IBA, Main Campus

Financial Institutions & Markets

How Do Risk and

Term Structure Affect Interest Rates?
Lecture 5

By
[email protected]
M. Yousuf Saudagar
1
 PREVIEW
• In our last session, Chapter 4, we examined the determination of just
one interest rate with the help of one security.
• Yet we saw earlier that there are enormous numbers of bonds on
which the interest rates can and do differ.
• In this chapter we complete the interest-rate picture by examining
the relationship of the various interest rates to one another.
• Understanding why they differ from bond to bond can help banks,
businesses, insurance companies, and private investors decide which
bonds to purchase as investments and which ones to sell.
• We first look at why bonds with the same term to maturity have
different interest rates.
• The relationship among these interest rates is called the risk
structure of interest rates, although risk, liquidity, and income tax
rules all play a role in determining the risk structure. 2
 PREVIEW
• Bond’s term to maturity also affects interest rate & the relationship
among interest rates on bonds with different terms to maturity is
called term structure of interest rates.

• In this chapter we examine the sources & causes of fluctuations in

interest rates relative to one another & look at a few theories that
explain these fluctuations.

3
 risk structure
How default risk, liquidity, and tax considerations can
influence interest rates

4
 Risk Structure of Interest Rates
FIGURE
5.1

5
 Risk Structure of Interest Rates
• Figure above shows the yields to maturity for several categories of
long-term bonds from 1919 to 2016.
• It shows us two important features of interest-rate behavior for
bonds of the same maturity:
1. Interest rates on different categories of bonds differ from one
another in any given year, and
2. Spread (or difference) between the interest rates varies over time.
• The interest rates on municipal bonds are higher than those on
government (Treasury) bonds in the late 1930s but lower thereafter.
• In addition, the spread between the interest rates on Baa corporate
bonds (riskier than Aaa corporate bonds) and government bonds is
very large during the Great Depression years 1930–1933, is
smaller during the 1940s–1960s, and then widens again afterward.
• Which factors are responsible for these phenomena?
6
 Default Risk
• One attribute of a bond that influences its interest rate is its risk of
default, which occurs when the issuer of the bond is unable or
unwilling:
a) To make interest payments when promised or
b) To pay off the face value when the bond matures.
• 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.
• By contrast, Treasury bonds are considered to have no default risk
because the federal government can always increase taxes to pay off
its obligations.
• Bonds like these with no default risk are called default-free bonds.
7
 Default Risk
• The spread between the interest rates on bonds with default risk and
default-free bonds, both of the same maturity, called the Default Risk
Premium.
• Default Risk Premium indicates how much additional interest
people must earn to be willing to hold that risky bond.
• Our supply-and-demand analysis as discussed in Chapter 4 can be
used to explain:
a) Why a bond with default risk always has a positive risk
premium and
b) Why the higher the default risk is, the larger the risk premium
will be.
• To examine the effect of default risk on interest rates, let’s look at
the supply and demand diagrams for the default-free (Treasury) and
corporate long-term bond markets in the figure 5.2 on slide 10. 8
 Default Risk
• To make the diagrams easier to read, let’s assume that initially
Corporate bonds have the same default risk as Treasury bonds.
• In this case, these two bonds have the same attributes (identical risk
and maturity); their equilibrium prices & interest rates will
initially be equal & the risk premium on corporate bonds will be
zero.
• Now suppose, the possibility of a default increases because a
corporation begins to suffer losses, the default risk on corporate bonds
will increase & the expected return on these bonds will decrease.
• Thus, the corporate bond’s return will be more uncertain.
• Theory of portfolio choice predicts that because expected return on
corporate bond falls relative to the expected return on the default-
free Treasury bond while its relative riskiness rises, the corporate
bond is less desirable (ceteris paribus) & demand for it will fall.
9
 Default Risk
FIGURE 5.2

10
 Default Risk
• If you were an investor, you would surely want to (demand) hold a
smaller amount of corporate bonds.
• The demand curve for corporate bonds in panel (a) of Figure 5.2
then shifts to the left, from Dc1 to Dc2.
• At the same time, the expected return on default-free Treasury
bonds increases relative to the expected return on corporate
bonds, while their relative riskiness declines.
• The Treasury bonds thus become more desirable, and demand
rises, as shown in panel ( b) by the rightward shift in the demand
curve for these bonds from DT1 to DT2.
• As we can see in the figure, the equilibrium price for corporate
bonds falls from Pc1 to Pc2
• Since the bond price is negatively related to the interest rate, the
equilibrium interest rate on corporate bonds rises to ic2. 11
 Default Risk

