1. The Risk and Term Structure of Interest Rates
Chapter 5
The Risk and Term Structure of Interest Rates

2. KEY WORDS AND CONCEPTS Yield Curve Maturity
Different ways (theories) of looking at the yield curve
1. Expectations (Pure Expectations)
2. Liquidity premium (the higher rate due to greater reward, but also greater risk
3. Preferred habit or way
4. Real world observations
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3. CHAPTER AND LESSON OBJECTIVE
The objective of this chapter and lesson is to understand the relationship between yield 产量 (Chǎnliàng) and maturity of securities and how it is illustrated or pictured in the yield curve.
Investors need to understand the behavior of interest rates to make good decisions regarding investments.
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4. The Term Structure of Rates and the Yield Curve
Term Structure—Relationship among Yields of different maturities of the same type of security. How long – time!
Yield 产量 (Chǎnliàng) Curve (Figure 5.1)
Yield is measured on the vertical and term to maturity (time) is on the horizontal
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5. Figure 5.1 Three alternative yield curves
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6. The Term Structure of Rates and the Yield Curve (Cont.)
Yield (Interest Rate) Curve (Figure 5.1)
The basic question—does the curve slope upward, downward, or horizontal (flat) (Figure 5.1).
The curve is a graphic representation of different interest rates paid by bonds with the same level of risk but different maturities from 3 months to 30 years.
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7. What Determines the Level of Interest Rates
The Importance of Expectations 预期(Yùqí) continued
Expectations people have—If individuals and institutions expect inflation and interest rates to increase, they will change behavior that causes higher rates.
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8. The Term Structure of Rates and the Yield Curve (Cont.)
The normal curve is represented by the red line, upward sloping
Short term rates are lower than long term rates. Longer term bonds have a higher yield over time due to risks.
Short term interest rates are expected to rise
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9. The Term Structure of Rates and the Yield Curve (Cont.)
The horizontal curve is represented by the blue line, basically flat.
Short term rates and long term rates are expected to stay the same. Investors expect rates to stay the same.
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10. The Term Structure of Rates and the Yield Curve (Cont.)
The inverted curve, downward sloping curve is represented by the green line.
Short term yields are higher than long term yields. Investors expect short term rates drop.
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11. The Term Structure of Rates and the Yield Curve (Cont.)
Different Theories of the Shape of the Yield Curve
Supply and Demand/Pure Expectations
Determined by supply and demand of different maturities
The shape of the curve helps to give an idea of future interest rate change and economic activity. The greater the curve the greater the expected change.
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12. The Term Structure of Rates and the Yield Curve (Cont.)
Different Theories of the Shape of the Yield Curve
Risk or Liquidity (Liquidity Premium)
Prices of long term securities are subject to greater changes in prices, making them more risky. If you have to sell before the maturity the price could be low.
If you need cash, short term securities have less risk thus making liquidity a greater reward for the investor.
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13. The Term Structure of Rates and the Yield Curve (Cont.)
Different Theories of the Shape of the Yield Curve (Cont.)
The Preferred Habitat Approach
Investors actually have a preference 偏爱 (Piān'ài) for different maturities
This suggests the supply/demand concept for different maturities will establish the specific rates for each maturity range
Changes in supply/demand can cause the rates to change expectations.
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14. What Determines the Level of Interest Rates (Cont.)
The Importance of Expectations 预期(Yùqí) continued
Expectations people have—If individuals and institutions expect inflation and interest rates to increase, they will change behavior that causes higher rates.
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15. The Term Structure of Rates and the Yield Curve (Cont.)
Different Theories of the Shape of the Yield Curve (Cont.)
Real-World Observations (cont.)
When rates are high, investors expect them to fall, which is why they want to hold long-term securities. Falling rates mean higher prices, more gains.
In the business cycle short-term rates fluctuate (change up or down) more than longer-term rates (Figure 5.3)
Yield curves tend to be upward sloping more often, suggesting the liquidity premium is the most common theory
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16. Figure 5.3 Short-term rates fluctuate (change) more than long-term rates over the business cycle
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17. Risk of Rates
Default Risk
The higher the perceived risk, the greater the upward shift of the curve for that particular security (Figure 5.4)
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18. CHAPTER 5 SUMMARY
The yield curve shows the relationship between the yields of short-term and long-term securities. Can be upward sloping, downward sloping or flat.
Expectations theory is determined by the expectations of investors. Long-term rates are averages of current and expected future short term rates
Life Insurance Companies like long-term securities as they can “lock-in” rates for a guaranteed return
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19. Figure 5.4 Riskier securities carry higher yields
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