Financial Institutions, Markets, and Money, Eleventh Edition

CHAPTER SIX

The Structure of Interest Rates

ARMED WITH A BASIC understanding of the determinants of the general level of interest rates, we can now explore why interest rates vary among financial products and over the business cycle. To get an idea of how much interest rates differ across financial products, take a close look at the financial section of any major newspaper. On any given day, newspapers report yields on thousands of financial instruments, and almost every product has a different market rate of interest.

In the accompanying table, you see the diversity of interest rates that existed on February 3, 2011. For example, why do 3-month Treasury bills yield 0.14 percent and 10-year Treasury bonds yield 3.58 percent when both had the same issuer— the U.S. Treasury Department? Aren't Treasury securities the proxy for the riskfree rate? Why do Aaa rated municipal bonds yield 4.25 percent and Aaa corporate bonds yield 5.21 percent? Don't both securities have the same credit rating? Even more perplexing, why have interest rates declined so much in recent years? For example, in the last edition of the textbook, we reported that the 3-month Treasury bill yield was 4.98 percent (January 2007); in February 2011 it yielded 0.21 percent. What economic forces have driven short-term interest rates so low?

It all seems very confusing. If you read this chapter carefully, you will be able to explain how their characteristics, such as maturity, default risk, and tax treatment, cause the ...