Risk and Term Structure of Interest Rates -- Fin THE RISK AND TERM STRUCTURE OF INTEREST RATES Risk Structure of Interest Rates Default risk Liquidity Income Tax Consideration Term Structure of Interest Rates Pure Expectation Theory Market Segmentation Theory Liquidity Premium Theory

Risk and Term Structure of Interest Rates -- Fin Risk Structure of Long Bonds in the US

Risk and Term Structure of Interest Rates -- Fin Puzzling Phenomenon 1. Riskfree bonds have a lower return than risky bonds 2. High risk bonds have a higher return than low risk bonds 3. Municipal bonds have a lower return than US Government long term bonds

Risk and Term Structure of Interest Rates -- Fin Increasing Default Risk on Corporate Bonds

Risk and Term Structure of Interest Rates -- Fin Bond Ratings

Risk and Term Structure of Interest Rates -- Fin Decrease in Liquidity of Corporate Bonds

Risk and Term Structure of Interest Rates -- Fin Why bonds have different liquidity US Treasury bonds are the most liquid because they are widely traded Corporate bond are less liquid because fewer bonds are traded and it’s costly to sell bonds in an emergency

Risk and Term Structure of Interest Rates -- Fin Tax Advantages of Municipal Bonds

Risk and Term Structure of Interest Rates -- Fin Term Structure Facts to Be Explained 1. Interest rates for different maturities move together 2. Yield curves tend to have steep upward slope when short rates are low and downward slope when short rates are high 3. Yield curve is typically upward sloping

Risk and Term Structure of Interest Rates -- Fin Interest rate maturities

Risk and Term Structure of Interest Rates -- Fin Three Theories of Term Structure 1. Pure Expectations Theory 2. Market Segmentation Theory 3. Liquidity Premium Theory A. Pure Expectations Theory explains 1 and 2, but not 3. B. Market Segmentation Theory explains 3, but not 1 and 2 C. Solution: Combine features of both Pure Expectations Theory and Market Segmentation Theory to get Liquidity Premium Theory and explain all facts

Risk and Term Structure of Interest Rates -- Fin Interest Rates on Different Maturity Bonds Move Together

Risk and Term Structure of Interest Rates -- Fin Yield Curves

Risk and Term Structure of Interest Rates -- Fin Pure Expectations Theory Key Assumption:Bonds of different maturities are perfect substitutes Implication:RET e on bonds of different maturities are equal Investment strategies for two-period horizon 1. Buy $1 of one-year bond and when matures buy another one-year bond 2. Buy $1 of two-year bond and hold it

Risk and Term Structure of Interest Rates -- Fin Pure Expectations Theory See definitions on page 131

Risk and Term Structure of Interest Rates -- Fin More generally for n-period bond: In words: Interest rate on long bond = average of short rates expected to occur over life of long bond

Risk and Term Structure of Interest Rates -- Fin More generally for n-period bond: Numerical example: One-year interest rate over the next five years 5%, 6%, 7%, 8% and 9%, Interest rate on two-year bond: Interest rate for five-year bond: Interest rate for one to five year bonds:

Risk and Term Structure of Interest Rates -- Fin Another example (on future short-term rate): The interest rates for 1-year through 5-year bonds are 5%, 6%, 7%, 8% and 9%, Expected interest rate of a 1-year bond in year 2: Expected interest rate of a 1-year bond in years 3, 4, and 5

Risk and Term Structure of Interest Rates -- Fin Pure Expectations Theory and Term Structure Facts Explains why yield curve has different slopes: 1. When short rates expected to rise in future, average of future short rates = i nt is above today's short rate: therefore yield curve is upward sloping 2. When short rates expected to stay same in future, average of future short rates same as today's, and yield curve is flat 3. Only when short rates expected to fall will yield curve be downward sloping

Risk and Term Structure of Interest Rates -- Fin Pure Expectations Theory and Term Structure Facts Pure Expectations Theory explains Fact 1 that short and long rates move together 1. Short rate rises are persistent 2. If i t  today, i e t+1, i e t+2 etc.   average of future rates   i nt  3.Therefore: i t   i nt , i.e., short and long rates move together

Risk and Term Structure of Interest Rates -- Fin Pure Expectations Theory and Term Structure Facts Explains Fact 2 that yield curves tend to have steep slope when short rates are low and downward slope when short rates are high 1. When short rates are low, they are expected to rise to normal level, and long rate = average of future short rates will be well above today's short rate: yield curve will have steep upward slope 2. When short rates are high, they will be expected to fall in future, and long rate will be below current short rate: yield curve will have downward slope

Risk and Term Structure of Interest Rates -- Fin Pure Expectations Theory and Term Structure Facts Doesn't explain Fact 3 that yield curve usually has upward slope Short rates as likely to fall in future as rise, so average of expected future short rates will not usually be higher than current short rate: therefore, yield curve will not usually slope upward

Risk and Term Structure of Interest Rates -- Fin Market Segmentation Theory Key Assumption:Bonds of different maturities are not substitutes at all Implication: Markets are completely segmented: interest rate at each maturity determined separately Explains Fact 3 that yield curve is usually upward sloping People typically prefer short holding periods and thus have higher demand for short-term bonds, which have higher prices and lower interest rates than long bonds Does not explain Fact 1 or Fact 2 because assumes long and short rates determined independently

Risk and Term Structure of Interest Rates -- Fin Liquidity Premium Theory Key Assumption:Bonds of different maturities are substitutes, but are not perfect substitutes Implication: Modifies Pure Expectations Theory with features of Market Segmentation Theory Investors prefer short rather than long bonds  must be paid positive liquidity premium, l nt, to hold long term bonds

Risk and Term Structure of Interest Rates -- Fin Liquidity Premium Theory Results in following modification of Pure Expectations Theory

Risk and Term Structure of Interest Rates -- Fin Relationship Between the Liquidity Premium and Pure Expectations Theory

Risk and Term Structure of Interest Rates -- Fin Liquidity Premium Theory: Explains all 3 Facts Explains Fact 3 of usual upward sloped yield curve by liquidity premium for long-term bonds Explains Fact 1 and Fact 2 using same explanations as pure expectations theory because it has average of future short rates as determinant of long rate

Risk and Term Structure of Interest Rates -- Fin Numerical Example: 1. One-year interest rate over the next five years:5%, 6%, 7%, 8% and 9% 2. Investors' preferences for holding short-term bonds so liquidity premium for one to five-year bonds: 0%, 0.25%, 0.5%, 0.75% and 1.0%.

Risk and Term Structure of Interest Rates -- Fin Numerical Example: Interest rate on the two-year bond: Interest rate on the five-year bond: Interest rates on one to five-year bonds: Comparing with those for the pure expectations theory, liquidity premium theory produces yield curves more steeply upward sloped

Risk and Term Structure of Interest Rates -- Fin Calculate future short term rate 1. Interest rates for one- to five-year bonds are:5%, 6%, 7%, 8% and 9% 2. Investors' preferences for holding short-term bonds so liquidity premium for one to five-year bonds: 0%, 0.25%, 0.5%, 0.75% and 1.0%. 3. Calculate 1-year short-term rate over the next five years.

Risk and Term Structure of Interest Rates -- Fin Market Predictions of Future Short Rates

Risk and Term Structure of Interest Rates -- Fin Forward Rate The expected future short-term rate is also known as forward rate, as opposed to the current short-term rate, known as the spot rate. Two ways to compute forward rates: (1) Using the formula covered in the class (2) Formula in the text book (page , not required)