Risk Structure of Interest Rates
How does the risk structure affect interest rates?
Interest rate is the amount charged after one scrounges money from an association such as the bank. It is habitually in a percentage form. Risk structure of interest rate can simply be defined as the relationship between interest rate on bonds of different maturities, (Singleton, (2003). In the market, there is a lot of diverse category of recognition market securities. These market instruments vary in interest rates. A valid example is where bonds of the same grace period have different risks.
There are three factors that affect risk structure. These are:
- Default Risk
- Liquidity
- Income Tax Consideration
Default Risk
This can be defined as the probability as to which the borrower might fail to pay the interested charges promptly. It also includes total payment of the bond when it matures. Therefore the implication this fact has on the interest rate is that, as the riskiness increases, the interest rate will consequently increase. What this implies is that, in cases where bonds have a higher risk of default, they will have to generate a higher interest rate. Probability is that, US government will never go bankrupt, and therefore its Treasury securities are default free. This means that their interest rate is low. This is not the case with corporations since they do default, making the interest rate to go higher. As a result, this is why it is evident that US government bonds are relatively lower in interest rates than the corporate bonds. Consequently, this fact can be used to explain the variation between the US government bonds with the corporate ones in time of recessions and depressions.
Liquidity
Liquidity can be defined as the process of converting an asset into monetary value. It counts for the flexibility in which the process can take place. It is evident that the US government bonds are more liquidity than the corporate ones in the sense that they are easily convertible into monetary value. The effect of liquidity in interest rate is that, the more liquid a bond is, the less the interest rate.
Income Tax Consideration
This is also known as municipal bonds. These are bonds which are issued out by the local government, or the state. These bonds are evaded from federal tax, hence making them generate less interest rate than both the US government bonds as well as the corporate one.
Conclusion
In a nutshell, the interest rate is directly affected by the riskiness of the bond. The more risk the bond is, the higher the interest rate.
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