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Structure of interest rates (define different characteristics affect the debt securities yield

The annual interest rate offered by debt securities at a given point in time varies among debt
securities. Consequently, the yields offered by debt securities at a given point in time have a
particular structure. Some types of debt securities always offer a higher yield than others.
Individual and institutional investor must understand why quoted yields vary so that they can
determine whether the extra yield on a given security outweighs any unfavorable characteristics.
Securities with different characteristics influence the yield to be offered. In general, securities
with unfavorable characteristics will offer higher to entice investor. The yields on debt securities
are affected by the following characteristics:

Credit(default )Risk
Liquidity risk
Tax status
Terms to maturity

1. Credit (default) risk:

Because most securities are subject to the risk of default, investors must consider the credit
worthiness. Although investors always have the option of purchasing risk free treasury securities,
the may prefer some other securities if the yield compensate them for the risk.
Investors may personally assess the credit worthiness of corporations that issue bonds, or they
may use bond ratings provided by rating agencies.
2. Liquidity risk:
Investors prefer securities that are liquid, meaning that are liquid, meaning that they could be
easily convert to each without a loss in value. If all the other characteristics are equal, securities
with loss liquidity will have to suffer a higher yield to be prefer.
3. Tax status:
Investors are more concerned with after tax income than before tax income earned on securities,
taxable securities will have to offer a higher than exempt securities to be preferred.
4. Term to maturity:
Maturity differs among debt securities and is another reason that debt security yields differ. The
term structure at interest define the relationship between the term to maturity and the annualized
yield of debt securities.

Segmented market theory:

According to these theory, investors and borrowers choose securities with maturity that satisfy
their forecasted cash needs. Pension funds and life insurance companies may generally prefer
long term investment that coincide with their long term investment to co-incide with their short
term liabilities. If investor and borrowers participate only in the maturity market that satisfy their
particular needs market are segmented, that is investors will shift from the long term market vice
versa only if the timing of their cash needs changes according to these theory, the choice of long
term vs. short term maturities is predetermined according to nee rather than expectation of future
interest rates.

Limitations of the theory:

A limitation of the segmented markets theory is that some borrowers savers have the flexibility
to choose among varies maturity markets. Corporations that needs long-term funds may initially
obtain short term financing if they expect interest to decline investors with long term fund may
made short term investment. If they expect inelastic to right, some investors with short term
funds available may be willing to purchase long term securities that have an active secondary
markets. So there is clear audience that interest rate among maturity markets move closely
intended over time providing there is some interaction among market which implies that funds
are being transferred across markets.

Commercial paper
An unsecured, short-term debt instrument issued by a corporation, typically for the financing of
accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial
paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting
prevailing market interest rates.
Financial institution such as financial companies and bank holding companies are major issuer of
commercial paper. The minimum denomination of commercial paper is usually $100000.
Primary benefit to largest & most creditworthy issuers is: Cost of borrowing is lower than at a
commercial bank