mon_econ_weeks4-5 - The University of Sydney Faculty of...

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The University of Sydney Faculty of Economics and Business MONETARY ECONOMICS {6 credit points} ECOS3010 — 2009: S EMESTER 2 Tony Aspromourgos WEEKS IV–V KEY POINTS 4.1 term structure defined 4.2 the expectations approach 4.3 the risk premia approach 4.4 market segmentation 4.5 risk structure & risk ratings READING: D.J. Jüttner & K.M. Hawtrey (1997) Financial Markets, Money and Risk , 4 th ed., Melbourne: Addison Wesley Longman; ch. 21 (‘The term structure of interest rates’: 534–569) and ch. 22 (‘The risk structure of interest rates’: 570–593). [This reading is for both weeks 4 & 5.] From weeks 4 to 8 we consider the determination of interest rates, dividing the issue into two dimensions: the overall level of interest rates as a whole (weeks 6–8); and the structure of rates – the determination of differentials among particular interest rates (weeks 4–5). 4.1 term structure defined There are a number of sources of difference in yields on interest-bearing (or ‘fixed income’) securities, which all ultimately boil down to differential risks and differential degrees of liquidity or illiquidity. (‘Marketability’ – mentioned at p. 534 – may be read as an aspect of ‘liquidity’: recall the definition of money in terms of degree of liquidity, from week 1.) If interest-bearing securities have economically relevant differential characteristics, one would expect markets to price them differently, to account for these differences. The different prices in turn entail different yields or interest rates on these securities, reflecting these differential characteristics (a higher price and lower yield if the different characteristic is an advantageous one; a lower price and higher yield if the characteristic is a disadvantageous one). Here, we focus on just one differential characteristic, the length of time to maturity of the security (its ‘term’). By comparing the yields on government securities identical in all respects except their term to maturity , we can isolate the role of differences in term to maturity in the behaviour of interest rate relativities.* NOTE * The striking feature of government securities is that – at least for orderly governments such as Australia, the U.S. etc. – their interest-bearing securities exhibit a zero default risk. Why? Sovereign governments that issue securities in the form of promises to make future payment in their domestic currency, are thereby issuing promises to make future payment in an asset which they can create ex nihilo (out of nothing), simply by printing currency. How could such governments ever be in a position of not being able to meet such liabilities or obligations? Furthermore, even if – while undoubtedly having the
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This note was uploaded on 04/20/2010 for the course ECOF 3001 taught by Professor - during the One '09 term at University of Sydney.

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mon_econ_weeks4-5 - The University of Sydney Faculty of...

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