Topic 5 – Term and Risk Structures of Interest Rates Flashcards
Yield on bond
return on bond when the bond is held until maturity.
the total return on an investment, comprising interest received, and any capital gain (or loss).
Interest rate (coupon rate)
on bond to maturity is known when issued but yield on bond may not be known because it depends on future interest rates
Bond sold before maturity date may incur
capital gain or loss.
Term Structure of Interest Rates
The relationship between interest rates and terms to maturity for debt instruments in the same risk class
Yield Curve
is a graph, at a point in time, of yields on an identical security with different terms to maturity
RISK STRUCTURE OF INTEREST RATES
The relationship between interest rates and default risk for debt instruments in the same maturities
There are four types of Yield Curves
Normal / Positive
Inverse / Negative
Humped
Flat
Normal / Positive Yield Curve
Long-term interest rates are higher than short-term rates
Upward Sloping
Inverse (Negative) Yield Curve
Long-term interest rates are lower than short-term rates
Downward Sloping
Possible in periods of tight liquidity or contractionary monetary policy
Flat Yield Curve
A flat yield curve means that the yield to maturity on all debt instruments (for example, govt securities) is the same.
Humped Yield Curve
The shape of the yield curve changes over time from being a normal curve to being an inverse curve.
i - Short-term bond with lower interest rate (high demand for short-term bond);
ii - Medium-term bond with higher interest rate;
iii - Long-term bond with lower interest rate (higher demand for long-term bond).
The fact that the shape of the yield curve changes over time suggests that
monetary policy interest rate changes are not the only factor affecting interest rates.
There are three theories that explain the term structure of interest rates
The Expectation Theory
The Segmented Markets Theory
The Liquidity Premium Theory
Expectations Theory
A theory that explains the shape of a yield curve through current and future short term interest rates.
Assumptions of the Expectations Theory
1 - Large number of financial investors with homogenous expectations about future values of short term interest rates;
2 - No transaction costs;
3 - No impediments;
4 - Bonds with different maturities are PERFECT SUBSTITUTES.
The Expectation Theory: Shapes of Yield Curves (normal_
result from expectations that future short-term rates will be higher than current short-term rates.
The Expectation Theory: Shapes of Yield Curves (inverse)
Will result if the market expects future short-term rates to be lower than current short-term rates.
The Expectation Theory: Shapes of Yield Curves (humped)
Investors expect short-term rates to rise in the future but to fall in subsequent periods.
The Segmented Markets Theory
All bonds are not perfect substitutes; investor have preferences when investing in short or longer term bonds
The Segmented Markets Theory (Assumptions)
- Bonds of different maturities are not substitutes at all.
2. Bonds may only be substitutes within certain time frames
How does the segmented markets theory reject the expectations theory
Rejects the expectations theory assumption that all bonds are perfect substitutes, or that investors are indifferent between holding short-term and longer-term securities
Implication of Segmented Markets Theory
Markets are completely segmented - Interest rate at each maturity are determined separately.
The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond with no effects from expected returns on other bonds with other maturities.
Implication of Segmented Markets Theory Assumptions
- Investors have particular holding period in their mind.
- If they match the maturity of the bond to the desired holding period, they can obtain a certain return with reduced risk.
Segmented Markets Theory: Yield Curve slopes up
because demand for short-term (ST) bonds is relatively higher than long-term (LT) bonds
Segmented Markets Theory: Yield Curve slopes down
would indicate that the demand for LT bonds is relatively higher, thus lower yield.
Suppose the Central Bank sold Treasury bonds with one-year to maturity in the market.
What would be the outcome under this theory?
- The price of short-term bonds would decline and the yield curve would lift.
- Since short-term bonds are not substitutes of medium to long-term bonds, the yield of medium to long-term bonds will not be affected according to this theory.
The Liquidity Premium Theory
Investors prefer short term securities; investors prefer short term securities and therefore require compensation to invest longer term
Liquidity Premium Theory Key Assumption
Bonds of different maturities are substitutes, but are not perfect substitutes!
Liquidity Premium Theory Implication
- Modifies Expectations Hypothesis with features of Segmented Markets Theory.
- Investors prefer short rather than long-term bonds and must be paid positive term premium, to hold long-term bonds.
Liquidity Premium Theory Equation
𝟎𝒊𝟐 =((𝟎𝒊𝟏 +𝑬𝟏𝒊𝟏+𝑳))/𝟐
Where:
0𝑖2 denotes rate on a two-year investment commencing today.
0𝑖1 denotes rate on a one-year investment commencing today.
𝐸1𝑖1 is expected rate that would prevail in one years time on a one-year instrument.
𝐿 denotes liquidity premium for long term securities.
Risk Structure of Interest Rates
Measures the perceived difference in credit quality amongst securities.
- Government securities are regarded as default risk free (treasury notes and treasury bonds).
- All other securities have a risk premium added above the risk-free rate.
Default Risk
Default occurs 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.
