Chapter 6

• Bonds with the same maturity have different interest rates due to:

  • default risk
  • Liquidity
  • tax considerations
• Default risk is the probability that the issuer of the bond is unable or unwilling to make interest payments of pay off the face value.
• Risk premium is the spread between the interest rates on bonds with default risk and the interest rates on treasury bonds.
• Liquidity is the relative ease with which an asset can be converted into cash.
• Income tax considerations are interest payments on municipal bonds are exempt from federal income taxes.
• Yield curve is a plot of the yield on bonds differing terms to maturity but the same risk, liquidity, and tax considerations.
• Upward-sloping means long term rates are above short term rates.
• Flat means short and long term rates are the same.
• Inverted means long term rates are below the short term rates.
• The theory of term structure : interest rates on bonds of different maturities move together over time.
• Expectations theory predicts future short term interest rates based on current long term interest rates.
• Segmented markets theory said that long and short term interest rates are not related to each other.
• Liquidity premium theory is a combination of expectations theory and segmented markets theory. It states that the returns from short term financial assets like bonds are generally higher than those from long term assets due to the reduced risk of short term investments.