Question

3 Explain (in detail) what the Risk Structure of Interest Rates refer to.

Answer 1

Default risk,taxation ,liquidity and information costs combinedly called as Risk Structure of Interest Rates.

So we have to understand about default risk,taxation ,liquidity and information costs to understand Risk Structure of Interest Rates.

1,.Default risk- Probablity of borrower not paid full amount which he made a promise to pay which includes principal and interest or both in borrowing,According to default risk interest rate is charged.Higher the default risk higher the interest rate and lower the default risk lower the interest rate.

2.Taxation-interest rate of financial instrument is higly effected by tax charge on such instrument.If the instrument is tax free offer lower interest rate.

3.LIquidity- Liquidity means instrument immediately convertible into cash.So an instrument has high liqudity for investor offer lower interest rates while for an instrument which has less liquidity must pay higher interest rates,

4.Information Costs-information costs also effect interest rates-gathering information required to incurred the cost and according to cost intrest rate charges for govt bonds and Treasury bills have the lowest information cost so the interest rate is also in lower side.When the information cost is higher interest rate on also high.