This chapter has focused our attention upon multiple factors that cause interest rates and prices to differ between one type of financial asset and another, including marketability, liquidity, default risk, call privileges, taxation, prepayment risk, and convertibility. Among the principal conclusions of the chapter are the following:

• Marketability, or the capacity to be sold readily, is positively related to an asset’s price and negatively related to its rate of return or yield. More marketable financial instruments generally carry lower yields.



• Liquid financial instruments also tend to carry lower yields, but possess the advantages of ready marketability, stable price, and reversibility (i.e., the capacity to fully recover the funds originally invested).



• Default risk—the danger that a borrower will not make all promised payments at agreed-upon times—results in the promised yields of risky assets rising above the yields on riskless financial instruments. Potential buyers of these instruments compare their estimated (subjective) probability of loss from a risky asset to the market’s assigned default-risk premium. For example, if a potential buyer anticipates less risk of loss than suggested by the market’s assigned risk premium, he or she will tend to purchase the financial instrument in question because its risky yield appears to be too high and its price too low (i.e., the asset in question looks like a bargain).



• Default-risk premiums attached by the financial marketplace to the promised yields on risky assets tend to be heavily influenced by the credit ratings assigned by various credit rating agencies (such as Moody’s Investors Service or Standard & Poor’s Corporation) and by the condition of the economy. An expanding economy tends to result in lower default-risk premiums, while an economy trapped in a recession with rising business bankruptcies tends to generate higher default-risk premiums on risky assets.



• Many lower-rated companies with questionable credit ratings have issued speculative or junk bonds in large quantities in recent years. The rise of junk bonds has broadened the market for corporate debt, offering participating investors substantially higher yields than were previously available.



• Debt securities with call privileges attached tend to carry higher promised rates of return than financial instruments not bearing a call privilege. The right of a security issuer to call away the security he or she has previously issued and retire it in return for paying a prespecified price gives borrowers greater flexibility in adapting their capital structure to changing market conditions. Recently call privileges have been declining in use as corporate borrowers have discovered other ways of raising funds and protecting themselves against risk.



• The rapid growth of loan-backed securities (such as mortgage-backed instruments) has given rise to prepayment risk—the danger that loans used to back loan-backed securities may be paid back early, lowering an investor’s expected yield from loan-backed instruments. The rapid expansion of loanbacked assets has made prepayment risk more important with time. Issuers of these instruments have sought to make them more attractive to buyers by creating different maturity classes (tranches) so that buyers can select how much prepayment risk they are willing to take on.



• Event risk has long been a significant factor in the pricing of corporate stock and debt securities. Events that appear to have an especially significant impact upon asset values include announcements of new security issues, stock dividends, stock splits, and management changes within a particular business firm.



• Financial assets generate interest or dividend payments and capital gains or losses—any or all of which may be subject to taxation at federal and state levels. Investors must be cognizant of continuing changes in tax laws and regulations. It is also important to be able to calculate tax-exempt yields versus taxable returns because some assets (such as municipal bonds) generate taxexempt income and some investing institutions (such as credit unions and pension funds) are tax-exempt.



• Some corporate debt and stock instruments carry a convertibility feature which allows them to be exchanged for a certain number of shares of stock. Convertibles are often called “hybrid securities” because they offer not only relatively stable income (interest payments or fixed dividends) but also the prospect of substantial capital gains when converted into stock. Assets with convertibility features tend to sell at a higher price and a lower promised yield due to their potential for exceptional gains upon conversion.



• The chapter closes with an overview of the interest rate structure model, which aids us in understanding why there are so many different interest rates in the real world. Each different interest rate or yield is viewed in this model as the sum of the risk-free interest rate plus a series of risk premiums dependent on varying degrees of risk exposure. Among the risk premiums included in this model are liquidity and term (or maturity) risk, inflation risk, default risk, call risk, prepayment risk, and exposure to tax risk. Because these risk premiums can change at any time, interest rates themselves may change at any time and the causes of any particular interest-rate movement can be very complex.