Chapter 5How Do Risk and Term Structure Affect Interest Rates?27Chapter 5How Do Risk and Term StructureAffect Interest Rates?Risk Structure of Interest RatesDefault RiskCase: The Enron Bankruptcy and the Baa-Aaa SpreadLiquidityIncome Tax ConsiderationsSummaryCase: Effects of the Bush Tax Cut on Bond Interest RatesTerm Structure of Interest RatesThe Wall Street Journal: Following the News: Yield CurvesExpectations TheoryMarket Segmentation TheoryLiquidity Premium TheoryEvidence on the Term StructureMini-Case Box: The Yield Curve as a Forecasting Tool for Inflation and the Business CycleSummaryCase: Interpreting Yield Curves, 19802002The Practicing Manager: Using the Term Structure to Forecast Interest RatesnOverview and Teaching TipsChapter 5 applies the tools the student learned in Chapter 4 to understanding why and how various interest rates differ. In courses that emphasize financial markets, this chapter is important because students are curious about the risk and term structure of interest rates. On the other hand, professors who focus on public policy issues might want to skip this chapter. The book has been designed so that skipping this chapter will not hinder the students understanding of later chapters.A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data and theory. As becomes clear in the discussion of the term structure, theories are modified because they cannot explain the data. On the other hand, theories do help to explain the data, as the case on interpreting yield curves in the 19802004 period demonstrates.The Practicing Manager application at the end of the chapter shows how forecasts of interest rates from the term structure using the theories outlined here can be used by financial institutions managers to set interest rates on their financial instruments.nAnswers to End-of-Chapter Questions1.The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that on the Baa bond.2.U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate.3.During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.4.True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.5.If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the pure expectations theory.6.The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on.7.The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on.8.The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.9.The government guarantee will reduce the default risk on corporate bo