1297279991990_Chapter7_Instructor_Notes - CHAPTER 7 THE...

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______________________________________________________________________________________ 1 CHAPTER 7: THE RISK AND TERM STRUCTURE OF INTEREST RATES A. T HE B ASICS Core Principles 1 and 2, that time has value and that risk requires compensation, are the keys to understanding the risk and term structures of interest rates. The risk structure focuses on the yields on bonds of different risk, holding maturities fixed. The term structure focuses on yields at different maturities, holding risk fixed. The risk structure shows how interest rates on bonds with a fixed maturity (say, 10-year bonds) change as bond risk changes. So, compare the yield on 10-year Treasury bonds with those on 10-year Aaa bonds and 10-year Baa bonds, as in Panel A of Figure 7.2 on text page 161. Treasury bonds are free of default risk, though they still have inflation risk and interest rate risk. Bonds issued by all others have at least some default risk, so Treasurys “anchor” the risk structure. Assuming other factors are given, the interest rates on the Treasury bonds are less than rates on Aaa bonds, which in turn are less than the rates on the Baa bonds; the riskier the bond (with lower bond ratings, as measured by bond rating agencies) the higher the yield since risk-averse investors require compensation for assuming additional risk (Core Principle 2). Furthermore, fluctuations in systematic risk raise and lower the riskiness of other bonds relative to Treasury issues. Finally, the risk of Treasurys changes due to factors like inflation risk. Changing risks to Treasury issues raise and lower the entire risk structure. The term structure compares the yields on bonds as the term to maturity changes, holding risk fixed. For example, examining the interest rates on various Treasury securities, from 3-month T-bills to 10-year Treasury notes and 30-year Treasury bonds, you will usually find that the longer the term to maturity, the higher the yield. Risk is “fixed” in that the U.S. Treasury will not default on its bonds. (Remember that Treasury issues still have interest rate and inflation risk, so the risk premium on Treasurys is not zero, and can vary with the term to maturity.) The usual patterns are for (i) the yields to rise with the term to maturity, (ii) short term interest rates to be more volatile than long- term rates, and (iii) all rates to move together. B. S OLIDIFY Y OUR K NOWLEDGE DISCUSSION/EXTENSIONS OF THE BASICS Liquidity Premium Theory: A look at the algebra and what it says . A quick way to organize your thoughts about the basic material is to consider equation (7) on text page 162, which expresses the liquidity premium theory, and is reproduced below:
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Chapter 7: The Risk and Term Structure of Interest Rates 2 , n i i i i rp i e 1 n t 1 e 2 t 1 e 1 t 1 t 1 n nt where nt i is the interest rate on an n-year bond,, expressed at an annual rate, where e j t , 1 i is the one-year interest rate expected today (period t) j years into the future, and where
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1297279991990_Chapter7_Instructor_Notes - CHAPTER 7 THE...

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