CHAPTER The Risk and Term Structure of Interest Rates LE A RNI NG OB JE CTI VE S After studying this chapter you should be able to describe how default risk, liquidity, and tax considerations affect interest rates explain how interest rates on bonds with different maturities are related by applying the expectations theory, the segmented markets theory, and the liquidity premium theory predict the movement of short-term interest rates in the future using the yield curve PRE VI EW In our supply and demand analysis of interest-rate behaviour in Chapter 5, we examined the determination of just one interest rate Yet we saw earlier that there are enormous numbers of bonds on which the interest rates can and differ In this chapter we complete the interest-rate picture by examining the relationship of the various interest rates to one another Understanding why they differ from bond to bond can help businesses, banks, insurance companies, and private investors decide which bonds to purchase as investments and which ones to sell We first look at why bonds with the same term to maturity have different interest rates The relationship among these interest rates is called the risk structure of interest rates, although risk and liquidity both play a role in determining the risk structure A bond s term to maturity also affects its interest rate, and the relationship among interest rates on bonds with different terms to maturity is called the term structure of interest rates In this chapter we examine the sources and causes of fluctuations in interest rates relative to one another and look at a number of theories that explain these fluctuations RISK ST RU CTU RE O F I N TE RE ST RAT ES Figure 6-1 shows the yields to maturity for several categories of long-term bonds from 1978 to 2008 It shows us two important features of interest-rate behaviour for bonds of the same maturity: interest rates on different categories of bonds differ from one another in any given year, and the spread (or difference) between the interest rates varies over time The interest rates on corporate bonds, for example, are above those on Canada bonds and provincial bonds In addition, the spread between the interest rates on corporate bonds and Canada bonds is very large during the 1980 1982 and 113