1. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. CHAPTER 8 The Structure of Interest Rates

2. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Interest Rates on Treasury Securities Term to January 16, January 29, July 17, Maturity198119931998 3 months15.19%2.92%5.01% 1 year13.913.415.36 2 year13.154.245.46 5 year12.696.085.47 10 year12.536.465.49 SOURCE: Federal Reserve Bulletin, various issues (1981-1998).

3. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Yield Curves 20 15 10 5 0 January 16, 1981 January 29, 1983 July 17, 1998 Interest Rate (Percent) Term to maturity 3 months Term to maturity 1 year Term to maturity 2 years Term to maturity 5 years Term to maturity 10 years

4. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Hypothetical Yield Curve 1 2 Yield to Maturity (Percent) Term to Maturity (Years) 6 - 5 - 4 - 3 - 2 - 1 - 5.99

5. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. New Hypothetical Yield Curve Yield to Maturity (Percent) Term to Maturity (Years) 9 - 8 - 7 - 6 - 5 - 4 - 3 - 2 - 1 - 1212 6.98 5.99 New Curve 1-year rate = 5% 2-year rate = 6.98% Expected future 1-year rate = 9% Original Curve 1-year rate = 5% 2-year rate = 5.99% Expected future 1-year rate = 7%

6. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Alternative Yield Curve Shapes Yield to Maturity Term to Maturity a.A Rise Expected in Interest Rates Yield to Maturity Term to Maturity b.No Change Expected in Interest Rates Yield to Maturity Term to Maturity c.A Decline Expected in Interest Rates

7. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Role of Liquidity Premiums 5 - Yield to Maturity (Percent) 1 2 3 4 5 6 7 8 9 10 Term to Maturity (Years) Yield Curve Based on Expectations (A) Liquidity Premium (B) Observed Yield Curve C = Expectations + Liquidity Premiums (C = A + B)

8. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Credit Ratings Moody’s Aaa Aa A Baa Ba B Caa Ca C General Description Best quality High quality Higher medium grade Medium Grade Lower medium grade having speculative elements Lacks characteristics of desirable investment Poor standing Highly speculative Lowest grade (in default Standard & Poor’s AAA AA A BBB BB B CCC CC, C D

9. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Spread between Baa-Rated Municipal Bonds and Aaa-Rated Municipal Bonds, 1960-2001* 16 14 12 10 8 6 4 2 0 1960196519701975198019851990199520002001* Moody’s 20-Year Baa Municipal Bond Moody’s 20-Year Aaa Municipal Bond *Through July 12, 2001 SOURCE: Global Financial Data, Los Angeles, California