• At the same time, the equilibrium price for the Treasury bonds
rises from PT1 to PT2 , and the equilibrium interest rate falls to iT2.
• The spread between the interest rates on corporate and default-
free bonds—that is, the risk premium on corporate bonds—has
risen from zero to ic2 - iT2.
• We can now conclude that a bond with default risk will always have
a positive risk premium, and an increase in its default risk will raise
the risk premium.
• 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.
• This information is provided by credit-rating agencies, investment
advisory firms that rate the quality of corporate and municipal bonds
in terms of the probability of default.
12
 Default Risk
• Table below provides the ratings and their description for the two largest credit-
rating agencies, Moody’s Investor Service and Standard and Poor’s Corporation.
• Bonds with relatively low risk of default are called investment-grade securities
and have a rating of Baa (or BBB) and above. Bonds with ratings below Baa (or
BBB) have higher default risk and have been aptly dubbed speculative grade or
junk bonds. Because these bonds always have higher interest rates than
investment-grade securities, they are also referred to as high-yield bonds.

13
 Default Risk
• Now let’s again look at Figure 5.1 and see if we can explain the
relationship between interest rates on corporate & Treasury bonds.

• Corporate bonds always have higher interest rates than T-Bonds

because they have some risk of default, while Treasury bonds do not.
• Similarly, Baa corporate bonds have greater default risk than Aaa
14
bonds, their risk premium is greater & Baa rate always exceeds
 Default Risk
• We can use the same analysis to explain the huge jump in the risk
premium on Baa corporate bond rates during the Great Depression
years 1930–1933 and the rise in the risk premium after 1970.

• The depression period saw a very high rate of business failures &
defaults.

• These factors led to a substantial increase in the default risk for

bonds issued by vulnerable corporations, and the risk premium for
Baa bonds reached unprecedentedly high levels.

• Since 1970, we have again seen a higher business failures/defaults,

though they were still below Great Depression levels.

• Accordingly, both default risks & risk premiums for corporate

bonds rose, widening the spread between interest rates on
corporate bonds and those on Treasury bonds.
15
 The Global Financial Crisis & the Baa-Treasury Spread CASE
• Starting in August 2007, the collapse of the subprime mortgage
market led to large losses in financial institutions (which we will
discuss more extensively in Chapter 8).
• As a consequence of the subprime collapse and the subsequent global
financial crisis, 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 interest rate, decreased the quantity
demanded, and shifted the demand curve for Baa bonds to the left.
• As shown in panel (a) of Figure 5.2, the interest rate on Baa bonds
should have risen, which is indeed what happened.
• Interest rates on Baa bonds rose by 280 basis points (2.80 percentage
points) from 6.63% at the end of July 2007 to 9.43% at the most
virulent stage of the global financial crisis in mid-October 2008. 16
 The Global Financial Crisis & the Baa-Treasury Spread CASE
• But the increase in perceived default risk for Baa bonds in October
2008 made default-free Treasury bonds relatively more attractive
and shifted the demand curve for these securities to the right—an
outcome described by some analysts as a “flight to quality.”
• Just as our analysis predicts in Figure 5.2, interest rates on Treasury
bonds fell by 80 basis points, from 4.78% at the end of July 2007 to
3.98% in mid-October 2008.
• The spread between interest rates on Baa and Treasury bonds rose by
360 basis points, from 1.85% before the crisis to 5.45% afterward.

17
 Liquidity

• Another attribute of a bond that influences its interest rate is its

liquidity.
• As we learned in Chapter 4, 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).
• Treasury bonds are the most liquid of all long-term bonds; because
they are so widely traded, 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.
• How does the reduced liquidity of the corporate bonds affect their
interest rates relative to the interest rate on Treasury bonds? 18
 Liquidity
• We can use supply-and-demand analysis with the same figure that
was used to analyze the effect of default risk, Figure 5.2, to show that
the lower liquidity of corporate bonds relative to Treasury bonds
increases the spread between the interest rates on these two bonds.
• Let’s once again assume that initially corporate and T-Bonds are
equally liquid & all their other attributes are the same. Therefore,
their equilibrium prices & interest rates will initially be equal.
• 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 to left from Dc1 to Dc2 as in panel (a).
• The T-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 in Figure 5.2 show that the price of the less
liquid corporate bond falls & its interest rate rises, while the price of
the more liquid Treasury bond rises and its interest rate falls. 19
 Liquidity
• Resultantly, the spread between interest rates on the two bond types
has increased.
• Therefore, the differences between interest rates on corporate
bonds and Treasury bonds (i.e. risk premiums) reflect not only the
corporate bond’s default risk but also its liquidity.
• Therefore, a risk premium is more accurately a “risk and liquidity
premium,” but convention dictates that it is called a risk premium.

