1 Lecture 13: Term structure of interest rate Mishkin Ch 6 – part B page

2 Review How do demand and supply curves and shift of curves determine interest rate?  Theory of asset demand: bond market  Liquidity preference framework: money market Why interest rates are different?  Risk structure of interest rate  Term structure of interest rate

3 Expected return and risk Risk-return tradeoff. Then the ‘average’ of return, i.e. expected return is measured by ‘mean’ of R: risk is measured by variance or standard deviation

4 Risk structure of interest rate

5 Term structure of interest rate

6 Term structure of interest rates Bonds with identical default risk, liquidity, and tax characteristics may still have different interest rates because the time remaining to maturity is different. Yield curve is a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations. Shape of the yield curve: 1. Usually upward-sloping (long-term i > short-term i ) sometimes ‘inverted’ (long-term i < short-term i ) 2. Flat implies short- and long-term rates are similar.

7 Facts about term structure of interest rates 1. Interest rates on bonds of different maturities move together over time. 2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted – ‘mean reversion’. 3. Yield curves almost always slope upward.

8 Three candidate theories 1. Expectations theory explains the first two facts but not the third. 2. Segmented markets theory explains fact three but not the first two. 3. Liquidity premium theory combines the two theories to explain all three facts.

9 Expectations theory Assume buyers of bonds do not prefer bonds of one maturity over another - perfect substitutes  expected returns of bonds with different maturity should equal. Conclusion: The interest rate on a long-term bond will equal average of the short-term interest rates that people expect to occur over the life of the long-term bond.

10 Example Suppose one-year interest rate over the next five years are expected to be: 5%, 6%, 7%, 8% and 9% Then, interest rate on the two-year bond:  (5% + 6%)/2 = 5. 5% Interest rate on the five-year bond:  (5% + 6% + 7% + 8% + 9%)/5 = 7% Interest rates on one to five-year bonds:  5%, 5.5%, 6%, 6.5%, and 7%

11 Expectations theory - derivation start with $1 If invest in one long-term bonds, the net rate of return would be …one long-term bonds If invest in two successive short-term bonds, the net rate of return would be …two successive short-term bonds Two ways to invest your $1 should yield the same return, otherwise one kind of bond will not be held.the same return

12 Investing in a long-term bond back

13 Investing in two short-term bonds back

14 Expectations theory - derivation

15 Explanation power of expectation theory Explains why interest rates on bonds with different maturities move together over time (fact 1) current short-term i rise  rise in future  long-term i Explains why yield curves tend to slope up when short- term rates are low and slope down when short-term rates are high (fact 2) current short-term i low  increase to normal level in the future  long term i would be high Cannot explain why yield curves usually slope upward (fact 3).

16 Segmented markets theory Assume: bonds of different maturities are not substitutes, investors have preferences for bonds of one maturity over another. If investors generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3). Can’t explain facts 1 and 2.

17 Liquidity premium theory Assume bonds of different maturities are substitutes but not perfect substitutes. The interest rate on a long-term bond will equal the average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond

18 Liquidity premium theory

19 Example Suppose one-year interest rate over the next five years are 5%, 6%, 7%, 8%, 9%, liquidity premiums for one to five-year bonds are 0%, 0.25%, 0.5%, 0.75%, 1.0% Then, interest rate on the two-year bond: (5% + 6%)/ % = 5.75% Interest rate on the five-year bond: (5% + 6% + 7% + 8% + 9%)/ % = 8% Interest rates on one to five-year bonds: 5%, 5.75%, 6.5%, 7.25% and 8%.

20 Comparing with the expectations theory, liquidity premium theory implies a more steeply upward sloped yield curve. Gap = liquidity premium

21 Interpret the yield curve using liquidity premium theory You can figure out what the market is predicting about future short-term interest rates by looking at the slope of the yield curve. yield curveexpect short-term i to __ in the future steeply upward slopingrise slightly upward slopingunchanged flatdecline moderately downward slopingdecline sharply

22 Explanatory power of liquidity premium theory Fact 1: interest rates on different maturity bonds move together over time; explained by the first term – expected average part. Fact 2: yield curves tend to slope upward when short- term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case. Fact 3: yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens.