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Homework_3 - CHAPTER 6 2. Four theories of the term...

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CHAPTER 6 The Risk and Term Structure of Interest Rates 139 2. Four theories of the term structure provide explanations of how interest rates on bonds with different terms to maturity are related. The expectations theory views long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond; by contrast, the segmented markets theory treats the determination of interest rates for each bond’s maturity as the outcome of supply and demand in that market only. Neither of these theories by itself can explain the fact that interest rates on bonds of different maturities move together over time and that yield curves usually slope upward. 3. The liquidity premium and preferred habitat theories combine the features of the other two theories, and by so doing are able to explain the facts just mentioned. They view long-term interest rates as equaling the average of future short-term interest rates expected to occur over the life of the bond plus a liquidity premium. These theories allow us to infer the market’s expectations about the movement of future short-term interest rates from the yield curve. A steeply upward- sloping curve indicates that future short-term rates are expected to rise, a mildly upward-sloping curve indicates that short-term rates are expected to stay the same, a flat curve indicates that short-term rates are expected to decline slightly, and an inverted yield curve indicates that a substantial decline in short-term rates is expected in the future. Key Terms default, p. 120 default-free bonds, p. 121 expectations theory, p. 129 inverted yield curve, p. 127 junk bonds, p. 124 liquidity premium theory, p. 133 preferred habitat theory, p. 134 risk premium, p. 121 risk structure of interest rates, p. 120 segmented markets theory, p. 132 term structure of interest rates, p. 120 yield curve, p. 127 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, “Answers to Selected Questions and Problems.” 1. Which should have the higher risk premium on its interest rates, a corporate bond with a Moody’s Baa rating or a corporate bond with a C rating? Why? *2. Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs? 3. Risk premiums on corporate bonds are usually anticycli- cal ; that is, they decrease during business cycle expan- sions and increase during recessions. Why is this so? *4. “If bonds of different maturities are close substitutes, their interest rates are more likely to move together.” Is this statement true, false, or uncertain? Explain your answer. 5. If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory? *6.
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Homework_3 - CHAPTER 6 2. Four theories of the term...

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