ECON 311 1nd Edition Lecture 7 Outline of Last Lecture I Bond Markets II Two Applications of the Bond Market Model III Liquidity Preference Model IV Effects of an Increase in Money Supply Outline of Current Lecture I The Risk Structure of Interest Rates Current Lecture Chapter 5 The Risk and Term Structure of Interest I Risk Structure of Interest Rates The relationship among yields on financial instruments that have the SAME MATURITY but different due to variations in LIQUIDITY AND TAX TREATMENT Why do 2 bonds with the same maturity have different yields o Reasons Risk Liquidity and tax treatment 1 Default Risk the chance that a borrower may be unable to honor their obligations o repay principal and or to make interest payments risk you won t get paid Price of Risk Free Bonds is greater than Risky bonds meaning the interest on Risk Free bonds is greater than Risky bonds Risk Free Bonds Risky Bonds P S P R F S DR F These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best Default Risk Premium used as a supplement to your own notes not as a substitute PR D R B B The Default Risk premium is the difference between the prices If default risk increases the default risk premium increases Credit Rating Agencies o Moody s o Standard and Poor Two Categories of Risk 1 Investment Grade Securities low yield a Relatively low default risk 2 Junk Bonds greater yield a Relatively high default risk 2011 Standard and Poor downgraded the rating of the US government bonds o Bond demand should have decreased but instead bond demand increased because whenever there s bad new US Gov Bond demand increases even if its about bonds 2 Liquidity a bond that is less liquid will have a higher yield other things equal Other things equal the price of liquid bonds should be greater than illiquid bonds which means the yield of illiquid bonds should be greater than liquid bonds PL PI i I i L Illiquid Bonds 3 Tax Treatment equal the B P S Liquid Bonds other things yield on tax will be less than the BS P L free bonds bonds state and local federal yield on taxable a Interest on Municipal or bonds is exempt from BD L government income tax PI BDI B Tax Free Bonds B Taxable Bonds P B S PTF P T i TF iT PT F BS BD TF PT BD T B B Bonds with Identical Maturities will have different yields if they have different 1 Default Risk 2 Liquidation 3 Tax Treatment