BB12

2. Money, Banking,
and Business
Lecture 12
Market Efficiency and
the Flow of Funds

3. Questions?

4. Rate is a function of
maturity
credit risk
liquidity
taxes

5. Maturity
rates over the life of
the instrument

6. Expectations Theory
long term rate is the
geometric average
of the expected
short term rates

7. Simple Average
Geometric Average
= (a + b) /2
= √a x b

8. Simple Average
= (3 + 7) /2
= 5
= √a x b
= 4.58
Geometric Average

9. Liquidity Premium
Premium to wait
longer to cash in

10. Credit Risk
default
ratings
junk bonds

11. Rating Agencies

13. Risk Premiums
spreads
between rates
benchmark
U.S Treasury

15. Taxes
After tax
Municipals
Higher marginal rates
attract demand

16. U.S.
Treasury
Municipal
Bond
Rate 5% 4%
Tax Bracket 30% 0%
After Tax Rate 3.5% 4%

17. Rate
Factors
Bond
A
Bond
B
∆
Base
Rate
2.5% 2.5% 0%
Maturity 1.0% 2.0% 1.0%
Liquidity 1.0% 1.5% 0.5%
Credit 1.0% 2.0% 1.0%
Taxes 1.0% 1.0% 0.0%
Overall
Rate
6.5% 9.0% 2.5%