6 RiskTermStructure - The Risk and Term Structure of...

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The Risk and Term Structure of Interest Rates Prof. Irina A. Telyukova UBC Economics 345 Fall 2008
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2 Outline ± We have now figured out how interest rates are calculated (yield to maturity) and how they are determined (in the equilibrium of the bond market). ± But different bonds have different interest rates: ± Bonds of the same term to maturity have differing interest rates because of risk, liquidity, taxes Æ risk and liquidity structure of interest rates . ± Bonds of the same risk and liquidity characteristics but differing terms to maturity have differing returns Æ term structure of interest rates .
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3 I. Risk Structure of Interest Rates ± The risk of default is an important determinant of the yield on a bond: ± The Government of Canada is not likely to default on its debts – its bonds are default-free. ± Corporations, on the other hand, could suffer losses and end up defaulting on their bonds – corporate bonds are more risky. ± Interest rates on these two bonds would be different; the difference amount is the risk premium ± People have to be compensated for the additional risk
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12 Risk Premium Q G BD G BS G BD G P G Q C BS C P C BD C’ BD C Government bonds Corporate bonds A bond with default risk will always have a positive risk premium; an increase in its default risk will raise the risk premium. risk premium i 2 G i 2 C
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13 Importance of Risk ± The risk of default affects the interest rate on the bond through its risk premium ± In order to understand the bond’s default risk, investors turn to rating agencies: ± BBB-AAA are investment-grade securities ± BB or below are speculative-grade securities (junk bonds) ± Rating agencies employ models that assess the probability of default of the issuer organization ± Sometimes they get it wrong: subprime-mortgage securities
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15 Risk Premia over Time
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16 Risk Premia over Time Corporates-Canada Spread
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This note was uploaded on 06/21/2011 for the course ECON 345 taught by Professor Sumaila during the Spring '09 term at The University of British Columbia.

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6 RiskTermStructure - The Risk and Term Structure of...

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