Chapter 6: The Risk and the Term Structure of Interest Rates Flashcards
The Risk Structure of Interest Rates
- Default Risk
- Liquidity
- (Income Tax considerations)
Term Structure of Interest Rates
- Expectations Theory
- Segmented Markets Theory
- Liquidity Premium and Preferred Habitat Theories
- Evidence on the Term Structure
Bonds with the same maturity have different interest rates due to
- Default risk
- Liquidity
- Tax considerations
Default
when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures
-> A bond with default risk will always have a positive risk premium, and an increase in its default risk will raise the risk premium
• Risk premium
the spread between the interest rates on bonds with
default risk and the interest rates on (same maturity) Treasury bonds
Credit rating agencies
• Investor advisory firms that rate the quality of corporate and municipal bonds in terms of their probability to default
- Who? Moody’s Investor Service, Standard and Poor’s Corporation and Fitch Ratings
- Typology: Investment-grade versus speculative grade (junk) bonds
Liquidity (def + variables)
the relative ease with which an asset can be converted into cash
- More liquid assets are more desirable (holding all else constant)
- Cost of selling a bond
- Number of buyers/sellers in a bond market
Yield Curve:
- a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
- Describes the term structure of interest rates for particular types of bonds, eggovernment bonds
Classification of Yield curves
- Upward-sloping: long-term rates are above short-term rates
- Flat: short- and long-term rates are the same
- Downward-sloping or Inverted: long-term rates are below short-term rates
The theory of the term structure of interest rates must explain the following facts:
- Interest rates on bonds of different maturities move together over time.
- 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.
- Yield curves almost always slope upward.
Term Structure of Interest Rates
- Three theories to explain the three facts:
- Expectations theory explains the first two facts but not the third.
- Segmented markets theory explains the third fact but not the first two.
- Liquidity premium theory combines the two theories to explain all three facts.
Expectations Theory
- Common sense proposition:
• The interest rate on a long-term bond will equal an average of the shortterm interest rates that people expect to occur over the life of the long-term bond.
Expectations Theory
- Key Assumption
- 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.
- Or: Bond holders consider bonds with different maturities to be perfect substitutes.
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)
Segmented Markets Theory
- What?
Theory sees markets for different-maturity bonds as completely separate and segmented. The interest rate on a bond of a particular maturity is determined by the supply of and demand for that bond, and is not affected by expected returns on other bonds with other maturities
