The risk and term strcture of interst rates

One attribute of a bond that influences its interest is its default risk. The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn to be willing to hold a risky bond.

Another attribute of a bond that influences its interest rate is its liquidity. US treasury bonds are the most liquid of all long-term bonds because they are so widely traded that they are the easiest to sell quickly and the cost of selling them is low. A bond with low liquidity is not as desirable as the one with higher liquidity, with all other conditions being equal. Thus people demand a liquidity premium, that is an extra amount of interest to hold them.

Interest payments on municipal bonds are exempt from federal income taxes.

Summary: more risk---higher interest rate, less liquid---higher interest rate,  exemption from tax payment----lower interest rate

Yield curves can be classified as upward-sloping, flat and downward-sloping
(1) When yield curves are upward-sloping
the long-term interest rates are above the short-term interest rates
(2) Flat
short- and long-term interest rates are the same
(3) Inverted
Short-term interest rates are higher than the long-term interest rates

The expectation hypothesis: The interest rate on a long-term bond will equal an average of short-term interest rates that people expect to occur over the life of the long-term bond. The explanation provided by the expectation theory for why interest rates on bonds of different maturities differ is that short-term interest rates are expected to have different values at future dates. The key assumption is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity.

The preferred habitat theory: interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bonds plus a liquidity premium that responds to supply and demand conditions for that bond. The key assumption is that bonds of different maturities are not perfect substitutes.

Three facts of yield curves:
(1) interest rates on bonds of different maturities tend to move together over time
(2) yield curves usually slope upward
(3) when short-term interest rates are low, yield curves are most likely to have a steep upward slope