Part 2

Fundamentals of
Financial Markets
LECTURE 3

Chapter 5

How Do The Risk and Term

Structure Affect Interest Rates

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 Chapter Preview

• In this chapter, we will examine the

different rates that we observe for financial
products.
• We will fist examine bonds that offer similar
payment streams but differ in price.
• The price differences are due to the risk
structure of interest rates.
• We will examine in detail what this risk
structure looks like and ways to examine it.
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 Chapter Preview

Next, we will look at the different rates required

on bonds with different maturities.
• That is, we typically observe higher rates on
longer-term bonds.
• This is known as the term structure of interest
rates.
• To study this, we usually look at Treasury bonds
to minimize the impact of other risk factors.

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 Chapter Preview

• So, in sum, we will examine how the individual

risk of a bond affects its required rate.
• We also explore how the general level of interest
rates varies with the maturity of the debt
instruments.
• Topics include:
– Risk Structure of Interest Rates
– Term Structure of Interest Rates

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 Risk Structure of Interest Rates

• To start this discussion, we first examine

the yields for several categories of long-
term bonds over the last 85 years.
• You should note several aspects regarding
these rates, related to different bond
categories and how this has changed
through time.

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 Risk Structure
of Long Bonds in the U.S.

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 Risk Structure
of Long Bonds in the U.S.

The figure show two important features of

the interest-rate behavior of bonds.

1. Rates on different bond categories

change from one year to the next.

2. Spreads on different bond categories

change from one year to the next.

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 Factors Affecting Risk Structure
of Interest Rates

To further examine these features, we will

look at three specific risk factors.

• Default Risk

• Liquidity

• Income Tax Considerations

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 Default Risk Factor
• 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 to make
interest payments when promised.
• Government Treasury bonds/Government
Securities have usually been considered to have
no default risk because the federal government
can always increase taxes to pay off its
obligations (or just print money).
– Bonds like these with no default risk are called default-
free bonds.
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 Default Risk Factor (cont.)

• The spread between the interest rates on bonds

with default risk and default-free bonds, called
the risk premium, indicates how much
additional interest people must earn in order to
be willing to hold that risky bond.

• A bond with default risk will always have a

positive risk premium, and an increase in its
default risk will raise the risk premium.

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 Think…..
• We can show the risk premium on bonds using
the S & D for Bonds framework
– We start by assuming that initially corporate bonds have
the same default risk as T-bonds. Their equilibrium price
and interest yield will be equal (assume that risk and
maturity are identical).
• If we now make the more realistic assumption that
the corporate bond is more risky than the T-
bond, what would happen to the demand for
corporate bonds, price and interest rate?
• What would happen to the demand for T-bonds,
price and interest rate?
Increase in Default Risk on Corporate Bonds

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 Figure 5.2: Increase in Default Risk
on Corporate Bonds
Price of bond

Price of bond
Risky Market Default-Free Market

ST

iT2 P2T
Sc

Risk P1T
P1c Premium

P2c iC2
D2T
D1c
D2c D1T

Qty of Corporate bond Qty of Treasury Bond

 Analysis of Figure 5.2: Increase in
Default on Corporate Bonds
• Corporate Bond Market
1. Re on corporate bonds , Dc , Dc shifts left
2. Risk of corporate bonds , Dc , Dc shifts left
3. Pc , ic 
• Treasury Bond Market
4. Relative Re on Treasury bonds , DT , DT shifts right
5. Relative risk of Treasury bonds , DT , DT shifts right
6. PT , iT 
• Outcome
– Risk premium, ic - iT, rises
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 Default Risk Factor (cont.)

• Default risk is an important component of the

size of the risk premium.
• Because of this, bond investors would like to
know as much as possible about the default
probability of a bond.
• One way to do this is to use the measures
provided by credit-rating agencies:
– Moody’s and Standard & Poor (U.S)

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Bond Ratings

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 Case: The Subprime Collapse and the
Baa-Treasury Spread

• Starting in 2007, the subprime mortgage market

collapsed, leading to large losses for financial
institutions.
• Because of the questions raised about the quality
of Baa bonds, the demand for lower-credit bonds
fell, and a “flight- to-quality” followed (demand for
T-securities increased).
• Result: Baa-Treasury spread increased from 185
bps to 545 bps.
 Liquidity Factor

• Another attribute of a bond that influences

its interest rate is its 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 (higher demand), holding everything else
constant.
• Let’s examine what happens if a corporate
bond becomes less liquid.
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 Decrease in Liquidity
of Corporate Bonds

Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds

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 Analysis of Figure 5.1: Corporate Bond
Becomes Less Liquid
• Corporate Bond Market
1. Liquidity of corporate bonds , Dc , Dc shifts left
2. Pc , ic 
• Treasury Bond Market
1. Relatively more liquid Treasury bonds, DT , DT shifts
right
2. PT , iT 
• Outcome
– Risk premium, ic - iT, rises
• Risk premium reflects not only corporate bonds'
default risk but also lower liquidity
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 Liquidity Factor (cont.)

