The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Chapter 6
The Risk and Term Structure
of Interest Rates

Copyright © 2019 Pearson Education, Ltd.

Preview
• In this chapter, we examine the sources and causes of
fluctuations in interest rates relative to one another and
look at a number of theories that explain these fluctuations.

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Learning Objectives
• Identify and explain three factors explaining the risk
structure of interest rates.
• List and explain the three theories of why interest rates
vary across maturities.

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Risk Structure of Interest Rates (1 of 3)
• Bonds with the same maturity have different interest rates
due to:
– Default risk
– Liquidity
– Tax considerations

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Figure 1 Long-Term Bond Yields, 1919–2017

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal
Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2

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Risk Structure of Interest Rates (2 of 3)
• 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

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

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Table 1 Bond Ratings by Moody’s, Standard
and Poor’s, and Fitch (1 of 2)
Moody’s Rating Agency S&P Fitch Definitions
Aaa AAA AAA Prime Maximum Safety
Aa1 AA+ AA+ High Grade High Quality
Aa2 AA AA Blank
Aa3 AA– AA– Blank
A1 A+ A+ Upper Medium Grade
A2 A A Blank
A3 A– A– Blank
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB Blank
Baa3 BBB– BBB– Blank
Ba1 BB+ BB+ Noninvestment Grade

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Table 1 Bond Ratings by Moody’s, Standard
and Poor’s, and Fitch (2 of 2)
Moody’s Rating Agency S&P Fitch Definitions
Ba2 BB BB Speculative
Ba3 BB– BB– Blank
B1 B+ B+ Highly Speculative
B2 B B Blank
B3 B– B– Blank
Caa1 CCC+ CCC Substantial Risk
Caa2 CCC — In Poor Standing
Caa3 CCC– — Blank
Ca — — Extremely Speculative
C — — May Be in Default
— — D Default

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The Global Financial Crisis and the Baa–
Treasury Spread
• Starting in August 2007, the collapse of the subprime
mortgage market led to large losses among financial
institutions. As a consequence, many investors began to
doubt the financial health of corporations with low credit
ratings such as Baa and even the reliability of the ratings
themselves. The perceived increase in default risk for Baa
bonds made them less desirable at any given price.

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Risk Structure of Interest Rates (3 of 3)
• 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.

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Figure 3 Interest Rates on Municipal and
Treasury Bonds

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Effects of the Obama Tax Increase on Bond
Interest Rates
• In 2013, Congress approved legislation favored by the
Obama administration to increase the income tax rate on
high-income taxpayers from 35% to 39%. Consistent with
supply and demand analysis, the increase in income tax
rates for wealthy people helped to lower the interest rates
on municipal bonds relative to the interest rate on Treasury
bonds.

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Term Structure of Interest Rates (1 of 4)
• 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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Term Structure of Interest Rates (2 of 4)
• 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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Term Structure of Interest Rates (3 of 4)
The theory of the term structure of interest rates must
explain the following facts:
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.

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Term Structure of Interest Rates (4 of 4)
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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Figure 4 Movements over Time of Interest Rates on
U.S. Government Bonds with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory (1 of 7)
• 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.

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Expectations Theory (2 of 7)
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 (3 of 7)

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 (4 of 7)

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 (5 of 7)

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 (6 of 7)

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 (7 of 7)
• 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 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.
• If investors generally prefer bonds with shorter maturities
that have less interest-rate risk, then this explains why
yield curves usually slope upward (fact 3).

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Liquidity Premium & Preferred Habitat
Theories (1 of 2)
• 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.

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Liquidity Premium Theory

it  ite1  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.

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

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Liquidity Premium & Preferred Habitat
Theories (2 of 2)
• 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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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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Figure 7 Yield Curves for U.S. Government
Bonds

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