The amount of additional interest investors receive due to various risk premiums changes over time. Sometimes risk premiums are much larger than at other times. For example, the default risk premium was very small in the late 1990s when the economy was so healthy that business failures were rare. This risk premium increases during recessions

Go to http://www.federalreserve.gov/releases/h15 (historical data), and find the following three interest rate listings for AAA- and Baa-rated bonds: the most current listing; the listing for January 5, 2018; and the listings for June 1, 2008, and June 1, 2007. Prepare a http://www.federalreserve.gov/Releases/h15/update/ The Federal Reserve reports the yields on different-maturity U.S. Treasury bonds. graph that shows the interest rate information for these bonds over these three time periods (see Figure 1 for an example). Are the risk premiums stable, or do they change over time?

Short Answer

Expert verified

The risk premiums have been changing over time.

Step by step solution

01

Definition

Risk premium is the additional financial, paid over and above the return on the risk free assets it is a monetary reward tot the investor for bearing the risk.

02

Explanation

In the country US, the great depression officially lasted from December 2007to June 2009. The investors were willing to stay in the market. While the three months treasury bill implied a short-term investment, the investment in the long-term assets is rewarded with a higher risk premium during the recessionary phase of an economy. The investor who chose to purchase or stay with BAA corporate bond was given the highest return in the form of the risk premium as interest listings as stated. The corporate bond yield was highest during the period of depression ending June 2009. The investment in long-term government bonds too was high yield investment at that time since shattering public confidence was keeping funds away from the market. This is again illustrated in the plummeting interest figures against the government bonds particularly during the initial year of depression from Q22007toQ32008.

As the economy entered the stage of recovery, the financial assets became safer to put money into. This is reflected in the gradually falling interest rates from 5.59percent in October to 1.89percent in October 2017for BAA corporate bonds and from 4.84percent to 2.84percent for long-term treasury bonds during the same period. Thus the risk premium is responsive to the level of economic activity.

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Most popular questions from this chapter

During 2008, the difference in yield (the yield spread) between three-month AA-rated financial commercial paper and three-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. What explains this sudden increase?

Go to the St. Louis Federal Reserve FRED database, and find daily yield data on the following U.S. treasuries securities: one-month (DGS1MO), three-month (DGS3MO), six-month (DGS6MO), one-year (DGS1), two-year (DGS2), three-year (DGS3), five-year (DGS5), seven-year (DGS7), 10-year (DGS10), 20-year (DGS20), and 30-year (DGS30). Download the last full year of data available into a spreadsheet.

a. Construct a yield curve by creating a line graph for the most recent day of data available, and for the same day (or as close to the same day as possible) one year prior, across all the maturities. How do the yield curves compare? What does the changing slope say about potential changes in economic conditions?

b. Determine the date of the most recent Federal Open Market Committee policy statement. Construct yield curves for both the day before the policy statement was released and the day on which the policy statement was released. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?

If the income tax exemption on municipal bonds were abolished, what would happen to the interest rates on these bonds? What effect would the change have on interest rates on U.S. Treasury securities?

If the yield curve suddenly became steeper, how would you revise your predictions of interest rates in the future?

Assuming the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curves for the following paths of one-year interest rates over the next four years:

a. 4%, 6%, 11%, 15%

b. 3%, 5%, 13%, 15%

How would your yield curves change if people preferred shorter-term bonds to longer-term bonds?

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