20
 Income Tax Considerations

• Returning to Figure 5.1, we are still left with one puzzle—the

behavior of municipal bond rates.
• Municipal bonds are certainly not default-free.
• State and local governments have defaulted on the municipal bonds
they have issued in the past, particularly during the Great Depression.
• Also, municipal bonds are not as liquid as Treasury bonds.
• Why is it, then, that municipal bonds have had lower interest
rates than T-Bonds for at least 70 years?
• The explanation lies in the fact that interest payments on municipal
bonds are exempt from federal income taxes, a factor that has the
same effect on the demand for municipal bonds as an increase in their
expected return.

21
 Income Tax Considerations

• Let’s imagine that you have enough income & you fall in 35% income
tax bracket.
• If you own a $1,000-face-value T-Bond that sells for $1,000 and has a
coupon payment of $100 coupon rate of 10%, you get to keep only
$65 of the payment after taxes. Although the bond has a 10% interest
rate, you actually earn only 6.5% after taxes.
• Suppose, however, that you put your savings into a $1,000-face-value
Municipal Bond that sells for $1,000 and pays only $80 in coupon
payments. Its interest rate is only 8%, but because it is a tax-exempt
security, you pay no taxes on the $80 coupon payment, so you earn
8% after taxes. Clearly, you earn more on the municipal bond after
taxes, so you are willing to hold the riskier and less liquid municipal
bond even though it has a lower interest rate than the T-Bond.
• This was not true before World War II, when the tax-exempt status
of municipal bonds did not convey much of an advantage because
income tax rates were extremely low. 22
 example - Income Tax Considerations

• Suppose you had the opportunity to buy either a municipal bond or a

corporate bond, both of which have a face value and purchase price of
$1,000. The municipal bond has coupon payments of $60 and a
coupon rate of 6%. The corporate bond has coupon payments of $80
and an interest rate of 8%. Which bond would you choose to
purchase, assuming a 40% tax rate?
• Solution
• You would choose to purchase the municipal bond because it will earn
you $60 in coupon payments and an interest rate after taxes of 6%.
Since municipal bonds are tax-exempt, you pay no taxes on the $60
coupon payments and earn 6% after taxes.
• However, you have to pay taxes on corporate bonds. You will keep
only 60% of the $80 coupon payment because the other 40% goes to
taxes. Therefore, you receive $48 of the coupon payment and have an
interest rate of 4.8% after taxes.
• Buying the municipal bond would yield you higher earnings. 23
 Income Tax Considerations
• Another way to understand why municipal bonds have lower interest
rates than T-Bonds is to use demand/supply analysis as in Figure 5.3.
• We assume that municipal and T-Bonds have identical attributes and
so have the same bond prices as drawn in & the same interest rates.
• Once the municipal bonds are given a tax advantage their after-tax
expected return rises relative to T-Bonds & their demand rises, and
their demand curve shifts to the right, from Dm1 to Dm2.
Figure 5.3

24
 Income Tax Considerations
• The result is that their equilibrium bond price rises from Pm1 to
Pm2 and their equilibrium interest rate falls.
• By contrast, Treasury bonds have now become less desirable
relative to municipal bonds; demand for Treasury bonds decreases,
and DT1 shifts to DT2.
• The Treasury bond price falls from PT1 to PT2 , and the interest
rate rises.
• The resulting lower interest rates for municipal bonds and higher
interest rates for Treasury bonds explain why municipal bonds can
have interest rates below those of Treasury bonds.