• 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.

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 Income Taxes Factor

• Municipal bonds tend to have a lower

rate than the Treasuries. Why?
• Munis certainly can default. Orange County
(California) is a recent example from the
early 1990s.
• Munis are not as liquid a Treasuries.

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 Income Taxes Factor

• 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.

• Treasury bonds are exempt from state and

local income taxes, while interest payments
from corporate bonds are fully taxable.
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 Income Tax Considerations
• Assume you are in the 35% income tax bracket.
• If you own a $1000 face value US Treasury bond
that has a coupon payment of $100, you will get
$65 of the payment after taxes.
– Although the bond has a 10% interest rate, you
actually earn 6.5% after taxes.
• Suppose you put you money into a $1000 face
value municipal bond that pays only $80 in
coupon payments.
– Although the interest rate is only 8%, but because it is
tax-exempt, you earn 8% after taxes.
• You earn more on the municipal bond.
Tax Advantages of Municipal Bonds

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 Analysis of Figure 5.3:
Tax Advantages of Municipal Bonds
• Municipal Bond Market
1. Tax exemption raises relative Re on municipal bonds,

Dm , Dm shifts right
2. Pm 
• Treasury Bond Market
1. Relative Re on Treasury bonds , DT , DT shifts left
2. PT 
• Outcome
im < iT

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 Exercise:
• 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 $1000.
• 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?
• Municipal bonds are tax exempted, however have
to pay taxes on corporate bonds, assuming a 40%
tax rate.
Solution:
 Term Structure of Interest Rates

Now that we understand risk, liquidity, and

taxes, we turn to another important
influence on interest rates – maturity.
Bonds with different maturities tend to have
different required rates, all else equal.

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 Yield Curve

• The yield curve graphically depicts the term

structure of interest rates.
– The length of time to maturity is on the
horizontal axis and the yield on the vertical
axis.
– Each point on a curve corresponds to the yield
on a given day of a particular type of bond for a
particular maturity date.
– Figure 5.7
 Term Structure Facts to Be Explained

Besides explaining the shape of the yield

curve, a good theory must explain why:
Fact 1:
• Interest rates for different maturities
move together. We see this on the next
slide.

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Interest Rates on Different Maturity
Bonds Move Together

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 Term Structure Facts to Be Explained

Besides explaining the shape of the yield curve, a

good theory must explain 3 facts. why:
1. Interest rates for different maturities
move together.
2. Yield curves tend to have steep upward slope
when short rates are low and downward slope
when short rates are high.
3. Yield curve is typically upward sloping.

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 Three Theories of Term Structure
A. Expectations Theory
– Pure Expectations Theory explains Facts 1
and 2, but not 3
B. Market Segmentation Theory
– Market Segmentation Theory explains 3, but
not 1 and 2
C. Liquidity Premium Theory
– Solution: Combine features of both Pure
Expectations Theory and Market
Segmentation Theory to get Liquidity
Premium Theory and explain all facts
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 Expectations Theory

• Key Assumption: Bonds of different

maturities are perfect substitutes
• Implication: Expected return, Re on
bonds of different maturities are equal

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 Expectations Theory

To illustrate what this means, consider two

alternative investment strategies for a two-
year time horizon.
– Strategy 1: Buy $1 of one-year bond, and
when it matures, buy another one-year
bond with your money.
– Strategy 2: Buy $1 of two-year bond and
hold it.

