Determination of

Interest Rates Risk and

Term Structure of Interest Rates

ACF 2203 -Financial Markets

Week 12
Mr. Uwin Ariyarathna
 Content

1. Introduction to the Risk and

Term Structure of Interest Rates
2. The Risk Structure of Interest
Rates
3. The term structure of interest
rates
Introduction to the Risk and Term Structure of
Interest Rates
Why bonds with same term to maturity have different
interest rates—for example, all the bonds that will
mature in 30 years—have different interest rates, or
yields to maturity?
The relationship among these interest rates is called the
risk structure of interest rates (same term to maturity
and different YTM).
When other factors constant, the relationship among
bond’s term to maturity and its interest rate is called as
the term structure of interest rates.
Factors Affecting Interest Rates
• Default Risk
• Liquidity and Information Cost
• Tax Status
• Maturity
The Risk Structure of Interest Rates
Interest rates or yields on credit market instruments
with the same maturity vary because of differences in
default risk, liquidity and tax status.
Three factors account for these differences:
1. Default risk (also called Credit Risk)
2. Liquidity and Information costs
3. Tax status
1. Default Risk
Default risk (sometimes called credit risk) is the risk that the
bond issuer will fail to make payments of interest or principal
when the bond matures.
Bonds which has no default risk are called default-free bonds (
Eg. Treasury bonds)
The spread between the interest rates on bonds with default risk
and default-free bonds, called the default risk premium (higher
the default risk is, the larger the risk premium)
In other words, The default risk premium on a bond is the
difference between the interest rate on the corporate bond and
the interest rate on a Treasury bond that has the same maturity.
It indicates how much additional interest people must
earn in order to be willing to hold that risky bond.
During recessions, the default risk on corporate
bonds typically increases, which can cause an
increase in default risk premium.
Response to an Increase in Default Risk
on Corporate Bonds
Default Risk- Example
• Assume the one-year risk-free interest rate is 5 %.A
company has issued a 5 percent coupon bond with a
face value of Rs. 100. (1 year maturity)
1. If this bond was risk-free, calculate the price of the
bond.
2. Suppose, however, there is a 10% probability that the
company will go bankrupt before paying back the
loan. Calculate the price of the bond.
3. Calculate yield to maturity
4. Calculate default risk premium
In Class Activity
Default Risk - Conclusion
A bond with default risk will always have a positive
risk premium, and an increase in its default risk will
raise the risk premium.
2. Liquidity and Information Costs
• 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. They are
so widely traded because they are the easiest to sell
quickly and the cost of selling is low.
• Similarly, investors care about the costs of acquiring
information on a bond.
• Treasury bonds are the most liquid. Corporate bonds are
not as liquid.
• It can be costly to sell these bonds in an emergency,
because it might be hard to find buyers quickly.
• An increase in a bond’s liquidity or a decrease in the cost
of acquiring information about the bond will increase the
demand for the bond.
Liquidity and Information Costs continued
• If the corporate bond becomes less liquid than the
Treasury bond because it is less widely traded, then
(as the theory of asset demand indicates) its demand
will fall
• The lower liquidity of corporate bonds relative to
Treasury bonds increases the spread between the
interest rates on these two bonds
Response to a Decrease in the Liquidity
of Corporate Bonds
Explanation
• If the corporate bond becomes less liquid than the
Treasury bond because it is less widely traded, then
demand for it will fall, shifting its demand curve from
Dc1 to Dc 2 as in panel (a). The Treasury bond now
becomes relatively more liquid in comparison with the
corporate bond, so its demand curve shifts rightward from
DT1 to DT2 as in panel (b). The shifts in the curves show
that the price of the less liquid corporate bond falls and its
interest rate rises, while the price of the more liquid
Treasury bond rises, and its interest rate falls.
• The differences between interest rates on corporate bonds
and Treasury bonds (that is, the risk premiums) reflect not
only the corporate bond’s default risk but also its
liquidity. This is why a risk premium is more accurately a
“risk and liquidity premium,” but convention dictates that
it is called a risk premium.
Note
The differences between interest rates on corporate
bonds and Treasury bonds (that is, the risk premiums)
reflect not only the corporate bond’s default risk but its
liquidity too. This is why a risk premium is sometimes
called a risk and liquidity premium.
3. Income Tax Consideration
Investors care about the after-tax return on their
investments—that is, the return the investors have left
after paying their taxes.

Corporate bond: FV = $1,000; coupon = 10%; t = 40%.

