chap007 - Chapter 7 The Risk and Term Structure of Interest...

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Chapter 7 The Risk and Term Structure of Interest Rates Chapter Overview In this chapter students are introduced to the three factors that affect bond yields: default risk, taxes, and maturity. The chapter begins with a discussion of the ratings companies that work to assess default risk, and moves to considering the relationship between ratings and yields. This moves into a history of junk bonds, told largely as the story of Michael Milken (and Drexel). Tax status is explored next, followed by an analysis of the term structure of interest rates. Students are introduced to the two theories of the term structure and the chapter concludes with an analysis of the information contained in the risk structure and term structure of interest rates. Reading this chapter will prepare students to: Important Points of the Chapter It is important to understand the differences among the many types of bonds that are sold and traded in financial markets. Interest rate spreads, which reflect movement in the prices of different bonds, provide important information about the workings of financial markets. Indeed, in the example cited in this chapter (the Russian default of 1998), there was a significant “flight to quality” (everyone wanted to hold safe U.S. Treasuries) and markets ceased to function properly. Another example used in the chapter describes how GE’s issuance of additional short-term debt upset its investors because the increased supply threatened to lower the prices of all the debt outstanding. Application of Core Principles Principle #2: Risk (page 151) The lower a bond’s rating, the lower its price and the higher its yield. The yield on any bond is the sum of the yield on the benchmark U.S. Treasury bond (the closest to being risk free) plus a default risk premium that increases with the probability of default. High yield is the compensation for high risk. Principle #1: Time (page 156) Longer term bonds tend to have higher yields because of the additional time involved. Their yields depend on what people expect to happen in years to come. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 90
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Chapter 7 The Risk and Term Structure of Interest Rates Principle #2: Risk (page 161) Uncertainty about inflation creates uncertainty about a bond’s real return, making bonds a risky investment. A bond’s inflation risk increases with its time to maturity. Teaching Tips/Student Stumbling Blocks You may wish to review the material in Chapter 6 that introduced students to the idea that changes in risks can be seen as shifts in the demand for bonds. This concept is illustrated in Figure 7.1 (page 154), which shows that increased risk results in a decreased demand for bonds, a lower bond price, and a higher yield.
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