Book cover for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9780132770248

10th Edition

610 Questions

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Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This chapter explains the risk structure and term structure of interest rates by highlighting key factors such as default risk, liquidity differences, and tax considerations that influence bond yields. It compares three major term structure theories and emphasizes the liquidity premium theory as a comprehensive model that not only considers expected future rates but also incorporates investor preferences for liquidity. Understanding these concepts is essential for analyzing bond market behavior and predicting future interest rate trends.

Learning Objectives

1

Describe the factors shaping the risk structure of interest rates, including default risk, liquidity differences, and tax considerations.

2

Explain why bonds with higher risk and lower liquidity require a risk premium above default-free Treasury bonds.

3

Compare and contrast the main term structure theories: expectations theory, segmented markets theory, and liquidity premium theory.

4

Analyze how the liquidity premium theory accounts for various yield curve shapes and predicts future interest rate movements.

Key Concepts

CONCEPT

DEFINITION

Risk Structure of Interest Rates

The variation in interest rates across different bonds due to factors such as default risk, liquidity differences, and tax considerations.

Default Risk

The possibility that a bond issuer will fail to make interest or principal payments, leading investors to demand higher yields.

Liquidity

The ease with which an asset can be converted into cash without affecting its market price; lower liquidity often leads to higher required yields.

Tax Considerations

The impact of tax treatments on bond yields, where less favorable tax conditions require a higher yield to attract investors.

Expectations Theory

A theory positing that the shape of the yield curve is determined solely by market expectations of future interest rates.

Segmented Markets Theory

A theory suggesting that bonds of different maturities are not substitutes, with supply and demand in each market segment independently influencing yields.

Liquidity Premium Theory

A theory that combines investor expectations of future rates with a premium for the added risk and decreased liquidity associated with longer maturities.

Example Problems

Example 1

If junk bonds are "junk," then why would investors buy them?

Example 2

Which should have the higher risk premium on its interest rates, a corporate bond with a Moody's Baa rating or a corporate bond with a C rating? Why?

Example 3

Why do U.S. Treasury bills have lower interest rates than large-denomination negotiable bank CDs?

Example 4

In the fall of $2008,$ AlG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result. the U.S. government stepped in to support AlG with large capital injections, and an ownership stake. How would this affect, if at all, the yield and risk premium on $\mathrm{AlG}$ corporate debt?

Example 5

Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
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Step-by-Step Explanations

QUESTION

How does the liquidity premium theory explain the shape of the yield curve?

STEP-BY-STEP ANSWER:

Step 1: Define the concept by explaining that the liquidity premium theory suggests that investors prefer shorter maturity bonds due to their lower risk and higher liquidity.
Step 2: Explain that bonds with longer maturities carry additional risks, such as greater interest rate uncertainty, which investors demand compensation for in the form of a liquidity premium.
Step 3: Illustrate that the yield on a long-term bond is therefore the sum of the expected future short-term rates (as per expectations theory) and an extra liquidity premium, leading to various yield curve shapes.
Final Answer: The liquidity premium theory accounts for both market expectations and the additional risk premium demanded by investors for holding less liquid, longer maturity bonds, thus explaining the diverse patterns observed in yield curves.

Liquidity Premium Theory

QUESTION

Why do bonds with higher default risk command a higher risk premium compared to default-free Treasury bonds?

STEP-BY-STEP ANSWER:

Step 1: Define default risk and emphasize that it is the risk of the issuer not meeting its payment obligations.
Step 2: Explain that investors require additional yield (risk premium) to compensate for the higher likelihood or impact of default.
Step 3: Include considerations such as lower liquidity and unfavorable tax treatments, which further increase the required risk premium.
Final Answer: Bonds with higher default risk offer a risk premium as compensation to investors for the increased probability of non-payment and additional risks such as lower liquidity and adverse tax effects, relative to more secure Treasury bonds.

Risk Premium

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Common Mistakes

  • Confusing the risk structure with the term structure of interest rates.
  • Overlooking tax considerations when evaluating bond yields.
  • Assuming that yield curves are solely determined by market expectations without a liquidity premium.
  • Neglecting the impact of liquidity differences on the risk premium demanded by investors.