25
 Effects of Tax Cut and Tax Increase on Bond Interest Rates
• The Bush tax cut passed in 2001 scheduled a reduction of the top
income tax bracket from 39% to 35% over a 10-year period.
• What was the effect of this income tax decrease on interest rates in
the municipal bond market relative to those in the T-Bond market?
• Our supply-and-demand analysis provides the answer.
• A decreased income tax rate for wealthy people means that the after-
tax expected return on tax-free municipal bonds is lower, relative to
that on Treasury bonds because the interest on Treasury bonds is now
taxed at a lower rate.
• Because municipal bonds now become less desirable, their demand
decreases, shifting the demand curve to the left, which lowers their
price and raises their interest rate.
• Conversely, the lower income tax rate makes Treasury bonds more
desirable; this change shifts their demand curve to the right, raises
their price, and lowers their interest rates. 26
 Effects of Tax Cut and Tax Increase on Bond Interest Rates
• Analysis thus shows that the Bush tax cut raised the interest rates
on municipal bonds relative to the interest rate on Treasury bonds.
• With the Obama tax increase that repealed the Bush tax cuts for
high-income taxpayers in 2013, the analysis would be reversed.
• The Obama tax increase raised the after-tax expected return on tax-
free municipal bonds relative to Treasury bonds.
• Demand for municipal bonds would increase, shifting the demand
curve to the right, which raises their price and lowers their interest
rate.
• Conversely, the higher tax rate would make Treasury bonds less
desirable, shifting their demand curve to the left, lowering their price,
and raising their interest rate.
• The higher tax rates for high-income households put in place by the
Obama administration thus led to lower interest rates on municipal
bonds relative to the interest rate on Treasury bonds. 27
Effects of Tax Cut and Tax Increase on Bond Interest Rates

28
 Summary – risk structure

• The risk structure of interest rates (the relationship among interest

rates on bonds with the same maturity) is explained by three factors:
1. default risk,
2. liquidity, and
3. income tax treatment of a bond’s interest payments.
• As a bond’s default risk increases, the risk premium on that bond
(the spread between its interest rate and the interest rate on a default-
free Treasury bond) rises.
• The greater liquidity of Treasury bonds also explains why their
interest rates are lower than those on less liquid bonds.
• If a bond has a favorable tax treatment, as do municipal bonds,
whose interest payments are exempt from federal income taxes, its
interest rate will be lower.
29
Another factor that influences the interest rate
on a bond is its term to maturity

30
 Term Structure of Interest Rates
The following chart shows movements over time of interest rates on
Government Bonds with different maturities.
Interest rates on bonds of different maturities move together over time.
Figure 5.4

31
 Term Structure of Interest Rates

• We have seen how risk, liquidity, and tax considerations

(collectively embedded in the risk structure) can influence interest
rates.
• Another factor that influences the interest rate on a bond is its
term to maturity.
• Bonds with identical risk, liquidity, and tax characteristics may
have different interest rates because the time remaining to maturity
is different.
• 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.
• The yield curve describes the term structure of interest rates for
particular types of bonds, such as government bonds.

32
 Term Structure of Interest Rates
• The following chart shows several yield curves for Treasury
securities.
• Yield curves can be classified as upward-sloping, flat & downward-
sloping (the last sort is often referred to as an inverted yield curve).
– When yield curves slope upward, the most
usual case, the long-term interest rates are
above the short-term interest rates.
– When yield curves are flat, short &
long term interest rates are the same.
– When yield curves are inverted, long-term
interest rates are below short-term rates.
– Yield curves can also have more complicated
shapes in which they first slope up and
then down, or vice versa.
Why do we usually see upward slopes of 33
 Term Structure of Interest Rates
• Besides explaining why yield curves take on different shapes at different
times, a good theory of the term structure of interest rates must explain the
following three important empirical facts:
1. Interest rates on different maturities bonds move together over time, as
we saw in Figure 5.4.
2. When short-term interest rates are low, yield curves have an upward
slope; when short-term interest rates are high, yield curves are more
likely to slope downward and be inverted.
3. Yield curves almost always slope upward, as shown below

35
 Term Structure of Interest Rates
• Three theories have been put forward to explain the term structure
of interest rates—that is, the relationship among interest rates on
bonds of different maturities reflected in yield curve patterns:
1. The expectations theory
2. The market segmentation theory, and
3. The liquidity premium theory
• Each of these is described in the following sections.
• The expectations theory does a good job of explaining the first two
facts on our list, but not the third.
• The market segmentation theory can account for fact 3 but not the
other two facts, which are well explained by the expectations theory.
• Because each theory explains facts that the other cannot, a natural
way to seek a better understanding of the term structure is to combine
features of both theories, which leads us to the liquidity premium
theory, which can cover all three facts. 36
 Term Structure of Interest Rates

• The liquidity premium theory does a better job of explaining the

facts and is hence the most widely accepted theory.
• If this is so, then why do we spend time discussing the other two
theories?
• There are two reasons.
• First, the ideas in these two theories lay the groundwork for the
liquidity premium theory.
• Second, it is important to see how economists modify theories to
improve them when they find that the predicted results are
inconsistent with the empirical evidence.

