1.

Defenition

CDO: Major mechanism to reallocate credit risk in the fixed income markets. Loans are pooled together
and split into tranches with different levels of default risk. Synthetic CDOs are created from a portfolio of
default-free securities with a combination of credit default swaps.

Collateral: A particular asset bondholders receive if the firm defaults

YTC: the return a bondholder receives if the bond is held until the call date

Credit curve is the graphical representation of the relationship between the return offered by a security
(credit-generating instrument) and the time to maturity of the security.

The credit curve applies to non-government borrowers and incorporates credit risk into each rate.
Upward-sloping credit curves imply a greater likelihood of default in later years, whereas downward-
sloping credit curves imply a greater probability of default in the earlier years. Downward sloping curves
are less common and often a result ofsevere near-term stress in the financial markets.

Inverted yield curve: The yield curve can also take an inverted shape when the yields at the front end of
the curve are higher than at the long end, i.e., the slope of the yield curve is negative. An inverted yield
curve occurs when short-term debt instruments have higher yields than long-term instruments of the
same credit risk profile.

2. How can you derive expected future spot rates from the yield curve? How can a yield curve
predict business cycles?

a/ Assume that liquidity premiums are constant

An estimate of that premium can be subtracted from the forward rate to obtain the market’s expected
interest rate

we would estimate from historical data that a typical liquidity premium in this economy. After calculating
the forward rate from the yield curve, the expectation of the future spot rate would be determined by
forward rate minus liquidity premium

two problems:

 it is next to impossible to obtain precise estimates of a liquidity premium

general approach: comparing forward rates and eventually realized future short rates and to
calculate the average difference between the two
 there is no reason to believe that the liquidity premium should be constant
Empirical evidence suggests that liquidity premiums do fluctuate over time

b/ The yield curve is a good predictor of the business cycle

• Long term rates tend to rise in anticipation of economic expansion
• Inverted yield curve may indicate that interest rates are expected to fall and signal a recession
a) very steep yield curves are interpreted by many market professionals as warning signs of impending
rate increases
b) the usually observed upward slope of the yield curve, especially for short maturities, is the empirical
basis for the liquidity premium doctrine that long-term bonds offer a positive liquidity premium
c) a downward sloping yield curve is taken as a strong indication that yields are more likely than not to
fall

3. What are the main factors which explain the difference between treasury yields and corporate
bond yields? How can you estimate these components of the yield spread

the main factors which explain the difference between treasury yields and corporate bond yields is
Credit Spread.