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Canada (161,511)
ECON 302 (16)
Tom Velk (16)
Chapter

Risk and Term Structure of Interest Rates - Mishkin

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Department
Economics (Arts)
Course
ECON 302
Professor
Tom Velk
Semester
Fall

Description
THE RISK AND TERM STRUCTURE OF INTEREST RATES Risk Structure of Interest Rates What determines its interest rate y Default Risk o One aspect of a bond that influences the interest rate is the risk of defaultThis occurs when the issuer of a bond is unable or unwilling to make interest payments when promisedThe issuer could also not pay off the face value when the bond matures o Could have to corporations suffering big losses are likely to suspend payments on bondsTherefore their default risk would be quite high o Some bonds like sovereign bonds such as US Treasury bonds have almost no risk because they can always raise taxes to pay them offThese are called defaultfree bonds o The spread between the interest rates of bonds with default risk and the defaultfree bonds is called the risk premiumIndicates how much more people much earn in order to be willing to hold the risky bond o This can be understood by comparing default free US Treasuries and defaultrisk corporate bondso Assume here that initially both bonds are have the same default riskThe theory of asset demand states that if the expected return of a default risk bond decreases relative to the default free bond then its demand will fall
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