Analyze Inflation And Interest Rates - Series 65

1. What is reinvestment rate risk for a bond investor?

   Risk that coupons/principal are reinvested at lower future rates. Reinvestment risk arises because future interest rates may decline, reducing returns on reinvested bond cash flows.

2. Identify what happens to credit spreads in a typical "flight to quality" episode.

   Spreads widen as investors demand more compensation for credit risk. In flight to quality, investors prefer safer assets, increasing demand for Treasuries and widening spreads on riskier bonds.

3. What is deflation?

   A sustained decline in the general price level. Deflation represents a persistent drop in prices, often leading to reduced economic activity and debt burdens.

4. What is the market segmentation theory view of the yield curve?

   Supply and demand in maturity "segments" set yields independently. Market segmentation theory argues that yields are determined by supply and demand within distinct maturity segments, independent of others.

5. What is disinflation?

   A decrease in the inflation rate (prices still rise, slower). Disinflation occurs when the rate of price increases slows, but prices continue to rise overall.

6. What is the liquidity preference theory explanation for a normally upward-sloping yield curve?

   Investors demand a term premium for longer maturities. Liquidity preference theory posits that investors require higher yields for less liquid long-term bonds to compensate for uncertainty.

7. What is the exact Fisher relationship between nominal rate, real rate, and inflation?

   $1+i=(1+r)(1+\pi)$. The Fisher equation accounts for the compounding effect of inflation on nominal rates to derive the real return.

8. What is interest rate risk (market risk) for a bond?

   Risk that bond prices fall when market yields rise. Interest rate risk causes bond prices to inversely react to changes in market yields due to discounted cash flow valuation.

9. Which has greater price sensitivity to rate changes: higher duration or lower duration?

   Higher duration. Duration measures a bond's sensitivity to interest rate changes, with higher values indicating greater price volatility.

10. Which yield curve shape is classically associated with recession expectations?

    Inverted (downward sloping). An inverted curve signals anticipated economic slowdown, with short-term rates higher than long-term due to expected rate cuts.

11. What is the term structure of interest rates?

    The relationship between yields and maturities for similar credit risk. It describes how yields vary with time to maturity for bonds with equivalent credit quality, reflecting expectations and risks.

12. What is inflation as measured by the Consumer Price Index (CPI)?

    A sustained rise in CPI, reducing purchasing power of money. CPI measures the average change in prices of goods and services, so sustained increases indicate inflation that erodes the real value of currency.

13. What is the formula for a credit spread versus a Treasury benchmark?

    $\text{Credit spread}=y_{\text{corp}}-y_{\text{Treas}}$. The spread quantifies the extra yield required for corporate bonds over Treasuries to account for credit risk.

14. What does a flat yield curve generally indicate about expected economic conditions?

    Transition/uncertainty; similar short- and long-term rate expectations. A flat curve suggests balanced expectations for short- and long-term rates, often during economic transitions or uncertainty.

15. If a corporate bond yields $6\%$ and a Treasury yields $4\%$, what is the credit spread?

    $2\%$. Credit spread is calculated as the difference in yields, reflecting the risk premium for the corporate bond.

16. What is the difference between nominal yield and real yield?

    Nominal includes inflation; real is inflation-adjusted. Nominal yield reflects the stated return, while real yield adjusts for inflation to show true purchasing power return.

17. Identify which risk inflation creates for fixed-rate bond investors.

    Purchasing power risk (inflation risk). Fixed-rate bonds pay constant nominal amounts, so inflation diminishes the real value of future payments.

18. Which yield curve shape is most common in an expanding economy: normal, flat, or inverted?

    Normal (upward sloping). In expansion, investors expect higher future rates, leading to an upward slope compensating for longer-term risks.

19. If the nominal rate is $7\%$ and inflation is $3\%$, what is the approximate real rate?

    $4\%$. Using the Fisher approximation, subtract inflation from nominal rate to estimate the real rate of return.

20. Identify what happens to corporate bond prices if credit spreads widen and Treasury yields are unchanged.

    Prices fall (required yield rises due to wider spreads). Wider spreads increase the required yield on corporate bonds, lowering their prices via inverse yield-price relationship.

21. If expected inflation rises while real rates are unchanged, what should happen to nominal yields?

    Nominal yields rise (to incorporate higher expected inflation). Per the Fisher effect, nominal yields adjust upward to maintain real returns when inflation expectations increase.

22. What is the expectations theory explanation for the yield curve shape?

    Long-term yields reflect expected future short-term rates. Expectations theory holds that the curve shape arises from market forecasts of future short-term interest rates.

23. What is the definition of a credit spread?

    Yield difference between a credit-risky bond and a benchmark. Credit spreads compensate investors for the additional default risk compared to a risk-free benchmark like Treasuries.

24. What is a yield curve?

    A graph of yields to maturity across different maturities. The yield curve plots yields against maturities to visualize interest rate expectations and economic forecasts.

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