37
 Expectations Theory
• The expectations theory of the term structure states the following
commonsense proposition:
• 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 5-years to maturity will be 10%, too.
• If short-term interest rates were expected to rise even higher after this
5-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 be 11%
& higher than the interest rate on 5-year bonds.
• Now we can see that the explanation provided by the expectations theory
for why interest rates on bonds of different maturities differ:
• Because short-term interest rates are expected to have different values
at different future dates. 38
 Expectations Theory
• 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.
• In practice this means, ‘if bonds with different maturities are
perfect substitutes, the expected return on these bonds must be
equal’.
• To see how the assumption that bonds with different maturities are
perfect substitutes leads to the expectations theory, let’s 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.
• Since both strategies must have the same expected return if people are
39
holding both one- & two-year bonds, the interest rate on the two-year
 example - Expectations Theory
• 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?
Solution
• The expected return over the two years will average 10% per year.
• The bondholder will be willing to hold both, one and two-year bonds
only if the expected return per year of the 2-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.

• This equation 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. 40
 Expectations Theory
• The 1-year interest rates over the next 5 years are expected to be 5%,
6%, 7%, 8%, and 9%. Given this information, what are the interest
rates on a 2-year bond and a 5-year bond? Explain what is happening
to the yield curve.

Interest rate on
2-year bond = 7%

Interest rate on
5-year bond =7%
• Using the same equation for the one-, three-, and four-year interest
rates, you will verify the 1-year to 5-year rates as 5.0%, 5.5%, 6.0%,
6.5%, & 7.0%, respectively.
• The rising trend in ST interest rates produces an upward-sloping
41
yield curve along which interest rates rise as maturity lengthens.
 Expectations Theory
• The elegant expectations theory explains why the term structure of
interest rates (represented by yield curves) changes at different times.
• When the yield curve is upward-sloping, the expectations theory
suggests that short-term interest rates are expected to rise in the
future, as we have seen in our numerical example.
• In this situation (upward slope), the long-term rate is currently higher
than the short-term rate, the average of future short-term rates is
expected to be higher than the current short-term rate, which can occur
only if short-term interest rates are expected to rise.
• When the yield curve is inverted (slopes downward), the average of
future short-term interest rates is expected to be lower than the
current short-term rate, implying that short-term interest rates are
expected to fall, on average, in the future.
• Only when the yield curve is flat, expectations theory suggests that
ST interest rates are not expected to change in the future on average.
42
 Expectations Theory
• Expectations theory explains fact 1, which states that interest rates
on bonds with different maturities move together over time.
• Historically, ST interest rates have had the characteristic that if
they increase today, they will tend to be higher in the future. Hence
a rise in ST rates will raise people’s expectations of future ST rates.
• Since LT rates are the average of expected future ST rates, a rise in
ST rates will also raise LT rates, causing ST & LT rates to move
together.
• The expectations theory also explains fact 2, which states that yield
curves tend to have an upward slope when short-term interest rates
are low and are inverted when short-term rates are high.
• When short-term rates are low, people generally expect them to
rise to some normal level in the future, and the average of future
expected short-term rates is high relative to the current short-term rate.
• Therefore, LT interest rates will be substantially higher than
43
current short-term rates, and the yield curve would then have an
 Expectations Theory
• Conversely, if short-term rates are high, people usually expect them
to come back down.
• Long-term rates would then drop below short-term rates because the
average of expected future short-term rates would be lower than
current short-term rates, and the yield curve would slope downward
and become inverted.
• The expectations theory is an attractive theory because it provides a
simple explanation of the behavior of the term structure, but it has a
major shortcoming:
• It cannot explain fact 3, which says that yield curves usually slope
upward.
• The typical upward slope of yield curves implies that short-term
interest rates are usually expected to rise in the future.
• In practice, short-term interest rates are just as likely to fall as they
are to rise, and so the expectations theory suggests that the typical 44
yield curve should be flat rather than upward-sloping.
 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.
• This theory is at opposite extreme to the expectations theory, which
assumes that bonds of different maturities are perfect substitutes.
• 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. 45
 Market Segmentation Theory
• This occurs because they have a particular holding period in mind
& if they match the maturity of the bond to the desired holding
period, they can obtain a sure return with no risk at all. (Ref: Ch 3,
if term to maturity equals the holding period, there is no interest-rate
risk.)
• Conversely, if you’re saving for your child to go to college, your
holding period might be much longer & you would hold LT bonds.
• In market segmentation theory, differing yield curve patterns are
accounted for by supply-and-demand differences associated with
bonds of different maturities.
• If investors desire short holding periods & generally prefer bonds
with shorter maturities that have less interest-rate risk, market
segmentation theory can explain fact 3, which states that yield
curves typically slope upward.
• Because in this typical situation, demand for LT bonds is relatively
lower than ST bonds, LT bonds will have lower prices & higher 46
 Market Segmentation Theory
• Although market segmentation theory can explain why yield curves
usually tend to slope upward, it has a major flaw in that it cannot
explain facts 1 and 2.
• First, because 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).
• 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).
• Because each of our two theories explains empirical facts that the
other cannot, a logical step is to combine the theories, which leads
us to the liquidity premium theory. 47
 Liquidity Premium Theory
• Liquidity premium theory of the term structure states that interest
rate on a LT bond will equal an average of ST rates expected to occur
over the life of the LT bond plus a liquidity or term premium that
responds to supply & demand conditions for that bond.
• Liquidity premium theory’s key assumption is that bonds of different
maturities are substitutes, which means, expected return on one bond
does influence expected return on a bond of a different maturity, but it
allows investors to prefer one bond maturity over another.
• In other words, bonds of different maturities are assumed to be
substitutes, but not perfect substitutes.
• Investors tend to prefer ST 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. 48
 Liquidity Premium Theory
• The liquidity premium theory is thus written as

