Using Mortgage Rates to Explain Risk Premiums in an Introductory Finance Course

Abstract

Devising an effective way to teach interest rate determinants and
help students understand various risk premiums is an essential
part of any introductory finance course. Unfortunately, because
these topics are commonly taught in conjunction with the
introduction of bonds, students often become confused while
trying to simultaneously learn new terminology and concepts
related to bond pricing. In this paper, we describe a more
student friendly approach to teaching interest rate determinants.
We believe students gain a better understanding of risk
premiums when related to loan types they are already somewhat
familiar with. Specifically, this paper describes how to use a
simple comparison of various mortgage rates to more clearly
explain concepts such as default risk, interest rate risk, and
liquidity risk. This approach focuses students' attention on the
concepts at hand rather than confusing them with multiple high
level applications at one time.