FIN 427

Chapter 6

Production Opportunities Yield Curve

the investment opportunities in productive (cash- a graph showing the relationship between bond yields
generating) assets and maturities

Time Preferences for Consumption Normal Yield Curve

the preferences of consumers for current an upward-sloping yield curve
consumption as opposed to saving for future
consumption Inverted Abnormal Yield Curve
a downward-sloping yield curve
Risk
in a financial market context, the chance that an Humped Yield Curve
investment will provide a low or negative return a yield curve where interest rates on intermediate-
term maturities are higher than rates on both short-
Inflation and long-term maturities
the amount by which prices increase over time
Pure Expectations Theory
Real Risk-Free Rate of Interest, r* a theory that states that the shape of the yield curve
the rate of interest that would exist on default-free depends on investors expectations about future
U.S. Treasury securities of no inflation were expected interest rates

Nominal (Quoted) Risk-Free Rate, rRF Foreign Trade Deficit

the rate of interest on a security that is free of all risk; the situation that exists when a country imports more
rRF is proxied by the T-bill rate or the T-bond rate. than it exports
rRF includes an inflation premium

Inflation Premium (IP)

a premium equal to expected inflation that investors
add to the real risk-free rate of return

Default Risk Premium (DRP)

the difference between the interest rate on a U.S.
Treasury bond and a corporate bond of equal maturity
and marketability

Liquidity Premium (LP)

a premium added to the equilibrium interest rate on a
security if that security cannot be converted to cash
on short notice and at close to its fair market value.

Interest Rate Risk

the risk of capital losses to which investors are
exposed because of changing interest rates

Maturity Risk Premium (MRP)

a premium that reflects interest rate risk

Reinvestment Rate Risk

the risk that a decline in interest rates will lead to
lower income when bonds mature and funds are
reinvested

Term Structure of Interest Rates

the relationship between bond yields and maturities