Thursday, August 13, 2009

the yield curve and the risk premium

we know that day-to-day policy actions by the Fed have their immediate effects on te very short-term (1-day) interest rate at which depository institutions exchange reserves: the Federal funds rate. it may be hard, right off the bat, to see why any of us should ever care about an interest rate on a financial instrument with only a 1-day maturity. After all, that doesn't seem to have much to do with broader issues such as investment spending or the demand for money. or does it?
if we abstract from issues such as default risk liquidity , and tax treatment differences among bonds, it is very often the case that bonds with different terms to maturity earn different rates. Specifically, financial instruments of different terms to maturities tend to have higher yields as the time to maturity rises. Hence, there is a term structure of interest rates that implies that the yield curve typically slopes upward for financial assets with similar risk, liquidity , and tax characteristics.
Likewise, there is a risk structure of interest rates. Holding term to maturity constant, other factors- default risk, liquidity properties, and tax-treatment characteristics.
Likewise, there is a risk structure of interest rates. holding term to maturity constant, some financial instruments more risky than others. for instance , it typically is the case that a security with higher default risk pays a higher market interest rate.
one-day Federal funds have a much shorter maturity than financial instruments involved in determining the opportunity costs relevant to firms‘ decisions concerning real investment and money holdings. Furthermore, unsecured federal funds loan are riskier than U.S. Treasury securities. Nevertheless, the theories of the term structure and risk structure of interest rates.

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