Professor Yamin Ahmad, Money and Banking ECON 354

Professor Yamin Ahmad, Money and Banking ECON 354

Big Concepts

ECON 354

Money and Banking

Professor Yamin Ahmad

The Risk Structure of Interest Rates

The Term Structure of Interest Rates

Lecture 5
Risk
Term Structure

Premiums:
Risk
Liquidity

Theories to explain facts

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Risk Structure of Long-Term

g
Bonds in the United
States
20
18
16

Corporate Baa Bonds

14

State and Local Bonds

12

US Government Long Term

Bonds

Effects of Increase in
Default Risk on Corporate Bonds
Corporate
p
Bond Market
Re on corporate bonds , Dc , Dc shifts left
Risk of corporate bonds , Dc , Dc shifts left

Pc , ic

10
8
6
4
2
0
Apr-53
A
A
Aug-54
Nov-55
N
Mar-57
M
Jul-58
Nov-59
N
Mar-61
M
Jul-62
Nov-63
N
Mar-65
M
Jul-66
Nov-67
N
Mar-69
M
Jul-70
Nov-71
N
Mar-73
M
Jul-74
Nov-75
N
Mar-77
M
Jul-78
Nov-79
N
Mar-81
M
Jul-82
Nov-83
N
Mar-85
M
Jul-86
Nov-87
N
Mar-89
M
Jul-90
Nov-91
N
Mar-93
M
Jul-94
Nov-95
N
Mar-97
M
Jul-98
Nov-99
N
Mar-01
M
Jul-02
Nov-03
N
Mar-05
M
Jul-06
Nov-07
N
Mar-09
M

Annual Yield (%
%)

Corporate Aaa Bonds

Professor Yamin Ahmad, Money and Banking ECON 354

Note: These lecture notes are incomplete without having attended lectures.

Treasury Bond Market

Relative Re on Treasury bonds , DT , DT shifts right
Relative risk of Treasury bonds , DT , DT shifts right

PT ,
iT
Outcome:
Risk premium
premium, ic iT, rises
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Professor Yamin Ahmad, Money and Banking ECON 354

Increase in Default Risk on Corporate Bonds

Price of Bonds, P($)
P Increasing

Interest Rate i (%)

Price of Bonds, P($)

i increases

P Increasing

i increases

ST

P1C

i1C

P2C

P2T

i2T

P1T

i1T

i2C

D2c

AAA

AAA

Definitions
Prime Maximum Safety

Aa1

AA+

AA+

High Grade Quality

Aa2

AA

AA

Aa3

AAAA

AAAA

A1

A+

A+

A2

A3

A-

A-

Baa1

BBB+

BBB+

Baa2

BBB

BBB

Baa3

BBB-

BBB-

Upper Medium Grade

Lower Medium Grade

D1T

Quantity of Corporate Bonds

Quantity of Treasury Bonds

(a) Corporate Bond Market

Fitch

Aaa

D2T

Risk
Premium

D1c

S&P

Interest Rate i (%)

Sc
i2T

Bond Ratings
Moodys

(b) Default free (US Treasury) Bond

Market

Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Professor Yamin Ahmad, Money and Banking ECON 354

Bond Ratings
Moodys

S&P

Fitch

Ba1

BB+

BB+

Non Investment Grade

Speculative

Ba2

BB

BB

Ba3

BB-

BB-

B1

B+

B+

B2

Definitions

Highly Speculative

B3

B
B-

B
B-

Caa1

CCC+

CCC

Substantial Risk
In poor standing

Caa2

CCC

Caa3

CCC
CCC-

Ca

Extremely speculative

May be in default

DDD

DD

Note: These lecture notes are incomplete without having attended lectures.

Default
-

Liquidity
Corporate
p
Bond Market
1. Less liquid corporate bonds Dc , Dc shifts left
2. Pc , ic
Treasury Bond Market
1. Relatively more liquid Treasury bonds, DT , DT shifts
right
2. PT , iT
Outcome:
Risk premium, ic iT, rises
Risk premium reflects not only corporate bonds default
risk, but also lower liquidity
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Municipal Bonds
Puzzle: Why are interest rates on municipal
b d llower th
bonds
than T
Treasuries?
i ?

Professor Yamin Ahmad, Money and Banking ECON 354

Practice Question
Consider the two markets:
Market for municipal bonds
Market for US Treasuryy bonds

Municipal bonds are not default free!

