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Knowledge Station 2020/2021 Gergs Ayyad 01553058768

Bonds of the same maturity can have different interest rates due to default risk, liquidity, and tax considerations. The term structure of interest rates shows that bonds with different maturities but the same risk and tax profiles can have different yields, with the yield curve typically sloping upward. Expectations theory and preferred habitat theory both aim to explain the term structure by considering expectations of future short-term rates and liquidity preferences of investors.

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28 views

Knowledge Station 2020/2021 Gergs Ayyad 01553058768

Bonds of the same maturity can have different interest rates due to default risk, liquidity, and tax considerations. The term structure of interest rates shows that bonds with different maturities but the same risk and tax profiles can have different yields, with the yield curve typically sloping upward. Expectations theory and preferred habitat theory both aim to explain the term structure by considering expectations of future short-term rates and liquidity preferences of investors.

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Knowledge Station 2020/2021

GERGS AYYAD 01553058768


Chapter (6): Risk Structure of Interest Rates (Money & Banking)

Bonds with the same maturity have different interest rates due to:
(Default risk–Liquidity –Tax considerations).
A) Default risk: probability that the issuer of the bond is unable or unwilling to make interest
payments or pay off the face value.
U.S. Treasury bonds are considered default free (government can raise taxes).
Risk premium: the spread between the interest rates on bonds with default risk and the interest
rates on (same maturity) Treasury bonds.
Response to an Increase in Default Risk on Corporate Bonds

Liquidity: the relative ease with which an asset can be converted into cash.
Cost of selling a bond. -Number of buyers/sellers in a bond market.
Income tax considerations: Interest payments on municipal bonds are exempt from federal
income taxes.
Interest Rates on Municipal and Treasury Bonds

Term Structure of Interest Rates:


Bonds with identical risk, liquidity, and tax characteristics may have different interest rates
because the time remaining to maturity is different.
Yield curve: a plot of the yield on bonds with differing terms to maturity but the same risk,
liquidity and tax considerations.
Upward-sloping: long-term rates are above short-term rates.
Flat: short- and long-term rates are the same.
Inverted: long-term rates are below short-term rates.

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Knowledge Station 2020/2021
GERGS AYYAD 01553058768
Facts that the Theory of the Term Structure of Interest Rates Must (Explain):
1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to have an upward slope;
when short-term rates are high, yield curves are more likely to slope downward and be inverted.
3. Yield curves almost always slope upward.
Expectations Theory:
•The interest rate on a long-term bond will equal an average of the short-term interest rates that
people expect to occur over the life of the long-term bond.
•Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity
of a bond if its expected return is less than that of another bond with a different maturity.
•Bond holders consider bonds with different maturities to be perfect substitutes.
Segmented Markets Theory:
•Bonds of different maturities are not substitutes at all.
•The interest rate for each bond with a different maturity is determined by the demand for and
supply of that bond. •Investors have preferences for bonds of one maturity over another.
Liquidity Premium & Preferred Habitat Theories:
The interest rate on a long-term bond will equal an average of short-term interest rates expected to
occur over the life of the long-term bond plus a liquidity premium that responds to supply and
demand conditions for that bond. •Bonds of different maturities are partial (not perfect) substitutes.

Preferred Habitat Theory: •Investors have a preference for bonds of one maturity over another.
•They will be willing to buy bonds of different maturities only if they earn a somewhat higher
expected return. •Investors are likely to prefer short-term bonds over longer-term bonds.

The Relationship Between the Liquidity Premium (Preferred Habitat) and Expectations Theory:

•Interest rates on different maturity bonds move together over time; explained by the first term in
the equation.
•Yield curves tend to slope upward when short-term rates are low and to be inverted when short-
term rates are high; explained by the liquidity premium term in the first case and by a low
expected average in the second case.
•Yield curves typically slope upward; explained by a larger liquidity premium as the term to
maturity lengthens. A

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