chapter6 - Chapter 6 - Risk and Term Structure of Interest...

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Chapter 6 - Risk and Term Structure of Interest Rates In CH 5 we assumed just one interest rate in the economy, the interest rate on bonds. We now look at why interest rate will vary, either due to differences in risk or differences in maturity . Risk structure of interest rates is the analysis of why interest rates on bonds with the same maturity will vary, due to differences in risk . Term Structure of interest rates looks at why interest rates on bonds with the same risk (e.g. T-bills) will vary due to differences in term to maturity . Figure 1 on page 129 shows how interest rates on four bonds with the same maturity have moved over time from 1920-1999 - municipals (tax free), T-bonds, Corporate Baa (medium quality) bonds and Corporate Aaa (high quality) bonds. We want to explain the movement of (nominal) interest rates over time and the spread between (nominal) interest rates. Some of the spread is explained by tax treatment - munis are tax free, corporates are completely taxable and T-bonds are taxable at the federal, but not state level. Bond yields also differ due to differences in default risk. Default risk is the probability of: _________ interest payments, _________ interest payments, _________ payments or complete default/liquidation. Risk-free bonds, like T-bonds, are default-free bonds. The spread between the risk-free rate on treasuries and the rate/yield on all other risky bonds is the risk premium . Municipal bonds are usually very safe, but are not completely risk-free. There is a chance that a local municipality won't make the payments on time or will make partial payments. All state governments, county governments and city governments have a credit rating, reflecting their creditworthiness. We can show the risk premium on bonds using the S & D for Bonds framework (see page 130). We start by assuming that there is no risk of default for corporate bonds, so that T-bonds and corporate bonds sell for the same price (P 1 ) and have the same yield (i 1 ) (assume that risk and maturity are identical). If we now make the more realistic assumption that the corporate bond is more risky than the Tbond, what would happen to the demand for Tbonds, price and interest rate?_____________ What would happen to the demand for corporate bonds, price and interest rate? ____________________________________ In equilibrium, the spread, or difference, between the Tbond and the corporate will be the risk premium (see page 130). Risk premium is always positive for corporate and muni bonds (on an after tax basis), and the riskier the company/govt. agency, the greater the risk premium. Moody's and Standard & Poors are the two national bond rating services that do financial analyses on companies and municipalities (cities, counties, states) and based
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on their evaluation and assessment of creditworthiness and default probability, they assign a bond rating in one of nine categories, from Aaa/AAA to C/D, using plusses and minuses. Financial statement analysis: look at debt ratios, coverage ratios, cash
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This note was uploaded on 11/18/2011 for the course ECON 210 taught by Professor Blare during the Fall '10 term at Rutgers.

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chapter6 - Chapter 6 - Risk and Term Structure of Interest...

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