ECON 311 1nd Edition Lecture 7 Outline of Last Lecture I. Bond MarketsII. Two Applications of the Bond Market ModelIII. Liquidity Preference ModelIV. Effects of an Increase in Money SupplyOutline of Current Lecture I. The Risk Structure of Interest RatesCurrent LectureChapter 5: The Risk and Term Structure of InterestI. 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 treatment1. 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 These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. Risky BondsRisk Free BondsPRPBSSPRFBDRDRFDefault Risk PremiumThe Default Risk premium is the difference between the prices- If default risk increases, the default risk premium increases- Credit Rating Agencieso Moody’so Standard and Poor- Two Categories of Risk1. Investment Grade Securities (low yield)a. Relatively low default risk2. Junk Bonds (greater yield)a. Relatively high default risk- 2011 – Standard and Poor downgraded the rating of the US government bondso 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 bonds2. 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 bondsPL> PI→iI>iL3. Tax Treatment – other things equal, the yield on tax free bonds will be less than theyield on taxable bondsa. Interest on Municipal or state and local government bonds is exempt from federal income taxPTF> PT→iTF< iTIlliquid BondsLiquid BondsPIPBBSBSPLBBDIBDLTaxable BondsTax Free BondsPTPBBSBSPTFBBDTBDTF- Bonds with Identical Maturities will have different yields if they have different1. Default Risk2. Liquidation3. Tax