Money and Banking Lecture 17

Review of the Previous Lecture Bonds and Risk Default Risk Inflation Risk Interest Rate Risk Bond Ratings Bond Ratings and Risk

Topics under Discussion Tax Effect Term Structure of Interest Rate Expectations Hypothesis Liquidity Premium

Tax Effect The second important factor that affects the return on a bond is taxes Bondholders must pay income tax on the interest income they receive from privately issued bonds (taxable bonds), but government bonds are treated differently Interest payments on bonds issued by state and local governments, called “municipal” or “tax-exempt” bonds are specifically exempt from taxation

Tax Effect A tax exemption affects a bond’s yield because it affects how much of the return the bondholder gets to keep Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1- Tax Rate).

Term Structure of Interest Rates The relationship among bonds with the same risk characteristics but different maturities is called the term structure of interest rates. A plot of the term structure, with the yield to maturity on the vertical axis and the time to maturity on the horizontal axis, is called the yield curve.

Term Structure of Interest Rates

Term Structure of Interest Rates Term Structure of Treasury Interest Rates

Term Structure of Interest Rates Term Structure “Facts” Interest Rates of different maturities tend to move together Yields on short-term bond are more volatile than yields on long-term bonds Long-term yields tend to be higher than short-term yields.

Expectations Hypothesis The risk-free interest rate can be computed, assuming that there is no uncertainty about the future Since certainty means that bonds of different maturities are perfect substitutes for each other, an investor would be indifferent between holding a two-year bond or a series of two one-year bonds Certainty means that bonds of different maturities are perfect substitutes for each other

Expectations Hypothesis Assuming that current 1-year interest rate is 5%. The expectations hypothesis implies that the current 2-year interest rate should equal the average of 5% and 1-year interest rate one year in future. If future interest rate is 7%, then current 2-year interest rate will be (5+7) / 2 = 6% Therefore, when interest rates are expected to rise long-term rates will be higher than short-term rates and the yield curve will slope up (and vice versa)

Expectations Hypothesis Yield to maturity Yield curve when interest rates are expected to rise Time to maturity

Expectations Hypothesis From this we can construct investment strategies that must have the same yield. Assuming the investor has a two-year horizon, the investor can: invest in a two-year bond and hold it to maturity Interest rate will be i2y Investment will yield (1 + i2y) (1 + i2y) two years later invest in a one-year bond today and a second one a year from now when the first one matures Interest rate will be iey+1 Investment will yield (1 + i1y) (1 + iey+1) in two years

Expectations Hypothesis The hypothesis tells us that investors will be indifferent between the two strategies, so the strategies must have the same return Total return from 2 year bonds over 2 years Return from one year bond and then another one year bond

Expectations Hypothesis If one and two year bonds are perfect substitutes, then: Or Or in general terms

Expectations Hypothesis Therefore the rate on the two-year bond must be the average of the current one-year rate and the expected future one-year rate Implications would be the same old Interest rates of different maturities tend to move together. Yields on short-term bonds are more volatile than those on long-term bonds. Long-term yields tend to be higher than short-term yields

Expectations Hypothesis However, expectations theory can not explain why long-term rates are usually above short term rates In order to explain why the yield curve normally slopes upward, we need to extend the hypothesis to include risk

Summary Bonds Tax Effect Term Structure of Interest Rate Expectations Hypothesis Liquidity Premium