Treasury FV = $1,000; coupon = 10%; t = 30%.
Calculate Return after tax
Income Tax Consideration
Explanation
When the municipal bond is given tax-free status,
demand for the municipal bond shifts rightward from
Dm1 to Dm2 and demand for the Treasury bond shifts
leftward from DT 1 to DT 2. The equilibrium price of
the municipal bond rises from Pm1 to Pm2, so its
interest rate falls, while the equilibrium price of the
Treasury bond falls from PT 1 to PT 2 and its interest
rate rises. The result is that municipal bonds end up
with lower interest rates than those on Treasury bonds.
Summary on Risk Structure
• Default risk increases → Demand for bonds
decreases → Interest rates increases
• Less liquidity and high cost of information →
Demand for bonds decreases → Interest rates increases
• More Tax→ Demand for bonds decreases → Interest
rates increases
The 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. The term
structure of interest rates defines the relationship
between maturity and yield.
A plot of the yields on bonds with different terms to
maturity but the same risk, liquidity, and tax
considerations is called a yield curve, and it describes
the term structure of interest rates for particular types
of bonds, such as government bonds.
Shapes of the Yield Curve
Yield curve Shapes
• When yield curves slope upward, the most usual case,
the long-term interest rates are above the short-term
interest rates. An upward-sloping yield curve
indicates that Securities with longer maturities offer
higher annual yields
• When yield curves are flat, short- and long-term
interest rates are the same
• When yield curves are inverted, long-term interest
rates are below short-term interest rates.
• Yield curves can also have more complicated shapes
in which they first slope up and then down, or vice
versa.
 Why Does the Term Structure of
Interest Rates Matter?
• Generally, the term structure of interest rates is a
good measure of future economic growth
expectations.
• Highly positive normal curve means - future
economic growth to be strong and inflation high.
• Highly negative inverted curve means - future
economic growth to be slow-moving and inflation
low.
Three theories have been put forward to explain
the term structure of interest rates
1. The expectations theory
2. The market segmentation theory
3. The liquidity premium theory
 1. 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.
The key assumption behind this theory is that buyers of
bonds do not prefer bonds of one maturity over another, so
they will not hold any quantity of a bond if its expected
return is less than that of another bond with a different
maturity. Bonds that have this characteristic are said to be
perfect substitutes. What this means in practice is that if
bonds with different maturities are perfect substitutes, the
expected return on these bonds must be equal
Expectations Theory –Example 1
The current interest rate on a one-year bond is 9%, and
you expect the interest rate on the one-year bond next
year to be 11%. What is the expected return over the
two years? What interest rate must a two-year bond
have to equal the two one-year bonds?
which tells us that the two-period rate must equal the
average of the two one-period rates. Graphically, this
can be shown as
Expectations Theory -Answer
The expected return over the two years will average
10% per year ([9% + 11%]/2 = 10%). The bondholder
will be willing to hold both the one- and two-year
bonds only if the expected return per year of the two-
year bond equals 10%. Therefore, the interest rate on
the two-year bond must equal 10%, the average interest
rate on the two one-year bonds. Graphically, we have
We can conduct the same steps for bonds with a longer
maturity so that we can examine the whole term
structure of interest rates. Doing so, we will find that
the interest rate of int on an n-period bond must be

Equation 2 states that 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. This is a
restatement of the expectations theory in more precise
terms.
Expectations Theory –Example 2
The one-year interest rates over the next five years are
expected to be 5%, 6%, 7%, 8%, and 9%. Given this
information, what are the interest rates on a two-year
bond and a five-year bond? Explain what is happening
to the yield curve.
• Two-year rate = (5+6)/2=5.5%
• Five-year rate = (5+6+7+8+9)/5= 7%
Using equation for the one-, three-, and four-year
interest rates, you will be able to verify the one-year to
five-year rates as 5.0%, 5.5%, 6.0%, 6.5%, and 7.0%,
respectively. The rising trend in short-term interest rates
produces an upward-sloping yield curve along which
interest rates rise as maturity lengthens.
 2. The market segmentation theory
As the name suggests, the market segmentation 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
then determined by the supply of and demand for that bond,
with no effects from expected returns on other bonds with
other maturities.
The key assumption in market segmentation theory is that
bonds of different maturities are not substitutes at all, so the
expected return from holding a bond of one maturity has no
effect on the demand for a bond of another maturity.
Bonds of different maturities are not substitutes, investors
have preferences for bonds of one maturity over another
(bonds of different maturities are NOT substitutes at all).This
theory of the term structure is at the opposite extreme to the
expectations theory, which assumes that bonds of different
maturities are perfect substitutes.
The market segmentation theory
3. Liquidity premium theory
The liquidity premium theory of the term structure
states that 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 (also referred to as a term
premium) that responds to supply-and-demand
conditions for that bond.
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.
Liquidity premium theory continued
In other words, bonds of different maturities are
assumed to be substitutes, but not perfect substitutes.
Investors tend to prefer shorter-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.
Such an outcome would modify the expectations theory
by adding a positive liquidity premium to the equation
that describes the relationship between long- and short-
term interest rates. The liquidity premium theory is
thus written as
Liquidity premium theory Example
let’s suppose that the one-year interest rates over the next five
years are expected to be 5%, 6%, 7%, 8%, and 9%. Investors’
preferences for holding short-term bonds have the liquidity
premiums for one-year to five-year bonds as 0%, 0.25%, 0.5%,
0.75%, and 1.0%, respectively. What is the interest rate on a
two-year bond and a five-year bond?
The interest rate on the two-year bond would be 5.75%.
 Discussion
1. Explain The Risk Structure of Interest Rates
2. Corporate bond: FV = $1,000; coupon = 8%; t = 40%.
Treasury FV = $1,000; coupon = 8%; t = 25%.
Calculate Return after tax
3. Explain the Term structure of interest rates
End of the lesson
Thank You !