Financial Markets, Banking, and Monetary Policy

CHAPTER 5 Factors Affecting Yields

WHAT YOU WILL LEARN IN THIS CHAPTER

• Interest rates at any point of time differ for various reasons.
• One important reason is the term to maturity.
• The yield curve or the term structure of interest rates.
• Yields at different points on the yield curve are based on an average of current and expected short-term interest rates.
• In addition, yields at different points on the yield curve embody a term premium reflecting price risk according to the term premium hypothesis.
• Central banks increasingly try to influence benchmark interest rates through forward guidance affecting expectations of future short-term interest rates.
• A second important reason why interest rates differ is credit risk—the risk of default.
• Credit rating agencies provide well-informed judgments of the likelihood of default in their letter-grade ratings of securities.
• A third reason why interest rates differ relates to differences in their liquidity and sovereign yields are typically the most liquid.
• A fourth reason why yields can differ is the tax treatment of the interest that they pay to their owner.
• A fifth reason has to do with whether they contain embedded options—some of which raise and some lower yields.

BACKGROUND

Ever wonder why interest rates at any point in time can vary so much? For example, the rate on a 30-year mortgage may be 5.5 percent, while the rate on a 10-year Treasury note is 3.5 percent and banks borrow from each other overnight at a 2 percent rate. Meanwhile, ...