Question

6. Explain the key factors that determine the yield on a given interest-paying security(i.e. bond).  Explain how each of these factors determines why the yield is different between one security and another.  How can this analysis be used to estimate the risk-free rate of return?  (12 points).

Answer 1

Answer:

Yield Versus Risk :

Prices and yields in the security or bond market consistently reflect the risk engaged with a particular bond investment. To procure a better return/yield, a speculator must acknowledge some structure or sort of extra risk. The current market yield of securities reflects the diverse risk factors related with that security or bond.

When you purchase a bond, your yield is secured, and the adjustments in advertise financing costs will be reflected in the market estimation of the bond in the event that you choose to sell. Bond costs and interest rates move conversely. In the event that rates increase, bond prices decrease. Also, if rates fall, bond prices will go up.

Issuer's Credit Quality:

The yield a security/bond pays is subject to the credit nature of the issuer. The U.S. government is viewed as the most secure issuer of bonds, so U.S. Treasury securities have the most minimal yields when different components are the equivalent. Bond issuers have FICO ratings demonstrating the capacity to make opportune interest and principal payments.

Appraisals are letter grades, with AAA as the top rating, at that point descending through AA, A, BBB and proceeding with the example to a solitary C or D (contingent upon the rating organization). Credit scores of BBB or higher meet the meaning of speculation grade bonds. Bonds with lower appraisals/ratings are viewed as non investment grade and are alluded to as high return or junk bonds. The lower the credit rating, the higher the yield a security will pay.

Time to Maturity :

During times of ordinary financial conditions, the yields on a more extended term will be higher than for a shorter term security. Speculators hope to be paid a higher rate in return for locking cash up for a more drawn out timeframe.

The relationship among term and rate is known as the yield curve. An ordinary yield curve slants upward to show longer-term rates higher as the term increments. In times of financial disturbance, the yield curve can straighten or even go transformed with short rates higher than long haul rates.

Future Inflation Expectations :

The rates on generally safe longer-term securities reflect the security or bond market attitude toward inflation. On the off chance that bond investors think  inflation will expand, security yields will increment and security costs will decay. Bond investors hope to win the pace of inflation in addition to some additional interest over the term of any bond. Current security yields move up and there as the assumptions regarding future inflation change.

The yields and costs of long haul securities are set by market supply and demand. Yields at the short end of the yield curve – terms shorter than two years – are more affected by approaches of the administration and the Federal Reserve.

How this identifies with chance free Bond :

Yeild of the risk free bonds/ securities incorporate Infaltion spread, Time to maturity and the Interest rate chance in to the market it does exclude the borrower's noteworthiness. since such venture are without risk or risk free so it doesn't have any risk of default.