Ch. 6: The Risk and Term Structure of Interest Rates

Risk structure of interest rates

The relationships among the interest rates on various bonds with the same term to maturity.

Term structure of interest rates

The relationships among interest rates on bonds with different terms to maturity.

Default

A situation in which the party issuing a debt instrument is unable to make interest payments or pay off the amount owed when the instrument matures.

Default-free bonds

Bonds with no default risk, such as U.S. government bonds.

Risk premium

The spread between the interest rate on bonds with default risk and the interest rate on default-free bonds.

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 the probability of default.

Junk bonds

Bonds with ratings below Baa (or BBB) that have a high default risk.

The more liquid an asset is, the more ___ it is

desirable

Municipal bonds ___ ___ default-free

are not

Municipal bonds are ___ liquid than U.S. treasury bonds

less

Municipal bonds are exempt from federal income taxes, causing them to have a ___ interest rate than U.S. Treasury bonds

lower

Yield curve

A plot of the interest rates on particular types of bonds with different terms to maturity.

When yield curves slope upward

long-term interest rates are above short-term interest rates

When yield curves are flat

short and long-term rates are the same

When yield curves are inverted

long-term interest rates are below short-term interest rates

Interest rates on bonds of different maturities move ___ over time

together

Yield curves almost always slope ____

upward

Expectations theory

The proposition that the interest rate on a long-term bond will equal the average of the short-term interest rates that people expect to occur over the life of the long-term bond.

Perfect substitutes

If bonds with different maturities are perfect substitutes, then the expected return on those bonds must be equal

When short-term rates are low, people generally expect them to __ to some normal level in the future

rise

Segmented Markets Theory

A theory of term structure that sees the markets for different-maturity bonds as completely separated and segmented, so that the interest rate on bonds of a given maturity is determined solely by supply of and demand for bonds of that maturity.

Liquidity premium theory

The theory that the interest rate on a long-term bond will equal an average of the short-term interest rates expected to occur over the life of the long-term bond, plus a positive term (liquidity) premium.

Preferred habitat theory

A theory that holds that the interest rate on a long-term bond is equal to an average of the short-term interest rates expected to occur over the life of the long-term bond, plus a positive term premium. Closely related to the liquidity premium theory.

Yield curves typically slope upward, by recognizing that the liquidity premium rises with a bond’s maturity because of investors’ preferences for ___ bonds

short-term