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OHCh6 - Chapter 6 The Risk and Term Structure of Interest...

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Chapter 6: The Risk and Term Structure of Interest Rates
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1 Risk Structure of Interest Rates 1.1 Default Risk ° default: The issuer of the bond is unable or unwilling to make interest payments when promised or pay o° the face value when the bond matures. ° default-free bonds: Bonds that are considered to have no default risk. U.S. Treasury bonds have usually been considered default-free. ° risk premium: The spread between the interest rates on bonds with default risk and default-free bonds. See Figure 1.
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° Response to an increase in default risk on corporate bonds: See Figure 2. ° risk premium: Credit-rating agencies. See Table 1. ° junk bonds: Bonds with rating below Baa (or BBB)
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1.2 Liquidity 1.3 Income Tax Consideration ° Municipal bonds are not default-free. ° Municipal bonds are less liquid than U.S. Treasury bonds. ° Puzzle: Why have municipal bonds had lower interest rates than U.S. Treasury bonds for at least 40 years as in Figure 1?
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2 Term Structure of Interest Rates 2.1 Yield Curve A yield curve is a plot of the yields on bonds with di°ering terms to maturity at a point in time (cf. A plot over time in Figure 4). Yield curves can be classi±ed as upward-sloping, ²at, and downward-sloping (inverted yield curve).
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