Quiz 5: The Structure of Interest Rates


A borrower will find the interest rate on a loan from the starting day. Here the interest rates are different at different debt securities, which will base on the supply and demand of securities like loan for a car is 7% and on business loans at 14 percent and at credit cards 14% these based on their characteristics. They include expected return, risk maturity liquidity and taxation here if the borrower may fail to pay loan at car loan then they can hand over their car and they can sell that car and can get money back because it is at collateral. However, the credit cards are not collateral. If the borrower fails to pay the amount, the lender cannot seize any of the borrower's assets instead. The lender must go to the court to get the payment by the force on borrower. This is an expensive process to the lender. For example: the interest rate on credit card (14.7percent) is much higher than the interest rate on automobile loans (5.2percent) or on at fixed mortgage (5.0percent) both auto mobile loans and mortgage loans have a little risk to the lenders. Lender will offer the loan at collateral this difference is reflected in on the interest rates similarly on yields to maturity on bonds.

The yield to maturity on local government bond is low-only 3.5 percent -primarily because interest earned on local government bonds is exempt from federal income taxes. Here there is some risk at local government bonds because a city or state may go bankrupt. Most city and state government used to issue their bonds at credit and ratings and it may allow corporate credit rating on better financial ratings 6.3 and lower financial rating 8.3 on local government bond 3.5. We can compare the yield to maturity of corporate bond and impact of tax on corporate bonds. Investors have pay taxes on interest earned but we need not pay at local government bonds and the interest rate is also low on government bonds and difference in yield to maturity reflects the investor used to buy the government bonds.

The treasury securities of a given time to maturity that was issued most recently in the primary market is called the on the run security. The treasury security that is not most recently issued is called off the run security. There is a source of difference to get a yield in liquidity comparing to the less liquid Securities, at the more liquid securities takes a lower cost of range. Here the investor can get more, at more liquid securities but the yield to maturity of less liquid securities must be higher to persuade investors to hold them instead of more liquid securities. Many investor uses on the run security for buying and selling. Either to speculate or to combine with other securities to reduce the risk in their portfolios by these its market is very liquid. The yield to maturity of an on the run security is usually a bit lower than the yield to maturity of an off the run security. For example: if the investor invests on on-the run-security at 30 years maturity at 4.4 % where as an off-the run security with 29 years to maturity the yield to maturity of 4.50% at a difference of 0.01% point.