• where lnt is the liquidity (term) premium for the n-period bond at time
t, which is always positive & rises with term to maturity of bond, n.

Relationship between
expectations theory &
liquidity premium theory

• Here we see that because the liquidity premium is always positive &
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 & generally has a steeper
slope. (Note that for simplicity we are assuming that the
49
expectations theory yield curve is flat.)
 EXAMPLE 5.4 - Liquidity Premium Theory
• As in earlier example 3, let’s suppose that the 1-year interest rates
over the next 5 years are expected to be 5%, 6%, 7%, 8% & 9%.
Investors’ preferences for holding short-term bonds have the liquidity
premiums for 1-year to 5-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? Compare these findings with the answer from
Example 5.3 dealing with the pure expectations theory.
• The interest rate on the two-year bond would be 5.75%.
Equation 3

• The interest rate on the five-year bond would be 8%.

Comparing these findings with those for pure expectations theory, we

can see that liquidity preference theory produces yield curves that
slope more steeply upward because investors prefer ST bonds. 50
 Liquidity Premium Theory
• Let’s see if the liquidity premium theory is consistent with all
three empirical facts we have discussed.
• It explain fact 1, which states that interest rates on different-maturity
bonds move together over time: A rise in short-term interest rates
indicates that short-term interest rates will, on average, be higher in
the future, and the first term in Equation 3 then implies that long-
term interest rates will rise along with them.
• It also explain fact 2, why yield curves tend to have an especially
steep upward slope when short-term interest rates are low and to be
inverted when short-term interest rates are high. Because investors
generally expect short-term interest rates to rise to some normal level
when they are low, the average of future expected short-term rates
will be high relative to the current short-term rate.
• It also explains fact 3, with additional boost of a positive liquidity
premium, LT interest rates will be substantially higher than
current ST rates & yield curve will mostly have a steep upward 51
 Liquidity Premium Theory
• Conversely, if short-term rates are high, people usually expect them to
come back down. LT rates will then drop below short-term rates because
the average of expected future short-term rates will be so far below
current short-term rates that despite positive liquidity premiums, the
yield curve will slope downward.
• Thus, liquidity premium theory also explains fact 3, which states that
yield curves typically slope upward, by recognizing that the liquidity
premium rises with a bond’s maturity because of investors’ preferences
for short-term bonds.
• Even if short-term interest rates are expected to stay the same on
average in the future, LT interest rates will be above short-term interest
rates, and yield curves will typically slope upward.
• Can the liquidity premium theory explain the occasional appearance
of inverted yield curves if the liquidity premium is positive? It must
be that at times ST interest rates are expected to fall so much in the
future that the average of the expected ST rates is well below the
current ST rate. Even when the positive liquidity premium is added
to average, the resulting LT rate will still be lower than the current ST52
 Liquidity Premium Theory
• A particularly attractive feature of the liquidity premium theory is that it tells
you what the market is predicting about future short-term interest rates
just from the slope of the yield curve.
• A steeply rising yield curve, (panel a) indicates that ST interest rates are
expected to rise in the future. A moderately steep yield curve, (panel b),
indicates that ST interest rates are not expected to rise or fall much in the
future. A flat yield curve, (panel c), indicates that ST rates are expected to
fall moderately in the future. Finally, an inverted yield curve, (panel d),
indicates that ST interest rates are expected to fall sharply in the future.

