The Risk and Term Structure of Interest

Rates

Reference: The Economics of Money, Banking, and

Financial Markets by Mishkin

Indraprastha Institute of Information Technology, Delhi

January 31st, 2025

Instructor: Kiriti Kanjilal The Risk and Term Structure of Interest Rates
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

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Risk Structure of Interest Rates
• Bonds with the same maturity have different interest rates
due to:
– Default risk
– Liquidity
– Tax considerations

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Risk Structure of Interest Rates
• 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).
• A corporation suffering big losses might be more likely to
suspend interest payments on its bonds. The default risk
on its bonds would therefore be quite high.

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Risk Structure of Interest Rates
• The spread between the interest rates on bonds with
default risk and default-free bonds, called the risk
premium.
• It indicates how much additional interest people must earn
in order to be willing to hold that risky bond.
• Our supply and demand analysis of the bond market can
be used to explain why a bond with default risk always has
a positive risk premium and why the higher the default risk
is, the larger the risk premium will be.

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Figure 2 Response to an Increase in Default
Risk on Corporate Bonds

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Risk Structure of Interest Rates
• Because default risk is so important to the size of the risk
premium, purchasers of bonds need to know whether a
corporation is likely to default on its bonds.
• Two major investment advisory firms, Moody’s Investors
Service and Standard and Poor’s Corporation, provide
default risk information by rating the quality of corporate
and municipal bonds in terms of the probability of default.

In India, CRISIL is a famous rating agency

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Risk Structure of Interest Rates
• Liquidity: a liquid asset is one that can be quickly and
cheaply converted into cash if the need arises.
• The more liquid an asset is, the more desirable it is
(holding everything else constant).
• U.S. Treasury bonds are the most liquid of all long-term
bonds, because they are so widely traded that they are the
easiest to sell quickly and the cost of selling them is low.
• Corporate bonds are not as liquid, because fewer bonds
for any one corporation are traded; thus it can be costly to
sell these bonds in an emergency, because it might be
hard to find buyers quickly.
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Risk Structure of Interest Rates
• Income tax considerations
– Interest payments on municipal bonds are exempt from
federal income taxes.

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Figure 3 Interest Rates on Municipal and
Treasury Bonds

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Term Structure of Interest Rates
• A plot of the yields on bonds with differing terms to maturity
but the same risk, liquidity, and tax considerations is called
a yield curve.
– 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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Term Structure of Interest Rates
Three theories to explain the three facts:
1. Expectations theory explains the first two facts but not
the third.
2. Segmented markets theory explains the third fact but
not the first two.
3. Liquidity premium theory combines the two theories to
explain all three facts.

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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.

• For example, if people expect that short-term interest rates

will be 10% on average over the coming five years, the
expectations theory predicts that the interest rate on bonds
with five years to maturity will be 10% too.

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Expectations Theory
• If short-term interest rates were expected to rise even
higher after this five-year period so that the average short-
term interest rate over the coming 20 years is 11%, then
the interest rate on 20-year bonds would equal 11% and
would be higher than the interest rate on five-year bonds.
• The explanation provided by the expectations theory for
why interest rates on bonds of different maturities differ is
that short-term interest rates are expected to have different
values at future dates.

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Expectations Theory
• 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.

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Expectations Theory
• To see how the assumption that bonds with different
maturities are perfect substitutes leads to the expectations
theory, let us consider the following two investment
strategies:
• 1. Purchase a one-year bond, and when it matures in one
year, purchase another one-year bond.
• 2. Purchase a two-year bond and hold it until maturity.

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Expectations Theory
• Because both strategies must have the same expected
return if people are holding both one- and two-year bonds,
the interest rate on the two-year bond must equal the
average of the two one-year interest rates.

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Expectations Theory
An example:
• Let the current rate on one-year bond be 6%.
• You expect the interest rate on a one-year bond to be 8%
next year.
• Then the expected return for buying two one-year bonds
averages (6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be 7% for you to
be willing to purchase it.

