THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 145

CHAPTER 6

The Risk and Term Structure
of Interest Rates

LE A RNI NG OB JE CTI VE S
After studying this chapter you should be able to
1. describe how default risk, liquidity, and tax considerations affect interest rates
2. explain how interest rates on bonds with different maturities are related by
applying the expectations theory, the segmented markets theory, and the
liquidity premium theory
3. predict the movement of short-term interest rates in the future using the
yield curve

PRE VI EW

In our supply and demand analysis of interest-rate behaviour in Chapter 5, we
examined the determination of just one interest rate. Yet we saw earlier that
there are enormous numbers of bonds on which the interest rates can and do
differ. In this chapter we complete the interest-rate picture by examining the
relationship of the various interest rates to one another. Understanding why they
differ from bond to bond can help businesses, banks, insurance companies, and
private investors decide which bonds to purchase as investments and which
ones to sell.
We first look at why bonds with the same term to maturity have different interest
rates. The relationship among these interest rates is called the risk structure of
interest rates, although risk and liquidity both play a role in determining the risk
structure. A bond s term to maturity also affects its interest rate, and the relationship
among interest rates on bonds with different terms to maturity is called the term
structure of interest rates. In this chapter we examine the sources and causes of
fluctuations in interest rates relative to one another and look at a number of theories

that explain these fluctuations.

RISK ST RU CTU RE O F I N TE RE ST RAT ES
Figure 6-1 shows the yields to maturity for several categories of long-term bonds from
1978 to 2008. It shows us two important features of interest-rate behaviour for bonds
of the same maturity: interest rates on different categories of bonds differ from one
another in any given year, and the spread (or difference) between the interest rates
varies over time. The interest rates on corporate bonds, for example, are above those
on Canada bonds and provincial bonds. In addition, the spread between the interest
rates on corporate bonds and Canada bonds is very large during the 1980 1982 and
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