Financial Markets and Institutions (2-downloads)

Chapter 4:

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Appendix 1: Models of Asset Pricing

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Appendix 2: Applying the Asset Market Approach to

a Commodity Market: The Case of Gold

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Appendix 3: Loanable Funds Framework

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Appendix 4: Supply and Demand in the Market for

Money: The Liquidity Preference Framework

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How Do Risk and 

Term Structure Affect

Interest Rates?

Preview

In our supply-and-demand analysis of interest-rate behavior in Chapter 4, we

examined the determination of just one interest rate. Yet we saw earlier that

there are enormous numbers of bonds on which the interest rates can and do

differ. In this chapter we complete the interest-rate picture by examining the

relationship of the various interest rates to one another. Understanding why

they differ from bond to bond can help businesses, banks, insurance compa-

nies, and private investors decide which bonds to purchase as investments and

which ones to sell.

We first look at why bonds with the same term to maturity have different

interest rates. The relationship among these interest rates is called the risk

structure of interest rates, although risk, liquidity, and income tax rules all play

a role in determining the risk structure. A bond’s term to maturity also affects its

interest rate, and the relationship among interest rates on bonds with different

terms to maturity is called the term structure of interest rates. In this chapter

we examine the sources and causes of fluctuations in interest rates relative to

one another and look at a number of theories that explain these fluctuations.

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Risk Structure of Interest Rates

Figure 5.1 shows the yields to maturity for several categories of long-term bonds from

1919 to 2010. It shows us two important features of interest-rate behavior for bonds

of the same maturity: Interest rates on different categories of bonds differ from one

another in any given year, and the spread (or difference) between the interest rates

varies over time. The interest rates on municipal bonds, for example, are higher than

those on U.S. government (Treasury) bonds in the late 1930s but lower thereafter.

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