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The risk and term structure of interest rates

Mishkin, Chap 6

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Chap 5 discusses:

I. The risk structure of interest rates

II. The term structure of interest rates – expectations theory, segmented markets theory, liquidity premium theory

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price of the bond

quantity of corporate bonds

quantity of Treasury bonds

Price of the bond

Start with the same demand and supply of both. Assume an increase in corporate default risk and/or lower liquidity. Conclusion?

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price of the bond

quantity of Municipal bonds

quantity of Treasury bonds

Price of the bond

Start with the same demand and supply of both. Assume an increase in federal tax rates. Conclusion?

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Two bonds with identical risk, liquidity and tax characteristics, such as may have different YTMs because

An yield curve is

yield curves are upward sloping if

yield curves downward sloping if

yield curves are flat if

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Empirical behavior of interest rates:

1. Historically interest rates on bonds of different maturities

2. Historically, when short-term interest rates are low, yield curves

when short-term rates are high, yield curves

3. Historically, yield curves almost always

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Expectations Theory of term structure:

1.Bonds are _________ substitutes of each other; buyers are

current interest rate on a one-year bond = short term interest rate =

short term interest rate next year =average interest rate earned by investing on two one year bonds in sequence = hence interest rate on a two-year bond must be

Expectations Theory : interest rate on a long term bond equals

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Expectations theory algebraically:

current interest rate on a one-period bond (today) = expected interest rate on a one-period bond next year =current interest rate on a two-period bond =

Return from investing $1 on a two period bond:

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Expectations theory algebraically (contd.):

Return from investing $1 two one-period bonds in sequence:

Since both bonds are perfect substitutes

for bonds with longer term to maturity:

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Expectations theory explains

1. why interest rates on bonds of different maturities

2. why yield curves are ________ sloping;When ___________ interest rates are _______ yield curve is ________ sloping.

When _________ interest rates are ________ yield curve is _________ sloping.

• cannot explain why

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Segmented Markets theory:

•bonds of different maturities are

•investors have different preferences

•interest rate for each bond determined by

•investors generally have

Segmented Markets theory explains why

cannot explain

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Liquidity premium and preferred habitat theories:

•bonds of different maturities are

•investors have different preferences

•interest rate for each bond determined by

•investors generally have

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Liquidity premium and preferred habitat theories explain why

•interest rates on bonds of different maturities

•yield curves are ________ sloping, when ___________interest rates are _______ and _________ sloping, when ______ interest rates are ________

•yield curves typically slope

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