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im7 - Chapter 7 Risk Structure and Term Structure of...

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Chapter 7 Risk Structure and Term Structure of Interest Rates Overview This chapter is important for courses that emphasize financial markets and for courses that emphasize policy. It focuses on why financial instruments with the same maturity may have different yields (the risk structure); why financial instruments with the same risk, liquidity, and tax characteristics, but with different maturities, may have different yields (the term structure); and how the risk and term structures can be used in forecasting. Students generally have some awareness that interest rates differ but little understanding of why. The material on the risk structure usually is easily understood, but the material on the term structure generally requires significant amounts of class time. Thus, instructors are tempted to skip this chapter in courses focusing on policy. However, the experience in the early 1990s, in which the Federal Reserve was able to drive short-term interest rates to low levels while initially having little impact on long-term interest rates, is difficult to discuss meaningfully without first discussing the term structure. The discussion of the risk structure makes use of the theory of portfolio selection developed in Chapter 5. The impact of changes in risk, liquidity, costs of information, and taxes on relative interest rates are illustrated with the saving–investment diagram. The discussion of the term structure reviews the major theories: segmented markets, expectations, and preferred habitat. The predictions of the theories are compared with the two key stylized facts about the yield curve: that it usually slopes up and that yields on instruments of different maturities tend to move together. The conclusion is drawn that the preferred habitat theory is logically consistent and explains the key stylized facts about yield curves. The two “Consider This ” exhibits will provide students with good background for discussions of the impact of a consumption tax on the demand for municipal bonds and for the impact of the federal budget surplus on the shape of the yield curve in 2000. The chapter concludes with a section on using the term structure for forecasting that is likely to be of interest to students. A useful exercise is to give students actual Treasury yield curves (printed daily in the “Money and Investing” section of The Wall Street Journal ) and have them prepare their own forecasts of future short-term interest rates and future inflation rates. Outline I. Risk Structure of Interest Rates A) The risk structure of interest rates summarizes effects of differences in default risk, liquidity, information costs, and taxation on yields for a given maturity. B) The default risk on a security is measured relative to U.S. Treasury securities, which are default-risk-free instruments .
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