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 Expectations Theory

The important point of this theory is that if

the Expectations Theory is correct, your
expected wealth is the same (a the start)
for both strategies. Of course, your actual
wealth may differ, if rates change
unexpectedly after a year.
We show the details of this in the next few
slides.
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 Expectations Theory

• Expected return from strategy 1

e e e
(1  it )(1  i )  1 1  it  i
t 1 t 1
 it (i )  1
t 1

Since it(iet+1) is also extremely small,

expected return is approximately
it + iet+1

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 Expectations Theory

• Expected return from strategy 2

(1  i2t )(1  i2t )  1 1  2(i2t )  (i2t )2  1

Since (i2t)2 is extremely small, expected

return is approximately 2(i2t)

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 Expectations Theory

• From implication above expected returns of two

strategies are equal
• Therefore

2i2t it  i e
t 1

Solving for i2t

it  ite1 (1)
i2t 
2
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 Expectations Theory

• To help see this, here’s a picture that

describes the same information:

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 Example 5.2: Expectations Theory

• This is an example, with actual #’s:

 More generally for n-period bond…

it  it 1  it  2  ...  it  n 1
int  (2)
n
• Don’t let this seem complicated. Equation
2 simply states that the interest rate on a
long-term bond equals the average of short
rates expected to occur over life of the
long-term bond.

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 Exercise 1:
More generally for n-period bond…

• The one-year interest rates over the next

five years are expected to be 5%, 6%, 7%,
8%, and 9%.
• Given this information,
a) What are the interest rates on a two-years
bond and a five-years bond?
b) Explain what is happening to the yield curve?
 Answer for Exercise 1:
More generally for n-period bond…

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 Answer for Exercise 1:
More generally for n-period bond…

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 Expectations Theory
and Term Structure Facts

• Explains why yield curve has different slopes

1. When short rates are expected to rise in future,
average of future short rates = int is above
today's short rate; therefore yield curve is
upward sloping.
2. When short rates expected to stay same in
future, average of future short rates same as
today's, and yield curve is flat.
3. Only when short rates expected to fall will yield
curve be downward sloping.
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 Expectations Theory
and Term Structure Facts

• Pure expectations theory explains fact 1

—that short and long rates move together
1. Short rate rises are persistent
2. If it  today, iet+1, iet+2 etc.  
average of future rates   int 
3. Therefore: it   int 
(i.e., short and long rates move together)

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 Expectations Theory
and Term Structure Facts

• Explains fact 2—that yield curves tend to have

steep slope when short rates are low and
downward slope when short rates are high
1. When short rates are low, they are expected to rise
to normal level, and long rate = average of future
short rates will be well above today's short rate;
yield curve will have steep upward slope.
2. When short rates are high, they will be expected to
fall in future, and long rate will be below current
short rate; yield curve will have downward slope.

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 Expectations Theory
and Term Structure Facts

• Doesn't explain fact 3—that yield curve

usually has upward slope
– Short rates are as likely to fall in future as rise,
so average of expected future short rates will
not usually be higher than current short rate:
therefore, yield curve will not usually
slope upward.

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 Market Segmentation Theory

• Key Assumption: Bonds of different

maturities are not substitutes at all

• Implication: Markets are completely

segmented; interest rate at each maturity
are determined separately
 Market Segmentation Theory

• Explains fact 3—that yield curve is usually

upward sloping
– People typically prefer short holding periods and
thus have higher demand for short-term bonds,
which have higher prices and lower interest rates
than long bonds

• Does not explain fact 1or fact 2 because

its assumes long-term and short-term rates
are determined independently.

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 Liquidity Premium Theory

• Key Assumption: Bonds of different

maturities are substitutes, but are not
perfect substitutes

• Implication: Modifies Pure Expectations

Theory with features of Market
Segmentation Theory
 Liquidity Premium Theory

• Investors prefer short-term rather than

long-term bonds.

• This implies that investors must be

paid positive liquidity premium, int, to
hold long term bonds.

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 Liquidity Premium Theory

• Results in following modification of Expectations

Theory, where lnt is the liquidity premium.

e e e
it  i
t 1 i
t2  ...  i
t  n 1
int   nt (3)
 n
• We can also see this graphically…

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Liquidity Premium Theory

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 Numerical Example

1. One-year interest rate over the next five

years: 5%, 6%, 7%, 8%, and 9%
2. Investors' preferences for holding short-
term bonds so liquidity premium for one-
to five-year bonds: 0%, 0.25%, 0.5%,
0.75%, and 1.0%

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 Numerical Example

• Interest rate on the two-year bond:

Risk
Premium
0.25% + (5% + 6%)/2 = 5.75%
• Interest rate on the five-year bond:
1.0% + (5% + 6% + 7% + 8% + 9%)/5 = 8%
• Interest rates on one to five-year bonds:
5%, 5.75%, 6.5%, 7.25%, and 8%
• Comparing with those for the pure expectations
theory, liquidity premium theory produces yield
curves more steeply upward sloped

