The document discusses several factors that influence interest rates in financial markets including maturity, credit risk, liquidity, taxes, and expectations theory. It provides examples of how different risk premiums can cause spreads between rates for different types of bonds based on their characteristics. Specifically, it demonstrates how municipal bonds can offer a higher after-tax rate than Treasury bonds for investors in high tax brackets.

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%