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Unformatted text preview: The Risk Structure of Interest Rates The Term Structure of Interest Rates Last Lecture: The Liquidity Preference Framework : Alternative model for understanding interest rate movements. Supply and demand in the market for money . Effects of an increase in money supply on interest rate i : Liquidity effect ( i ↓ ). Income effect ( i ↑ ). Pricelevel effect ( i ↑ ) Expected inflation effect ( i ↑ ) In the short run, the liquidity effect probably dominates. In the long run, the income, pricelevel and expected inflation effects dominate. The Risk Structure of Interest Rates The Term Structure of Interest Rates CHAPTER 6 The Risk and Term Structure of Interest Rates The Risk Structure of Interest Rates The Term Structure of Interest Rates Two Observations: 1. Interest rates differ among bond categories at a given point in time. 2. The spread (i.e. difference) between interest rates fluctuates over time. Two Key Explanatory Factors: 1. Risk structure 2. Term to maturity The Risk Structure of Interest Rates The Term Structure of Interest Rates The Risk Structure of Interest Rates ⇒ refers to interest rate differentials for bonds with identical maturities that are related to: 1. Default risk Occurs when the issuer of the bond is unable or unwilling to make interest payments or pay off the face value 2. Liquidity ; the ease with which an asset can be converted into cash 3. Income tax considerations (e.g municipal bonds) The Risk Structure of Interest Rates The Term Structure of Interest Rates Default Risk Interest rates on corporate bonds are higher than on Tbonds. U.S. Tbonds are considered virtually default free Unlike a company, the US government can raise taxes. If taxes are insufficient, the government can print money. The solvability of private firms is much less certain. Risk premium : the spread between the interest rates on bonds with default risk and the interest rates on Tbonds Rating agencies assign ratings to bonds according to default risks Standard and Poor’s Moody’s Fitch The Risk Structure of Interest Rates The Term Structure of Interest Rates The Risk Structure of Interest Rates The Term Structure of Interest Rates An increase in default risk raises the risk premium....
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This note was uploaded on 10/08/2008 for the course ECON 3310 taught by Professor Davis during the Fall '07 term at Cornell.
 Fall '07
 Davis
 Interest Rates, Supply And Demand

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