are lower.

U.S. Treasury Bonds are more liquid than corporate bonds because:

are

Interest payments on municipal bonds (are / are not) exempt from federal income tax

interest

Due to the exemption from federal income tax on municipal bonds helps explain why the _______ is so low as it compensates for the higher risk.

39.6% to 37%

The Tax Cuts and Jobs Act of 2017 lowered the top marginal income tax rate from ____% to _____%.

Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different.

identical

Bonds with ______ risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different.

risk, liquidity, and tax characteristics

Bonds with identical _____, _______, and ____ ___________ may have different interest rates because the time remaining to maturity is different.

interest rates

Bonds with identical risk, liquidity, and tax characteristics may have different _________ because the time remaining to maturity is different.

Bonds

_______ with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different.

the time remaining to maturity is different.

Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because:

yield curve

An important tool that shows the difference in the yields with different maturity’s is the:

Yield Curve

A plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations.

upward

If long-term rates are above short term rates, then the yield curve will be _______ sloping.

flat

If short term rates and long term rates are the same, then the yield curve will be:

inverted

If long-term rates are below short-term rates, then the yield curve will be ______ and have a negative slope.

horizontal

In regard to a yield curve, the maturity’s will be plotted on the ________ axis.

vertical

In regard to a yield curve, the yield will be plotted on the ________ axis.

1- Interest rates on bonds with different maturities tend to move together.
2- Yield curves will slope up if short-term interest rates are low and will be inverted if short-term rates are high.
3- Yield curves almost always slope upward.

Economists who study the term structure of interest rates with similar risk profiles have notices three empirical facts. What are those facts?

True

True or False:
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.

8%

If interest rates on short-term bonds are expected to average 8% over a 10 year period, the interest rate on a bond with 10 years to maturity will be ______%.

10%

If short-term interest rates are expected to be 10% over the next 20 years, a 20 year bond will have a _____% interest rate.

do not

An important assumption is that buyers of bonds (do / do not) prefer bonds of one maturity over another

Expectations Theory

_____________ argue that 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.

expectations

Under the ________ theory, bond holders consider bonds with different maturities to be perfect substitutes.

substitutes

Under the Expectations Theory, bond holders consider bonds with different maturities to be perfect _________.

True

True or False:
Under the Expectations Theory, bond holders will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity

Segmented Markets

In the ___________ Theory, the maturity on a bond influences the investors preferences for the bond.

demand and supply conditions

In a Segmented Market Theory, interest rates are ultimately determined by:

Liquidity Premium and Preferred Habitat

_________ Theory states that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond

preferred habitat

The____________ theory says investors prefer bonds of a particular maturity, but are willing to buy bonds of a different maturity for a higher expected return

short-term; longer-term

In the Preferred Habitat Theory, Risk-averse investors are likely to prefer ________ bonds over _________ bonds

inversion

A yield curve ________ occurs when rates on short-term Treasuries rise above rates on long-term Treasuries

recessions

A yield curve inversion has come to be seen as a predictor of ___________.

12-18

Yield curve inversions often happen _______ months before a recession (though there are exceptions)