Great depression; Orange County, CA in 1994

Answer: Interest payments on municipal bonds

are exemptt from
f
federal
f d l income
i
taxes,
t
and
d often
ft
from state taxes in the state where they are
issued.
issued
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Interest
e es Rates
a es o
on Different
e e Maturity
a u y Bonds
o ds Move
o e Together
oge e

Graphically,
p
y, show what happened
pp
in these
markets as a result of interest on municipal
bonds having tax free status.

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Yield Curves
What do Yield Curves Look Like?
Charting The Curves

Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Professor Yamin Ahmad, Money and Banking ECON 354

Term Structure Facts

Three Theories of Term Structure

We would wish to explain the following facts:

1. Interest rates for different maturities move together
over time
2. Yield curves tend to have steep upward slope when
short rates are low and downward slope when short
rates are high

1. Expectations Theory
2. Segmented Markets Theory
3. Liquidity Premium (Preferred Habitat) Theory

3 Yield
3.
Yi ld curve iis ttypically
i ll upward
d sloping
l i

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

What We Can Explain

Explain
Expectations Theory explains 1 and 2, but not 3
Segmented Markets explains 3
3, but not 1 and 2
Solution: Combine features of both Expectations
Theory and Segmented Markets Theory to get
Liquidity
qu d ty Premium
e u ((Preferred
e e ed Habitat)
ab tat) Theory
eo y
and explain all facts

Note: These lecture notes are incomplete without having attended lectures.

Expectations Theory
Key
y Assumption:
p
Bonds of different maturities are p
perfect
substitutes
Implication: Re on bonds of different maturities are equal
Investment strategies
g
for two-period
p
horizon
1.
2.

Buy $1 of one-year bond and when it matures buy another

one-year
one
year bond
Buy $1 of two-year bond (which pays out every year) and
hold it

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Professor Yamin Ahmad, Money and Banking ECON 354

Expected return from Strategy 2

1 i2t 1 i2t 1 1 2 i2t i2t

1

Since (i2t)2 is extremely small

small, expected return is
approximately 2(i2t), i.e.

1 i2t 1 i2t 1 2
1

i2t

What about the expected return from Strategy 1?

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

From implication above you would be indifferent between

the two strategies if and only if the expected returns of
the two strategies were equal.

Solving
g for i2t:

2(i2t) = it + iet+1

i2t

1 it 1 ite1 1

1 it ite1 it ite1 1
1
1
e
Since it(i t+1) is also extremely small, expected return is
approximately

it + iet+1
Question: Under what conditions would you be
indifferent in choosing between Strategy 1 and Strategy
2?
Answer: Only if the expected returns from strategy 1 and
strategy
t t
2 were equal!
l!
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Expectations Theory

Therefore:
Th f

Expected Return from Strategy 1

it i
2

e
t 1

i.e. if and only if the return on a two period bond were

equal to the average expected return on two one period
bonds over the two periods.
Note: These lecture notes are incomplete without having attended lectures.

Expected Return from Strategy 1

More generally for n-period
n period bond:
int

it ite1 ite 2 ... ite n 1

n

In words: Interest rate on long bond

= average
g short rates expected
p
to
occur over life of long bond

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Numerical Example
Numerical example:
p
Consider the following one-year interest rates expected to
occur over the next five years: 5%, 6%, 7%, 8% and 9%
IInterest
t
t rate
t on two-year
t
b d
bond:
(5% + 6%)/2 = 5.5%
Interest rate for five-year
five year bond:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
Calculate the interest rate for the three and four year
bonds:

Professor Yamin Ahmad, Money and Banking ECON 354

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 = int is above todays short rate:
th f
therefore
yield
i ld curve iis upward
d sloping
l i
2. When short rates expected to stay same in future,
average of future short rates are same as todays,
and yield curve is flat
3. Only when short rates expected to fall will yield
curve be downward sloping

Answer:
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Implications of Expectations Theory

Expectations
p
Theory
y explains
p
Fact 1 that short and
long rates move together

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Implications of Expectations Theory

Explains
p
Fact 2 that yield
y
curves tend to have steep
p
slope when short rates are low and downward
slope when short rates are high

1. Short rate rises are persistent

2 If it today,
2.
today iet+1, iet+2 etc.
etc average of future rates
int
3. Therefore: it int , i.e., short and long rates move
together

Note: These lecture notes are incomplete without having attended lectures.

