M05_MISH1438_06_IM_C05

M05_MISH1438_06_IM_C05 - Chapter 5 How Do Risk and Term...

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Chapter 5 How Do Risk and Term Structure Affect Interest Rates? Risk Structure of Interest Rates Default Risk Case : The Enron Bankruptcy and the Baa-Aaa Spread Liquidity Income Tax Considerations Summary Case : Effects of the Bush Tax Cut on Bond Interest Rates Term Structure of Interest Rates The Wall Street Journal: Following the News : Yield Curves Expectations Theory Market Segmentation Theory Liquidity Premium Theory Evidence on the Term Structure Mini-Case Box: The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle Summary Case : Interpreting Yield Curves, 1980–2002 The Practicing Manager: Using the Term Structure to Forecast Interest Rates Overview and Teaching Tips Chapter 5 applies the tools the student learned in Chapter 4 to understanding why and how various interest rates differ. In courses that emphasize financial markets, this chapter is important because students are curious about the risk and term structure of interest rates. On the other hand, professors who focus on public policy issues might want to skip this chapter. The book has been designed so that skipping this chapter will not hinder the student’s understanding of later chapters. A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data and theory. As becomes clear in the discussion of the term structure, theories are modified because they cannot explain the data. On the other hand, theories do help to explain the data, as the case on interpreting yield curves in the 1980–2004 period demonstrates. The Practicing Manager application at the end of the chapter shows how forecasts of interest rates from the term structure using the theories outlined here can be used by financial institutions managers to set interest rates on their financial instruments.
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24 Mishkin/Eakins • Financial Markets and Institutions, Sixth Edition Answers to End-of-Chapter Questions
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Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 25 1. The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that on the Baa bond. 2. U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate. 3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. 4. True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.
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