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Lecture Principles of money, banking, and financial markets (12th edition): Chapter 5 - Ritter, Silber, Udell

Chapter 5 - The term and risk structure of interest rates. In this chapter you will learn to envision and draw the yield curve and describe the determinants of its slope, explain how risk is important in influencing interest rates, comprehend the impact on interest rates of income taxes. | Chapter 5 The Term and Risk Structure of Interest Rates Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • Envision and draw the yield curve and describe the determinants of its slope • Explain how risk is important in influencing interest rates • Comprehend the impact on interest rates of income taxes Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-2 The Term Structure of Rates and the Yield Curve • Term Structure—Relationship among Yields of different maturities of the same type of security • Yield Curve (Figure 5.1) – Graphical relationship between yield and maturity – Yield is measured on the vertical axis and term to maturity is on the horizontal Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-3 1 The Term Structure of Rates and the Yield Curve (Cont.) • Yield Curve (Figure 5.1) (Cont.) – The basic question—does the curve slope upward, downward, or horizontal (Figure 5.1) – In the real world yields on all maturities tend to move together while there are distinct, divergent patterns between movements in short-term and longterm yields. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-4 FIGURE 5.1 Three alternative yield curves. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-5 The Term Structure of Rates and the Yield Curve (Cont.) • Different Theories of the Shape of the Yield Curve – Supply and Demand • Determined by relative supply/demand of different maturities • Deals with each maturity by itself and ignores the interrelationships between different maturities of the same security Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5-6 2 The Term Structure of Rates and the Yield Curve (Cont.) • Different Theories of the Shape of the Yield Curve (Cont.) – The Pure Expectations Approach • Short-term and long-term securities are very good substitutes for each other within investor’s portfolios who collectively impact the market • .