credit-rating agency

Investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default. 126

default

A situation in which the party issuing a debt instrument is unable to make interest payments or payoff the amount owed when the instrument matures. 30, 123

default-free bonds

Bonds with no default risk, such as U.S. government bonds. 124

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. 132

inverted yield curve

A yield curve that is downward sloping. 130

junk bonds

Bonds with ratings below Baa (or BBB) that have a high default risk. 126

liquidity premium theory

The theory 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 positive term (liquidity) premium. 136

preferred habit theory

A theory that is closely related to liquidity premium theory, in which the interest rate on a long-term bond equals an average of short-term interest rates expected to occur over the life of the long-term bond plus a positive term premium. 13 7

risk premium

The spread between the interest rate on bonds with default risk and the interest rate on default-free bonds. 124

risk structure of interest rates

The relationship among the interest rates on various bonds with the same term to maturity 123

segmented markets theory

A theory of term structure that sees markets for different-maturity bonds as completely separated and segmented such that the interest rate for bonds of a given maturity is determined solely by supply of and demand for bonds of that maturity 135

term structure of interest rates

The relationship among interest rates on bonds with different terms to maturity. 123

yield curve

A plot of the interest rates for particular types of bonds with different terms to maturity. 130

Corporate Baa Bonds

Generally, which bond has the highest interest rate?

the chance the issuer will be unable to make interest payments or repay principal.

Default risk is:

the demand for A to decrease and the demand for B to increase.

Suppose that there are two bonds, A and B. Suppose also the default risk on bond A increases. As a result of this we would expect to see:

the difference in interest rate between that bond and a US government bond.

The risk premium on a bond is:

increase the risk premium on bond A and reduce the risk premium on bond B.

An increase in the level of risk for bond A will:

they are exempt from Federal taxes.

Municipal bonds generally have lower interest rates than U.S. Government bonds because:

the relationship between time to maturity and bond interest rates (yields).

Yield curves show:

the market expects the interest rate on a one year bond in one year to be 9%.

According to the expectations theory of the term structure, if the interest rate on a one year bond is 5% and the interest rate on a two year bond is 7%, then:

up-sloping.

The liquidity premium theory suggests that yield curves should usually be:

investors prefer short-term bonds.

The liquidity premium theory is based upon the idea that, other things remaining equal,

upward sloping.

The shape of the yield curve is usually:

buyers of bonds consider bonds of different maturities to be perfect substitutes.

The expectations theory of the term structure assumes:

It will steeply slope upward.

What will the yield curve look like if future short-term interest rates are expected to rise sharply?

Will increase when the risk of default rises.

The risk premium of a bond

Investors have strong preferences for bonds of a particular maturity.

The Segmented Markets theory of term structure suggests that

____________ bonds are generally considered to be default risk-free

Treasury

The more risk, demand goes _______

down

The lower risk, demand goes ______

up

Additional interest that must be earned in order to entice someone to hold a risky bond over a risk-free bond.

risk premium

The higher the potential of default, the higher the __________________

risk premium

Have low risk of default and have a rating of Baa(or BBB) or above

Investment-Grade Securities

Have a higher risk of default and are given a lower rating.

Speculative-Grade (Junk Bond) Securities

Banks can only hold __________ bonds

investment grade

How quickly an asset can be converted into a medium of exchange

Liquidity

T-Bond market is extremely ____

active

__________ bonds are the most liquid long-term bonds

Treasury

Municipal bonds are _____________ exempt

income tax

You must pay income tax on ____________ bonds

treasury and corporate

Municipal bonds have higher expected return so demand goes __________

up

Treasury bonds have lower expected return so Demand goes ___________

down

A plot of the yields on bonds with differing-terms to maturity but identical risk structure factors such as treasury securities

Yield Curve

Interest rates tend to ___________ over time

move together

Yield curves are more likely to have an upward slope when short-term rates are _____

low

Yield curves are more likely to have an downward slope when short-term rates are _____

high

Yield curves usually have a __________ slope

upward

Long-term yields are an average of

expected future short-term yields

Bonds of different maturities (are/are not) substitutes

are not

the interest rate at each maturity is determined

separately

For short-term bonds they have a:

higher demand, higher price, and lower yield than long term

Long term bonds have ________ interest rate risk

higher

Steep Upward-Slope of yield curve so expect _____ interest rates

higher

mild upward-slope of yield curve so expect _______ interest rates

stable

flat slope of yield curve so expect _______ interest rates

falling

Downward-Slope of yield curve (inverted) so expect ____________ interest rates

sharply falling

credit-rating agency

default

default-free bonds

Bonds with no default risk, such as U.S. government bonds. 124

expectations theory

inverted yield curve

A yield curve that is downward sloping. 130

junk bonds

Bonds with ratings below Baa (or BBB) that have a high default risk. 126

liquidity premium theory

preferred habit theory

risk premium

risk structure of interest rates

The relationship among the interest rates on various bonds with the same term to maturity 123

segmented markets theory

term structure of interest rates

The relationship among interest rates on bonds with different terms to maturity. 123

yield curve

A plot of the interest rates for particular types of bonds with different terms to maturity. 130