53
 The Yield Curve as a Forecasting Tool for
• Because the yieldInflation
curve contains
and the information about future
Business Cycle
expected interest rates, it should also have the capacity to help
forecast inflation and real output fluctuations.
• To see why, recall from Chapter 4 that rising interest rates are
associated with economic booms and falling interest rates with
recessions.
• When the yield curve is either flat or downward-sloping, it suggests
that future short-term interest rates are expected to fall and, therefore,
that the economy is more likely to enter a recession. Indeed, the
yield curve is found to be an accurate predictor of the business
cycle.
• In Chapter 3, we also learned that a nominal interest rate is
composed of a real interest rate and expected inflation, implying
that the yield curve contains information about both the future path
of nominal interest rates and future inflation.
54
 The Yield Curve as a Forecasting Tool for
• A steep upward-sloping
Inflationyield curve
and the predicts
Business a future increase in
Cycle
inflation, while a flat or downward-sloping yield curve forecasts a
future decline in inflation.
• The ability of the yield curve to forecast business cycles and inflation
is one reason why the slope of the yield curve is part of the toolkit
of many economic forecasters.
• It is often viewed as a useful indicator of the stance of monetary
policy, with a steep yield curve indicating loose policy and a flat or
downward-sloping yield curve indicating tight policy.

55
 Summary
• The liquidity premium theory is the most widely accepted theory of
the term structure of interest rates because it explains the major
empirical facts about the term structure so well.
• It combines the features of both the expectations theory & the market
segmentation theory by asserting that a long-term interest rate will be
the sum of a liquidity (term) premium and the average of the
short-term interest rates that are expected to occur over the life of
the bond.
• The liquidity premium theory explains the following facts:
1. Interest rates on bonds of different maturities tend to move together
over time.
2. Yield curves usually slope upward.
3. When short-term interest rates are low, yield curves are more likely
to have a steep upward slope, whereas when short-term interest
rates are high, yield curves are more likely to be inverted. 56
 Summary
• The theory also helps us predict the movement of short-term interest
rates in the future.
• A steep upward slope of the yield curve means that short-term rates
are expected to rise,
• A mild upward slope means that short-term rates are expected to
remain the same
• A flat slope means that short-term rates are expected to fall
moderately, and
• An inverted yield curve means that short-term rates are expected to
fall sharply.

57
Interpreting Yield Curves, 1980–2016
Figure 5.7

58
 Interpreting Yield Curves, 1980–2016
• Figure 5.7 illustrates several yield curves that have appeared for U.S.
government bonds since 1980.
• What do these yield curves tell us about the public’s expectations of
future movements of short-term interest rates?
• The steep inverted yield curve that occurred on January 15, 1981,
indicated that short-term interest rates were expected to decline
sharply in the future.
• For longer-term interest rates with their positive liquidity premium to
be well below the short-term interest rate, short-term interest rates
must be expected to decline so sharply that their average is far
below the current short-term rate.
• Indeed, the public’s expectations of sharply lower short-term interest
rates evident in the yield curve were realized soon after January 15.
• By early March, three-month Treasury bill rates had declined from59 the
16% level to 13%.
 Interpreting Yield Curves, 1980–2016
• The steep upward-sloping yield curve on March 28, 1985, and
May 17, 2016, indicated that short-term interest rates would climb in
the future.
• The long-term interest rate is higher than the short-term interest
rate when short-term interest rates are expected to rise because their
average plus the liquidity premium will be higher than the current
short-term rate.
• The moderately upward-sloping yield curves on May 16, 1980, and
March 3, 1997, indicated that short-term interest rates were expected
neither to rise nor to fall in the near future.
• In this case, their average remains the same as the current short-term
rate, and the positive liquidity premium for longer-term bonds
explains the moderate upward slope of the yield curve.

