1. 1 Chapter 8 The Structure of Interest Rates ©2000 South-Western College Publishing

2. 2 The Structure of Interest Rates The pattern or spread among interest rates determined by the term to maturity, credit risk, and tax treatment

3. 3 Treasury Notes Securities issued by the U.S. Government with an original maturity of one to ten years

4. 4 Yield Curve A graphical representation of the relationship between interest rates (yields) on particular securities and their terms to maturity

5. 5 January 16, 1981 January 29, 1993 July 17, 1998 Maturity Interest Maturity Interest Maturity Interest 3 months 15.19% 3 months 2.92% 3 months 5.01% 1 year 13.91% 1 year 3.41% 1 year 5.36% 2 years 13.15% 2 years 4.24% 2 years 5.46% 5 years 12.69% 5 years 6.08% 5 years 5.47% 10 years 12.53% 10 years 6.46% 10 years 5.49% Exhibit 8.1 Interest Rates on Treasury Securities

6. 6 Interest Rate (percent) 0 5 10 15 20 January 16, 1981 January 29, 1993 July 17, 1998 Term to Maturity 10 years Term to Maturity 3 months Term to Maturity 1 year Term to Maturity 2 years Term to Maturity 5 years Exhibit 8.2 Yield Curves

7. 7 Expectations Theory A theory holding that the long-term interest rate is the geometric average of the present short-term rate and the short-term rates expected to prevail over the term to maturity of the long-term security

8. 8 Geometric Average An average that takes into account the effects of compounding used to calculate the long-term rate from the short-term rate and the short- term rates expected to prevail over the term to maturity of the long-term security

9. 9 1 2 3 4 5 6 1 2 5.99 Term to Maturity (years) Yield to Maturity (percent) Exhibit 8.3 Hypothetical Yield Curve

10. 10 1 2 1 2 3 4 5 6 7 8 9 Exhibit 8.4 New Hypothetical Yield Curve Yield to Maturity (percent) New Curve 1 year rate = 5% 2 year rate = 6.98% Expected future 1 year rate = 9% Term to Maturity (years) Original Curve 1 year rate = 5% 2 year rate = 5.99% Expected future 1 year rate = 7%

11. 11 Term to Maturity Yield to Maturity Term to Maturity Yield to Maturity Term to Maturity Yield to Maturity a. A Rise Expected in Interest Rates b. No Change Expected in Interest Rates c. A Decline Expected in Interest Rates Exhibit 8.5 Alternative Yield Curve Shapes

12. 12 Preferred Habitats An expectations theory modification hypothesizing that many borrowers and lenders have preferred maturities which creates a degree of market segmentation between the short-term and the long-term markets

13. 13 Liquidity Premium The extra return required to induce lenders to send long-term rather than short-term

14. 14 12345678910 1 2 3 4 5 6 7 8 9 Exhibit 8.6 The Role of Liquidity Premiums Yield to Maturity (percent) Term to Maturity (years) Observed Yield Curve = Expectations + Liquidity Premiums (C=A+B) Yield Curve Based on Expectations (A) Liquidity Premium (B)

15. 15 Credit Risk is... The probability of a debtor not paying the principal and/or the interest due on an outstanding debt

16. 16 Standard & Poor’s and Moody’s Investor Services The two major credit- rating agencies that evaluate a borrower’s probability of default and assign the borrower to a particular risk class

17. 17 AaaBest qualityAAA AaHigh qualityAA AHigher medium gradeA BaaMedium gradeBBB BaLower medium grade BB having speculative elements BLacks characteristics ofB desirable investment CaaPoor standingB CaHighly speculativeB CLowest grade (in default)D General Description Moody’s Standard & Poor’s General Description Exhibit 8.7

18. 18 Risk Premium The extra return or interest that a lender is compensated with for accepting more risk

19. 19 14% 12% 10% 6% 4% 2% 8% 95 9065 Exhibit 8.8 1960 707580 85 Baa-Rated Municipal Bonds Aaa-Rated Municipal Bonds Recessions

20. 20 Marginal Tax Rate The tax rate that is paid on the last dollar of income that the taxpayer earns

21. 21 Average Marginal Tax Rate The average of the marginal tax rates of all taxpayers