THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 169

CHAPTER The Risk and Term Structure of Interest Rates 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 upwardsloping curve indicates that future short-term rates are expected to rise, a mildly upward-sloping curve indi- 137 cates 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 basis point, p 117 junk bonds, p 116 credit-rating agencies, default-free bonds, p 114 expectations theory, fallen angels, p 115 p 121 p 116 forward rate p 134 risk structure of interest rates, p 113 liquidity premium theory, p 127 preferred habitat theory, risk of default, p 114 risk premium, p 114 segmented markets theory, p 126 p 127 spot rate p 134 term structure of interest rates, p 113 yield curve, inverted yield curve, p 120 p 119 QUESTIONS You will find the answers to the questions marked with an asterisk in the Textbook Resources section of your MyEconLab Yield to Maturity Which should have the higher risk premium on its interest rates, a corporate bond with an S&P BBB rating or a corporate bond with a C rating? Why? *2 Why Canadian treasury bills have lower interest rates than large-denomination negotiable bank CDs? Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions 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 Term to Maturity (a) Yield to Maturity 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 If a yield curve looks like the one shown in (a), what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market s predictions about the inflation rate in the future? Term to Maturity (b) If a yield curve looks like the one shown in (b), what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market s predictions about the inflation rate in the future?