1. When short rates are low, they are expected to rise to

normal
o a level,
e e , and
a d long
o g rate
ate = a
average
e age o
of future
utu e sshort
ot
rates will be well above todays 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
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Implications of Expectations Theory

Professor Yamin Ahmad, Money and Banking ECON 354

Segmented Markets Theory

Doesnt explain
p
Fact 3 that yield
y
curve usually
y has
upward slope

Key Assumption: Bonds of different maturities

are not substitutes at all

Short rates as likely to fall in future as rise, so average of

future short rates will not usually be higher than current
short rate: therefore, yield curve will not usually slope
upward

Implication: Markets are completely

segmented:
g
interest rate at each maturity
y
determined separately

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Implications of Segmented Markets Theory

Explains
p
Fact 3 that yyield curve is usually
y upward
p
sloping
p g
People typically prefer short holding periods and thus
have higher demand for short-term bonds, which have
higher price and lower interest rates than long bonds
Does not explain Fact 1 or Fact 2 because assumes long
and short rates determined independently

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Liquidity
q
y Premium ((Preferred Habitat))
Theories
Key Assumption: Bonds of different maturities are
substitutes,
b tit t
but
b t are nott perfect
f t substitutes
b tit t
Implication: Modifies Expectations Theory with
features of Segmented Markets Theory
Investors prefer short rather than long bonds must
be paid positive liquidity (term) premium, lnt, to hold
long-term bonds
Results in following modification of Expectations
Theory:
e
e
e

int
Note: These lecture notes are incomplete without having attended lectures.

it it 1 it 2 ... it n 1
n

Note: These lecture notes are incomplete without having attended lectures.

lnt

Professor Yamin Ahmad, Money and Banking ECON 354

Liquidity Premium (Preferred Habitat) Theory

int

it ite1 ite2 ... ite( n1)

lnt
n
where lnt is the liquidity premium for the n-period bond at time t

Professor Yamin Ahmad, Money and Banking ECON 354

Relationship
p Between the Liquidity
q
y Premium
(Preferred Habitat) and Expectations Theories
Interest Rate
int

Liquidity Premium (Preferred Habitat)

Theory Yield Curve

Liquidity
Premium
lnt

lnt is always positive

Rises with the term to maturity
Expectations Theory
Yield Curve

0
Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Liquidity Premium (Preferred Habitat) Theory

Interest rates on different maturityy bonds move together
g
over time; explained by the first term in
the equation
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
Yield curves typically
yp
y slope
p upward;
p
; explained
p
by a larger liquidity premium as the term to
maturity lengthens

Note: These lecture notes are incomplete without having attended lectures.

10

15

20

25

30

Years to Maturity, n

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Numerical Example
Consider the following one-year interest rates
expected
p
to arise over the next five yyears:
5%, 6%, 7%, 8% and 9%
Investors have a preference for holding short-term
bonds, and as such charge the following liquidity
premia for one to five year bonds:
0%, 0.25%, 0.5%, 0.75% and 1.0%
Question: Calculate the interest rate being offered by
these one to five year bonds.

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Professor Yamin Ahmad, Money and Banking ECON 354

Liquidity Premium (Preferred Habitat)

Theories: Term Structure Facts
Explains
E l i all
ll 3 Facts
F t
Explains Fact 3 of usual upward sloped yield curve by
investors preferences for short-term bonds

Market
Predictions
of Future
Short
Rates

Explains Fact 1 and Fact 2 using same explanations

as expectations hypothesis because it has average of
future short rates as determinant of long rate

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Interpreting Yield Curves 1980

19802009
2009

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Money and Banking ECON 354

Application:
pp
The Subprime
p
Collapse
p and the
Baa Treasury Spread
Corporate Bond Risk Premium and Flight to
Quality
10
8
6
4
2

-0
7
M
ay
-0
7
Ju
l-0
7
Se
p07
N
ov
-0
7
Ja
n08
M
ar
-0
8
M
ay
-0
8
Ju
l-0
8
Se
p08
N
ov
-0
8
Ja
n09

M
ar

Ja
n-

07

Corporate bonds, monthly data Aaa-Rate

Corporate bonds, monthly data Baa-Rate
10-year maturity Treasury bonds, monthly data
Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.