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 Liquidity Premium Theory:
Term Structure Facts

• Explains All 3 Facts

– Explains fact 3—that usual upward sloped
yield curve by liquidity premium for
long-term bonds
– Explains fact 1 and fact 2 using same
explanations as pure expectations theory
because it has average of future short rates as
determinant of long rate

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Market
Predictions
of Future
Short Rates

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 Case: Interpreting Yield Curves

• The picture on the next slide illustrates

several yield curves that we have observed
for U.S. Treasury securities in recent years.
• What do they tell us about the public’s
expectations of future rates?

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Case: Interpreting Yield Curves, 1980–2010
 Case: Interpreting Yield Curves

• The steep downward curve in 1981

suggested that short-term rates were
expected to decline in the near future. This
played-out, with rates dropping by 300 bps
in 3 months.
• The upward curve in 1985 suggested a
rate increase in the near future.

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 Case: Interpreting Yield Curves

• The slightly upward slopes in the

remaining years can be explained by
liquidity premiums.
– Short-term rates were stable, with longer-term
rates including a liquidity premium (explaining
the upward slope).

• The steep upward slope in 2010 suggests

short term rates in the future will rise.
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 Mini-case: The Yield Curve as a
Forecasting Tool

• The yield curve does have information

about future interest rates, and so it should
also help forecast inflation and real output
production.
– Rising (falling) rates are associated with
economic booms (recessions).
– Rates are composed of both real rates and
inflation expectations.

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The Practicing Manager: Forecasting Interest
Rates with the Term Structure

• Pure Expectations Theory: Invest in 1-period bonds

or in two-period bond 
1  it 1  ite1  1 1 i2t 1  i2t  1
Solve for forward rate, iet+1
 2t 
2
e 1  i (4)
it 1  1
1  it • Identical to the
expected one-year
interest rate one year
Numerical example: i1t = 5%, i2t = 5.5% in the future that we
use in Example.
e 1  0.0552
it 1   1 0.06 6% • Just another way of
1  0.05 looking at the PE
theory.
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 Forecasting Interest Rates
with the Term Structure

• Compare 3-year bond versus 3 one-year bonds

1  it 1  ite1 1  ite2  1 1  i3t 1 i3t 1  i3t  1

Using iet+1 derived in (4), solve for iet+2

e 1  i3t 3

i  2  1
1 i2t 
t 2

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 Forecasting Interest Rates
with the Term Structure

• Generalize to:
e 1 in1t  n 1

i  n 1 (5)
1  int 
t n

Liquidity Premium Theory: int - = same as pure

expectations theory; replace int by int - in (5)
to get adjusted forward-rate forecast

e 1 in1t  n 1t  n1

i  n 1 (6)
1 int  nt 
t n

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 Forecasting Interest Rates
with the Term Structure

• Numerical Example
2t = 0.25%, 1t=0, i1t=5%, i2t = 5.75%

1  0.0575  0.00252
ite1   1 0.06 6%
1  0.05
• Same as expected
rate use in Example.

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 Example 5.5: Forecasting Interest Rates
with the Term Structure
• A customer asks a bank if it would be willing to
commit to making the customer a one-year loan
at an interest rate of 8% one year from now.
• To compensate for the costs of making loan, the
bank needs to charge 1% more than expected
interest rate on a Treasury bond with same
maturity if it is to make a profit.
• If the bank estimates the liquidity premium to be
0.4% and the one-year TB rate is 6% and the
two-year bond rate is 7%, should the manage be
willing to make the commitment?
 Example 5.5: Forecasting Interest Rates
with the Term Structure

Solution:
The bank is unwilling.
e 1 in1t  n 1t 
n1

i  1 n
1 int  nt 
t n

Example: 1-year loan next year
T-bond + 1%, 2t = 0.4%, i1t = 6%, i2t = 7%
1  0.07  0.0042
ite1   1 0.072 7.2%
1  0.06
Loan rate must be > 8.2%
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 Chapter Summary

• Risk Structure of Interest Rates: We

examine the key components of risk in
debt: default, liquidity, and taxes.
• Term Structure of Interest Rates: We
examined the various shapes the yield
curve can take, theories to explain this, and
predictions of future interest rates based on
the theories.

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