Chapter 06 - 6. The Risk and Term Structure of Interest...

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6. The Risk and Term Structure of Interest Rates 6.1 Risk Structure of Interest Rates 6.2 Term Structure of Interest Rates
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6.1 2 For the period , evidence from the yields to maturity
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6.1 3 (ii) the spread between the interest rates varies over time (the spread between the interest rates on corporate bonds and Canada bonds is very large during 1980- 82 and 1990-91 recessions, is smaller during mid- 1990s, and then widens again afterwards) Risk of default – the risk arises 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, which influences its interest rate
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6.1 4 Canadian government 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 have no default risk are called default-free bonds . The spread between the interest rates on bonds with default risk and default-free bonds is the risk premium (the additional interest people must earn in order to be willing to hold that risky bond). The higher the default risk is, the larger the risk premium will be
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6.1 5 Assume that initially corporate bonds have the same default risk as Canada bonds , these two bonds have the same attributes (identical risk and maturity) so that their equilibrium prices and interest rates will initially be equal ( c P 1 = T P 1 and c i 1 = T i 1 ), and the risk premium on corporate bonds ( c i 1 - T i 1 ) will be
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6.1 6 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 . In addition, the corporate bond’s return will be more uncertain as well. The theory of asset demand predicts that because the expected return on the corporate bonds falls relative to the expected return on the default-free Canada bond while its relative riskiness rises, the corporate bond is less desirable (ceteris paribus), and demand for it will fall ( Figure 6.2 ). The equilibrium price for corporate bonds falls and since the bond price is negatively related to the interest rate, the equilibrium interest rate on corporate bonds rises
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6.1 7 The expected return on default-free Canada bonds increases relative to the expected return on corporate bonds while their relative riskiness declines. The Canada bonds thus become more desirable , and demand rises ( Figure 6.3 ). The equilibrium price for the Canada bonds rises and the equilibrium interest rate falls The spread between the interest rates on corporate and default-free bonds (risk premium on corporate bonds) exists . A bond with default risk will always have a positive risk premium , and an increase in its default risk will raise the risk premium ( Figure 6.4
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6.1 8 Because default risk is so important to the size of the risk premium , purchasers of bonds need to know whether a corporation is likely to default on its bonds.
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This note was uploaded on 10/05/2010 for the course ECO 349 taught by Professor H during the Fall '09 term at University of Toronto- Toronto.

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Chapter 06 - 6. The Risk and Term Structure of Interest...

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