Chapter 4 - The risk and term structure of interest rates(a)

Chapter 4 - The risk and term structure of interest...

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Chapter 4 The risk and term structure of interest rates We first look at why bonds with the same term to maturity have different interest rates. The relationship among these interest rates is called the risk structure rates, although risk, liquidity, and income tax rules all play a role in determining the risk structure. A bond’s term to maturity also affects its interest rate, and the relationship among interest rates on bond with different terms to maturity is called the term structure of interest rates. A. Risk structure of interest rates The following graph shows us two important features of interest-rate behavior for bonds of the same maturity: interest rates on different categories of bonds differ from one another in any given year, and the spread (or difference) between the interest rates varies over time. 4-1
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The following factors are responsible for these phenomena: 1. Default Risk It occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures. U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes to pay off its obligations. Bonds like these with no default risk are called default-free bonds. The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond. If the possibility of a default increases because a corporation begins to suffer large losses, the default risk on corporate bonds will increase, and the expected return on these bonds will decrease. At the same time, the expected return on default-free Treasury bonds increases relative to the expected return on corporate bonds, while their relative riskiness declines. The Treasury bonds thus become more desirable, and demand rises. 2. Liquidity The more liquid an asset is, the more desirable it is. U.S. Treasury bonds are the most liquid of all long-term bonds, because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low. Corporate bonds are no as liquid, because fewer bonds for any one corporation are traded; thus it can be costly to sell these bonds in an 4-2
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emergency, because it might be hard to find buyers quickly. This is why a risk premium is more accurately a ‘risk and liquidity premium,’ but convention dictates that it is called a risk premium. 3. Income Tax Consideration Municipal bonds are the bonds issued by state and local governments and they are not default-free. Moreover, they are not as liquid as U.S. Treasury bonds. Why municipal bonds have had lower interest rates than U.S. Treasury
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Chapter 4 - The risk and term structure of interest...

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