60
 Using the Term Structure to Forecast Interest Rates
• Interest-rate forecasts are extremely important to managers of
financial institutions.
• Our discussion of the term structure of interest rates has indicated that
the slope of the yield curve provides general information about the
market’s prediction of the future path of interest rates.
• However, a financial institution manager needs much more specific
information on interest-rate forecasts than this.
• To see how this is done, recall that under pure expectations theory,
which states that because bonds of different maturities are perfect
substitutes, we assumed that the expected return over two periods
from investing $1 in a two-period bond, which is
, must equal the expected return from investing $1 in one-
period bonds, which is . This is shown
graphically as follows:
•
61
 Using the Term Structure to Forecast Interest Rates
• In other words,

• Through some tedious algebra we can solve for :

• This measure of iet+1 is called the forward rate because it is the one-
period interest rate that the pure expectations theory of the term
structure indicates is expected to prevail one period in the future. (To
differentiate forward rates derived from the term structure from actual
interest rates that are observed at time t, we call these observed
interest rates spot rates).
• Going back to Example 3, which we used to discuss the pure
expectations theory earlier in this chapter, at time t the one-year
interest rate is 5% and the two-year rate is 5.5%. Plugging these
numbers into Equation 4 yields the following estimate of the forward
rate one period in the future:
62
 Using the Term Structure to Forecast Interest Rates
• Not surprisingly, this 6% forward rate is identical to the expected one-
year interest rate one year in the future that we used in Example 3.
• This is exactly what we should find, as our calculation here is just
another way of looking at the pure expectations theory.
• We can also compare holding the three-year bond against holding a
sequence of one-year bonds as
• And so on for nth period
• Because investors must be compensated with liquidity premiums to
induce them to hold longer-term bonds, we need to modify our
analysis, by allowing for liquidity premiums in estimating predictions
of future interest rates.
• The n-period interest rate differs from that indicated by the pure
expectations theory by a liquidity premium of lnt. In the case of
iet+1, Equation 6 produces the following estimate:
63
 Forward Rate - Using the Term Structure to Forecast Interest Rates
• A customer asks a bank if it would be willing to commit to making the
customer a one-year loan at interest rate of 8% one year from now.
• To compensate for the costs of making the loan, the bank needs to charge
1% more than the expected interest rate on a T-Bond with the same maturity
if it is to make a profit. If the manager estimates liquidity premium to be
0.4%, & 1-year T-Bond rate is 6% & 2-year bond rate is 7%, should the
manager make the commitment?

• Solution

• Thus 64
 Forward Rate - Using the Term Structure to Forecast Interest Rates
• The market’s forecast of the one-year T-Bond rate one year in the
future is 7.2%.
• Adding the 1% necessary to make a profit on the one-year loan means
that the loan is expected to be profitable only if it has an interest rate
of 8.2% or higher.
• The bank manager is unwilling to make the loan because at an interest
rate of 8%, the loan is likely to be unprofitable to the bank.
• As we will see in Chapter 6, the bond market’s forecasts of interest
rates may be the most accurate ones possible.
• If this is the case, the estimates of the market’s forecasts of future
interest rates using the simple procedure outlined here may be the best
interest-rate forecasts that a financial institution manager can obtain.

65
 overall summary
1. Bonds with the same maturity will have different interest rates
because of three factors: default risk, liquidity & tax considerations.
The greater a bond’s default risk, the higher its interest rate relative to
other bonds;
The greater a bond’s liquidity, the lower its interest rate; and
bonds with tax-exempt status will have lower interest rates than they
otherwise would.
The relationship among interest rates on bonds with the same maturity
that arise because of these three factors is known as the risk structure
of interest rates.

66
 overall summary
2. Several theories of the term structure provide explanations of how
interest rates on bonds with different terms to maturity are related.
The expectations theory views long-term interest rates as equaling the
average of future short-term interest rates expected to occur over the
life of the bond.
By contrast, the market segmentation theory treats the determination
of interest rates for each bond’s maturity as the outcome of supply and
demand in that market only.
Neither of these theories by itself can explain the fact that interest
rates on bonds of different maturities move together over time and
that yield curves usually slope upward.

67
 overall summary
3. The liquidity premium theory combines the features of the other two
theories and, by so doing, is able to explain the facts just mentioned.
It views long-term interest rates as equaling the average of future short-
term interest rates expected to occur over the life of the bond plus a
liquidity premium.
This theory allows us to infer the market’s expectations about the
movement of future short-term interest rates from the yield curve.
A steeply upward-sloping curve indicates that future short-term rates are
expected to rise; a mildly upward-sloping curve that short-term rates are
expected to stay the same;
a flat curve that short-term rates are expected to decline slightly; and
an inverted yield curve that a substantial decline in short-term rates is
expected in the future.
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