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Explain the factors that determine the risk structure of interest rates. Explain how a change of
each factor changes interest rates.
Answer: Default risk is the risk that interest or principal payments will not be made.
Liquidity is the ability to convert an asset to cash quickly and cheaply.
Tax-exempt bonds are more attractive to investors in high tax brackets.
An increase in default risk, a reduction in liquidity, and a tax cut increase interest rates on the
affected assets. A reduction of default risk, an increase in liquidity, and a tax increase reduce
interest rates on the affected assets.
Diff: 3 Type: SA Page Ref: 113 - 118
Skill: Recall
Objective List: 6.1 Describe how default risk, liquidity, and tax considerations affect interest
rates
Demonstrate graphically and explain how a reduction in default risk affects the demand or
supply of corporate and Canada bonds.
Answer: A reduction of default risk increases the demand for corporate bonds and reduces the
demand for Canada bonds. Corporate bond prices rise and interest rates fall. Canada bond prices
fall and interest rates rise.
Diff: 2 Type: SA Page Ref: 114
Skill: Applied
Objective List: 6.1 Describe how default risk, liquidity, and tax considerations affect interest
rates
Explain using a diagram how the "flight to quality" after the Subprime collapse lead to a
rising spread between lower-quality (BBB-rated) and highest-quality (AAA-rated) bonds.
Answer: Students must use supply and demand analysis on a graph to show that the subprime
collapse led to doubts about the financial health of lower-quality (BBB-rated) companies,
reducing demand for their bonds shifting their demand curve to the left and thus decreasing their
price and increasing their interest. The shift of the demand from BBB-rated to AAA-rated bonds
known as "flight to quality" increased the demand of AAA-bonds shifting the demand curve to
the right and thus increasing their price and decreasing their interest rates, resulting in a wider
interest rate spread between BBB and AAA-rated bonds.
Diff: 3 Type: SA Page Ref: 116
Skill: Applied
Objective List: 6.1 Describe how default risk, liquidity, and tax considerations affect interest
rates