Money, Banking, and Financial Markets slides about the term structure & risk structure of interest rates

1. Chapter 6 The Term Structure Of Interest Rates
It is the relationship at any given time between the length of
time to maturity and the yield on a debt security.
The Term Structure & The yield curve
The length of time to maturity is on the horizontal axis
Risk Structure Of Interest Rates
The yield is on the vertical axis.
Other factors constant; default risk, liquidity, …
©Thomson/South-Western 2006 1 2
Figure 6-1 The Term Structure Of Interest Rates
The shape of yield curve (Figure 6-2)
High Interest – Flat yield curve
rate
– Ascending (Upward sloping) yield curve
Downward Slope
– Descending (Downward sloping, inverted) yield curve
– Humped yield curve
Low Interest
rate
These shape can be explained by
Upward slope 4 Theories of Term Structure
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4 Theories Of Term Structure 1. Pure Expectations Theory
Investors seek to maximize holding period returns
1. The pure expectations theory
Investors have no institutional preference for particular
maturities. They regard various maturities as perfect
substitutes for each other.
2. The liquidity premium theory
There are no transactions costs associated with buying and
3. The segmented markets theory selling securities.
Large numbers of investors form expectations about the
4. The preferred habitat theory future course of interest rates, & act aggressively on those
expectations.
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2. 1. Pure Expectations Theory 1. Pure Expectations Theory
yield on a long-term bond equals the geometric mean (or Option 1: Invest in 1-year bond and roll-over
average) of the current short-term yield and successive 0 1 2 0i1 = 4%
future short-term yields. 1i2 = 8%
0i1 = 4% 1i2 = 8%
If transactions costs are zero, the investor would expect
to earn the same average return over the long run if they: Option 2: Invest in 2-year bond
1. purchase a short-term bond & "roll it over" every time 0 1 2 0i2 = 6%
it matures.
2. purchase a long-term bond & hold it to maturity
0i2 = 6%
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Pure Expectations Theory: Implications Pure Expectations Theory: Implications
If investors believe that short-term interest rates will If investors think interest rates will decline in the
be higher in the future, the yield curve today slopes future, the yield curve is downward.
upward.
Interest rate (%) Interest rate (%)
Maturity (Years) Maturity (Years)
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Pure Expectations Theory: Implications 2. Liquidity Premium Theory
In the pure expectations theory: The issue: long-term bonds entail greater market risk than
an ascending yield curve is evidence of market that short-term securities do.
interest rates are rising
a downward-sloping or inverted yield curve implies that
Market risk is the risk of fluctuation in the price of the
market expects that interest rates are falling
security due to interest rate changes.
a flat yield curve implies a consensus that future yields will
remain the same as current yields Investors may have to sell their assets prior to maturity,
In the pure expectations theory, nothing except the outlook exposing themselves to the possibility of losses as interest
for interest rates affects the shape of the yield curve. rates & thus market prices change.
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3. 2. Liquidity Premium Theory
If bond buyers are risk averse, they must be compensated
with a term premium for the greater market risk inherent in
long-term bonds.
tRL = tRL-1 + TP
The Liquidity Premium Theory states that the term
premium (TP) is positive & increases with the length of
term, so the normal yield structure is ascending (Upward
sloping).
Bond with longer maturity provides higher yield
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3. Segmented Markets Theory 3. Segmented Markets Theory
Interest rates depend on supply and demand in each market For Lenders (Supply):
Short term interest rates Long term interest rates Short term securities Long term securities provide
depend on depend on provide liquidity & stability stability of income (i.e. coupon
of principal (price bond)
1. Short-term supply for fund stability)
1. Long-term supply for fund
(Short-term lenders) (Long-term lenders) Lenders who prefer income
Lenders who prefer stability over principal stability
protection of principal will will prefer to invest in Long
2. Short-term demand for fund 2. Long-term demand for fund prefer to invest in Short
(Short-term borrowers) term securities (T-Bonds)
(Long-term borrowers) term securities (T-Bills)
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3. Segmented Markets Theory Segmented Markets Theory: Implications
For borrowers: Individuals & firms are strongly motivated to Yields in any maturity sector are determined strictly by supply
match the maturities of their assets with the maturities of & demand in that sector
their liabilities
Corporate & U.S. Treasury debt management decisions
Firms borrowing to finance Families buying homes prefer significantly influence the shape of the yield curve.
inventories prefer short- long-term fixed rate
If firms & the government are currently issuing
mortgages
term loans predominantly long-term debt the yield curve will be
relatively steep.
Municipalities & corporations
Banks need liquidity investing in long-term capital If they are issuing short-term debt short-term yields will
prefer to invest short-term projects borrow long-term be high relative to long-term yields.
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4. Segmented Markets Theory: Implications 4. Preferred Habitat Theory
Treasury debt management is a potential tool of economic This hybrid theory combines elements of the other three.
policy because it can influence the yield curve. Borrowers & lenders do hold strong preferences for particular
maturities.
Gov. wants to raise Short term yield & reduce Long term yield
The yield curve will not conform strictly to the predictions of
Gov. will issue only Short term debt
the other three theories.
higher demand
If expected additional returns to be gained by deviating
higher Short term yield from their preferred maturities become large enough,
Twisting the yield curve institutions will deviate from their preferred maturities.
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4. Preferred Habitat Theory The Risk Structure Of Interest Rates
Institutions will accept additional risk in return for A security issuer defaults if it fails to meet the terms of the
additional expected returns. contractual agreement (indenture) in full.
For a bond, default is either the borrower's failure to make full
Institutions change from their preferred maturities or
interest payments or to redeem at face value
habitats if expected additional returns from other
maturities are large enough. Embedded in the yields of risky securities is a premium to
Example (p. 133): banks shift to invest in L-T securities compensate lenders for default risk
if L-T securities provide large additional return (yield)
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Risk Premiums Risk Premiums
Moody's and Standard and Poor's, provide ratings of the
quality of bonds in the United States Risk premium = risky yield – risk free yield
(ranging from investment grade bonds to junk bonds)
Issuers (Borrowers) Credit Rating Interest rate Risk premiums increases during recessions & other
Government AAA 4% times when firms experience financial distress.
Good quality Company AA 6%
--- --- -- It decreased modestly during the economic boom.
--- --- --
Bad credit company D 10%
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5. Figure 6-7
Interest rate
Interest rate
Default-Free Market Risky Market
Sr2
Sr1
Sd1
ir2
Sd2 ir1
id1
Dr1
id2
Dd1
Loanable Funds (Q) Loanable Funds (Q)
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