term and structure - Finance 254 The Term Structure of...

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Finance 254 The Term Structure of Interest Rates The Determinants of Interest Rates As a starting point in our discussion of the determinants of interest rates, consider bonds issued by the U.S. Treasury. Purchasing a bond from the U.S. Treasury is really the same as making a loan. These bonds (loans) are considered to be free of default risk since they are backed by the full faith and credit of the U.S. government and thus purchasers of these bonds (lenders) do not worry that the U.S. Treasury will default on their obligations. People throughout the world consider these bonds a type of “benchmark” bond and consider them to have virtually no “credit risk.” Now, consider lending money to a corporation. What rate of interest will you require to make the loan? You will require an interest rate on that loan that is greater than the rate on a comparable U.S. Treasury bond since no corporation is free of credit risk. This is why we refer to the yield on a U.S. Treasury bond as the “base interest rate” or “benchmark interest rate.” So if we purchase a bond issued by Lehman Brothers (LEH), we will require a yield equal to the yield of an equivalent U.S. Treasury bond plus what we call a “risk premium ” or “spread”. We could write this relation as: Yield on corporate bond = Base interest rate + Risk Premium The Yield Curve
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