Charlee_CH_5 - FIN MKTS: Chapter 5 I. Risk Structure of...

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FIN MKTS : Chapter 5 I. Risk Structure of Interest Rates: relationship among interest rates on bonds with the same maturity a. Interest rates on different categories of bonds differ from one another in any given year, and the spread (difference) between interest rates varies over time. b. Default Risk: occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when bond matures. i. Corporations suffering big losses might default ii. Default Free: US Treasury Bonds; government can increase taxes to fulfill obligations iii. Risk Premium : spread between the interest rates on bonds with default risk and default-free bonds 1. indicates how much additional interest people must earn in order to be willing to hold that risky bond iv. Default Increase (Corp & T-Bond; corp. suffering large losses): 1. Corporate Bond : default risk increases and E(r) decreases – becomes less desirable and demands falls – shift D-curve left a. Equilibrium price drops b. Equilibrium interest rate rises 2. T-Bond : E(r) increases (relative to E(r) on corp. bond) and relative riskiness declines – becomes more desirable and demand rises – shift D-curve right a. Equilibrium price rises b. Equilibrium interest rate drops 3. Risk premium has risen 4. *A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium v. Credit-Rating Agencies: investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default 1. purchasers need to know if bonds will default 2. Investment-Grade Securities : bonds with relatively low risk of default (rating=Baa/BBB) 3. Junk Bonds : low ratings and high default risk (rating<Baa/BBB) 4. *Baa-rated corporate bonds have a greater default risk than the higher-rated Aaa bonds – risk premium is greater – Baa rate always exceeds the Aaa rate c. Liquidity : liquid asset can be quickly and cheaply converted into cash when need arises i. The more liquid, the more desirable 1. US T-Bonds – most liquid LT Bond; widely traded, can sell quickly; cost of selling low 2. Corp. Bonds – fewer bonds for any one corp., not as liquid; hard to find buyers, costly ii. Lower liquidity of corp. bonds relative to T-bonds increases the spread between the interest rates iii. Liquidity Decreases (corp. bond relative to T-Bond): 1. Corp. Bond: less widely traded – demand falls – shift D-curve left a. Price Falls b. Interest rate rises 2. T-Bond : relatively more liquid in comparison – shift D-curve right a. Price rises b. Interest rates fall 3. Spread between interest rates has risen – risk premium (liquidity premium)
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This note was uploaded on 02/21/2011 for the course FIN 3403 taught by Professor Duong during the Spring '08 term at The University of Oklahoma.

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Charlee_CH_5 - FIN MKTS: Chapter 5 I. Risk Structure of...

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