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CHAPTER 6 THE STRUCTURE OF INTEREST RATES CHAPTER OBJECTIVES 1. To introduce students to the structure of interest rates ; that is, to explain why large numbers of different interest rates coexist in financial markets on any given day. 2. Discuss the relationship between term to maturity and interest rates; understand how different theories of the term structure explain the yield curve. 3. Explain how other factors – default risk, tax treatment, marketability, and options on debt securities – influence interest rates. CHANGES FROM THE LAST EDITION 1. All time-sensitive tables and figures have been updated. 2. The information about bankruptcies in the section titled “Default Risk” has been updated. CHAPTER KEY POINTS 1. The term structure of interest rates is emphasized in this chapter; the concepts developed here will be used in later chapters that discuss the management of commercial banks and other financial institutions (especially savings and loan associations). An intuitive argument is made for the expectations theory that culminates in Equation (6.1) . If you want, you can give your students a more general version of Equation 6.2: Other theories that try to explain the shape of the yield curve, such as the Liquidity Premium theory, the Market Segmentation theory, and the Preferred Habitat theory are also discussed in this chapter. These theories do not necessarily contradict each other. Rather, they add to each other. Using the expectations theory as a starting point, one can explain upward- and downward-sloping, as well as flat yield curves. The liquidity premium theory helps explain why the yield curve slopes upward most of the time. The segmentation theory explains kinks, spikes, and discontinuities in the curve, while the preferred habitat theory supports a yield curve that is smooth (has no spikes or discontinuities but allows for kinks). The impact of liquidity premiums and inflation on the term structure is discussed, and the yield curve over the business cycle is discussed. 2. The concept and theory of default risk is developed in detail. Emphasis is given to discussion of how default risk premiums vary over the business cycle, bond rating as a 1 ( 29 ( 29 1 1 1 / 1 - + + = - - - + k k n k n t n n t k k n t R R f
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measure of default risk, and some recent major corporate defaults. 3. The impact of different tax treatments on security yield is presented. It is important to emphasize Equation (6.4) because it helps explain why the tax status of a financial institution (or individual) affects investment decisions. For example, property/casualty insurance companies usually purchase municipal rather than corporate securities because municipals usually provide a higher after-tax yield. 4.
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