Reference no: EM131593919

Bond yields observed in the market are influenced by six factors:

The real rate of interest - r, is a rate that has not been adjusted for inflation.

Expected future inflation - according to the Fisher equation the nominal rate, R, equals (1 + real rate) times (1 + inflation rate). A reasonable approximation, when expected inflation (h) is relatively low, is R = r + h.

Interest rate risk interest - the risk of changes in bond prices due to fluctuating interest rates. All else equal, when market rates fall (rise), bond prices increase (decrease). Also:

All else equal, the longer the time to maturity, the greater the interest rate risk.

All else equal, the lower the coupon rate, the greater the interest rate risk.

Default risk - the risk of no repayment or default.

Taxability - all else equal, unfavorable tax status results in higher yields.

Liquidity - all else equal, lack of liquidity results in higher yields.

The yield curve, or term structure of interest rates, is the relationship between nominal interest rates on default-free, pure discount bonds and maturity. The treasury yield curve is a plot of yields on treasury notes and bonds relative to maturity. Commonly, these default-free nominal treasury yields are the base above which yields on bonds of varying maturities with default risk are priced.

Now, think about US Treasury securities. How many of these apply to US Treasury securities?