More on Long-Term Interest Rates: Term Premia, Risk Premia, and Collateral

Question 1

Definition of term premium

Answer 1

the additional yield that investors demand for holding a longer-term bond compared to a shorter-term bond with the same credit risk. This premium compensates investors for the increased risk associated with holding a bond for a longer period.
expectations theory suggests that the yield curve should only shape upwards if markets anticipate increasing short-term interest rates. However, the yield curve almost always slopes upwards, implying that markets cannot consistently predict rising short rates.
To account for this discrepancy, term premium is used. A positive term premium is added to the model, acknowledging that investors require a higher return for holding longer-term bonds. This premium helps explain why the yield curve typically slopes upwards, even when market expectations for future short-term rates are not necessarily increasing.

Question 2

What are the factors affecting the riskiness of short term loans

Answer 2

• Short-Term Bonds -
  Lower Interest Rate Risk: Short-term bonds are less sensitive to changes in interest rates compared to long-term bonds. If interest rates rise, the value of a short-term bond will decline by a smaller amount than the value of a long-term bond
  Lower Inflation Risk: The guaranteed pay out for bonds is usually nominal, meaning it doesn’t account for inflation. Short-term bonds are less affected by unexpected inflation because their interest rates tend to adjust more quickly to inflation compared to long-term bonds. A strategy of “rolling over” short-term bonds as they mature can help mitigate inflation risk
  General Factors:
• Default Risk: All bonds are subject to some level of default risk, which is the risk that the issuer will fail to make interest payments or repay the principal at maturity
• Credit Risk: the risk that the bond issuer’s creditworthiness will deteriorate,.
• Liquidity risk: refers to the ease with which a bond can be bought or sold in the market without significantly affecting its price.

Question 3

Yield curve inversion as a signal of recession

Answer 3

The yield curve is a graph that plots the interest rates of bonds with different maturities but the same credit risk. Typically, the yield curve slopes upward, meaning long-term bonds have higher interest rates than short-term bonds.
When the yield curve slopes downward, it is called an inverted yield curve, and this is considered a strong signal that financial markets believe short-term interest rates are going to decline.
An inverted yield curve often precedes a recession because markets anticipate the central bank lowering interest rates to stimulate the economy during a downturn, potentially due to an anticipated recession.

Question 4

How do default risk and the value of collateral affect interest rates?

Answer 4

• Default risk influences interest rates: lenders typically charge higher interest rates to borrowers with higher default risk to compensate for the increased likelihood of loss
• Collateral impacts interest rates - Loans secured by valuable collateral usually have lower interest rates than unsecured loans because the lender faces less risk - formulas for both in lecture notes

Question 5

Why do some types of household borrowing have higher interest rates than others?

Answer 5

The higher the chance of default the higher the interest rate.
Household borrowing has varying changes of default thus varying interest rates
:Credit Cards: These typically carry the highest rate among household borrowings. This is attributed to several factors:
- No collateral: credit card debt is usually unsecured, meaning borrowers don’t pledge any specific asset as collateral. This lack of collateral increases the lender’s risk in case of default.
Flexible Repayment: Credit cards often have minimal monthly payment requirements and no fixed repayment schedule. This flexibility can attract irresponsible borrowers who may struggle to manage debt and increase the risk of default.
:Personal Loans: These generally have lower interest rates than credit cards but higher than car loans or mortgages.
- No collateral: Personal loans are also typically unsecured, exposing lenders to higher default risk compared to secured loans
- Repayment Schedule: Personal loans usually have a structured repayment schedule with fixed monthly instalments reducing the likelihood of default.
:Car Loans: these have relatively lower interest rates compared to credit cards and personal loans
- Repayment Schedule: Similar to personal loans, car loans typically have a fixed repayment schedule, contributing to responsible debt management and reducing default risk
:Mortgages: these have the lower interest rates among the four types of household borrowing.
- Reluctance to default

Question 6

The cyclical behaviour of risk spreads

Answer 6

Risk spreads - which represent the difference in yield between risky bonds and risk-free bonds, exhibit cyclical patterns.
Higher-rated firms, such as those with an AAA rating, are perceived as having lower default risk, while lower-related
BAA-rated corporate bonds have higher yields than AAA-rated bonds, This difference in yield reflects the risk spread.
Risk spreads exhibit cyclical behaviour, influenced by economic cycles, investor behaviour, and monetary policy. Wider spreads typically occur during periods of heightened risk and economic downturns, while narrower spreads are associated with lower risk and economic expansions.
- Wider spreads - heightened risk and economic downturns
- Narrower spreads - lower risk and economic expansions

Question 7

The “credit channel” of monetary policy

Question 8

What are the factors affecting the riskiness of short and long-term bonds

Answer 8

• Higher Interest Rate Risk: Long-term bonds are more sensitive to interest rate changes. If interest rates rise, the value of a long-term bond will fall more than the value of a short-term bond. This is because the bond’s fixed interest payments become less attractive compared to newly issued bonds with higher interest rates. This risk is especially relevant for investors with shorter time horizons or who may need to liquidate assets quickly
• Higher Inflation Risk: Because the guaranteed pay out of long-term bonds is typically nominal, they can be negatively affected by unexpected inflation. If inflation is higher than expected, the purchasing power of the bond’s future payments will be eroded
  General Factors:
• Default Risk: All bonds are subject to some level of default risk, which is the risk that the issuer will fail to make interest payments or repay the principal at maturity
• Credit Risk: the risk that the bond issuer’s creditworthiness will deteriorate,.
• Liquidity risk: refers to the ease with which a bond can be bought or sold in the market without significantly affecting its price.
  Long-term bonds generally carry greater risk than short-term bonds, primarily due to their higher interest rate risk and inflation risk.