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Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite+1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

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Expectations Theory

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t ) - 1
= 1 + 2i2t + (i2t ) 2 - 1
= 2i2t + (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

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Expectations Theory

If two one-period bonds are bought with the $1 investment

(1 + it )(1 + ite+1 ) - 1
1 + it + ite+1 + it (ite+1 ) - 1
it + ite+1 + it (ite+1 )
it (ite+1 ) is extremely small
Simplifying we get
it + ite+1

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Expectations Theory

Both bonds will be held only if the expected returns are equal
2i2t = it + ite+1
it + ite+1
i2t =
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it + ite+1 + ite+ 2 + ... + ite+ ( n -1)
int =
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

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Expectations Theory
• Expectations theory explains:
– Why the term structure of interest rates changes at
different times.
– Why interest rates on bonds with different maturities
move together over time (fact 1).
– Why yield curves tend to slope up when short-term
rates are low and slope down when short-term rates
are high (fact 2).
• Cannot explain why yield curves usually slope upward
(fact 3)

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Segmented Markets Theory
• Bonds of different maturities are not substitutes at all.
• The segmented markets theory of the term structure sees
markets for different-maturity bonds as completely
separate and segmented.
• The interest rate for each bond with a different maturity is
determined by the demand for and supply of that bond.
• The argument for why bonds of different maturities are not
substitutes is that investors have strong preferences for
bonds of one maturity but not for another, so they will be
concerned with the expected returns only for bonds of the
maturity they prefer.
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Segmented Markets Theory
• Investors have short desired holding periods and generally
prefer bonds with shorter maturities that have less interest-
rate risk, the segmented markets theory can explain fact 3
that yield curves typically slope upward.
• Because in the typical situation the demand for long-term
bonds is relatively lower than that for short-term bonds,
long-term bonds will have lower prices and higher interest
rates, and hence the yield curve will typically slope
upward.

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Segmented Markets Theory
• It cannot explain facts 1 and 2.
• It views the market for bonds of different maturities as
completely segmented, there is no reason for a rise in
interest rates on a bond of one maturity to affect the
interest rate on a bond of another maturity.
• Therefore, it cannot explain why interest rates on bonds of
different maturities tend to move together (fact 1).

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Segmented Markets Theory
• Second, because it is not clear how demand and supply
for short- versus long-term bonds change with the level of
short-term interest rates, the theory cannot explain why
yield curves tend to slope upward when short-term interest
rates are low and to be inverted when short-term interest
rates are high (fact 2).

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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.
• The liquidity premium theory’s key assumption is that
bonds of different maturities are substitutes, which means
that the expected return on one bond does influence the
expected return on a bond of a different maturity, but it
allows investors to prefer one bond maturity over another.

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Liquidity Premium Theory

it + it+1
e
+ it+2
e
+ ...+ it+(
e

int = n-1)
+ lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

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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 because these bonds bear less interest-rate
risk.
• For these reasons, investors must be offered a positive
liquidity premium to induce them to hold longer term
bonds.

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Figure 5: The Relationship Between the Liquidity
Premium (Preferred Habitat) and Expectations Theory

30
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Preferred Habitat Theory
• We see that because the liquidity premium is always
positive and typically grows as the term to maturity
increases
• The yield curve implied by the liquidity premium theory is
always above the yield curve implied by the expectations
theory and generally has a steeper slope.

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Liquidity Premium & Preferred Habitat
Theories
• 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

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Liquidity Premium & Preferred Habitat
Theories
• Suppose that the one-year interest rate over the next five
years is expected to be 5, 6, 7, 8, and 9%, while investors’
preferences for holding short-term bonds means that the
liquidity premiums for one- to five-year bonds are 0, 0.25,
0.5, 0.75, and 1.0%, respectively.
• The interest rate on the two-year bond would be:

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Liquidity Premium & Preferred Habitat
Theories
• while for the five-year bond it would be:

• Doing a similar calculation for the one-, three-, and four-

year interest rates, you should be able to verify that the
one- to five-year interest rates are 5.0, 5.75, 6.5, 7.25, and
8.0%, respectively.

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Figure 6 :Yield Curves and the Market’s Expectations of
Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory

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Yield Curves
• A steeply rising yield curve, as in panel (a) of Figure 6,
indicates that short-term interest rates are expected to rise
in the future.
• A moderately steep yield curve, as in panel (b), indicates
that short-term interest rates are not expected to rise or fall
much in the future.
• A flat yield curve, as in panel (c), indicates that short-term
rates are expected to fall moderately in the future.
• Finally, an inverted yield curve, as in panel (d), indicates
that short-term interest rates are expected to fall sharply in
the future.

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