3. Risk and Term Structure of Interest Rates Flashcards
Why can bonds with the same maturity have different interest rates?
- Default risk probability of the issuer not pay
- Liquidity relative ease converted into cash.
- Other transaction costs; e.g. income tax.
How does expected income tax affect the quantity demand at each bond price?
- Expected income tax increases, causes decrease in quantity demanded for the bond at each price. Leading to a lower price in bonds.
Risk Structure Analysis (Corporate Bonds and Treasury Bonds Relationship)
- An increase in default risks shifts the demand curve for corporate bonds inwards.
- Therefore, shifts the demand curve for treasury bonds outwards.
- Therefore raising the price of treasury bonds and lowers the price of corporate bonds and therefore lowers interest rate on treasury bonds and raises rate of corporate bonds, thereby increasing the spread between interest rates on corporate versus treasury bonds.
- Risk premium is the difference between the decrease in price of corporate bonds and the new increased price of treasury bonds.
Income Tax Factor on the Bond Market (S&D Analysis) (Municipal Bonds and Treasury Bonds)
- Tax-free status shifts the demand for municipal bonds to the right.
- Shifts the demand for treasury bonds to the left.
- With the result that municipal bonds end up higher price and a lower interest rate than treasury bonds.
Term Structure of Interest Rates Definition
Bonds with similar characteristics (risk, liquidity, tax) but differing in maturity.
Yield Curve Definition
- A plot of the yield on similar bonds (risk, liquidity, tax) against their different terms to maturity.
What should the theory term structure explain?
- Interest rates of different maturities move together over time.
- Yield curves tend to have steep upward slope when short rates are low and downward (/inverted) slope when short rates are high.
- Yield curves are mostly upwards sloping.
What are the three candidate theories for term structure of interest rates?
- Expectations Theory
- Segmented Markets Theory
- Liquidity Premium Theory
What does Expectations Theory explain?
- Explains interest rates of different maturities move together over time.
- Explains yield curves tend to have steep upward slop when short rates are low and downward (inverted) slope when short rates are high.
What does segmented markets theory explain?
Explains how yield curves are mostly upwards sloping.
What does liquidity premium theory explain?
- Interest rates of different maturities move together over time.
- Yield curves tend to have steep upward slope when short rates are low and downward (/inverted) slope when short rates are high.
- Yield curves are mostly upwards sloping.
Assumptions for Pure Expectations Theory
- Consider investors choosing similar bonds with different maturities.
- Bonds with different maturities are perfect substitutes.
- Investors only consider the expected interest returns.
- Implication: the long-term rate equals the average of short-term rates covering the same accrual period.
Segmented Markets Theory Assumptions
- Consider investors choosing similar bonds with different maturities.
- Bonds with different maturities are not substitutable.
- Interest rate for a given maturity is determined by the S&D of the corresponding bond.
- Investors have preferences over the bonds with different maturities.
- Implication: interest rates are determined separately.
- Segmented markets theory can explain why yield curves usually slope upwards.
Liquidity Premium & Preferred Habitat Theories Assumptions
- Bonds with different maturities are imperfect substitutes.
- Investors consider the expected interest returns.
- Investors have preferences of short-term bonds over the longer-terms ceteris paribus.
- Implication: Incorporate segmented markets theory with pure expectations theory.
What is income tax?
- Considered a Transaction Cost
