NOTES N

The Risk and Term Structure of Interest Rates Historic Interest Rates
Why do bonds with same term to maturity have different rates of return?
, 1-2-2002

=> Study the Risk Structure of Interest Rates

Why do bonds with different term to maturity have different rates of return?
-> Study the Term Structure of Interest Rates

A: Risk Structure
Default Risk = Issuer unable to pay either the interest or the face value
Investors get positive Risk Premium for holding risky assets

How To Gauge Default Risk: Credit Rating Companies (e.g. Moody, S&P)
Investment advisory firms that provide default risk information. That is:
how likely is the borrower to meet its financial obligations?
Three Theories
1. Expectations Theory explains 1 and 2, but not 3
2. Segmented Markets Theory explains 3, but not 1 and 2
3. Preferred Habitat Theory & Liquidity Premium
Combines features of both Expectations Theory and Segmented
Markets and explains all facts

B.1 Expectations Theory

I n v e s tm e n t
G rade Key Assumption: Bonds of different maturities are perfect substitutes.
Implication: RETe on holding bonds of different maturities must be equal
in equilibrium

1: Example - Two investment strategies for one year horizon (invest $100)
1. Buy $100 of one-year bond and hold it until maturity (buy & hold strategy)
2. Buy $100 of 6-month bond. When it matures buy another
Junk B onds six months bond. (roll-over strategy)

Expected return from buy & hold strategy (it=todays interest on the one-year bond):

(1 + it)x$100 $100
RetB&H = = it
Other factors related to the bond issuer: $100
Liquidity = How quickly asset is converted to cash. Investors get Expected return from roll-over strategy (it1 = todays interest on the 6-months bond,
positive Liquidity Premium for holding less liquid assets iet2 = expected interest on the future 6-months bond)
Information Costs = A fraction of return is lost due to costs of studying the (1 + it1/2)(1 + iet2/2)x$100 $100 it1 + iet2 it1 x iet2
default risk of a bond ReteB&H = = +
Income Taxes = A fraction of return is lost due to taxes $100 2 4
No-Arbitrage Condition: iTaxFree = i (1 - tax rate) Since it1 x iet2 is very small, expected about return is about (it1 + iet2)/2

We have said that expected returns from both strategies must be equal, in
B: Term Structure equilibrium (no-arbitrage is possible).
Three Facts to be Explained:
Therefore: it1 + iet2
1. Interest rates for different maturities move together
it = (1)
2. Yield curves tend to have steep slope when short rates are low and 2
downward slope when short rates are high
3. Yield curve is typically upward sloping

27
More generally to find interest for an n-period bond (from a B&H strategy) as a B.3 Liquidity Premium or Preferred Habitat Theory
straight average of one-period bonds (from a roll-over strategy):
it + iet+1 + iet+2 + ... + iet+n-1
Key Assumption: Bonds of different maturities are substitutes, but are not
int = (2) perfect substitutes (e.g. Coke & Pepsi)
n Implication: Modify Expectations Hypothesis with features of Segmented
Markets Theory.
Interest rate Average short rates expected to
on long bond occur over life of long bond Investors prefer short rather than long bonds
2: Numerical example on Expectations Theory => must be paid positive term premium, knt , to hold long-term bonds.
One-year interest rates over the next five years are 5%,6%,7%,8% and 9%, thus Results in following modification of Expectations Theory:
Annual interest rate on two-year bond: (5% +6%)/2 = 5.5%
Annual interest rate on three-year bond: (5% +6% +7%)/3 = 6.0%
Annual interest rate on four-year bond: (5% +6% +7% +8%)/4 = 6.5%
it + iet+1 + iet+2 + ... + iet+n-1
Annual interest rate for five-year bond: (5% +6% +7% +8% +9%)/5 = 7.0% int = + knt (3)
Annual interest rates for one to five year bonds: 5%, 5.5%, 6%, 6.5% and 7%. n

Expectation Theory Explains why yield curve has different slopes: If knt >0 and is assumed to be increasing in n, then this is called the Liquidity
1. When short rates expected to rise in future, the average of future short rates is above Premium Theory
todays short rate: therefore yield curve is upward sloping
3: Numerical Example of Liquidity Premium Theory
2. When short rates expected to stay same in future, average of future short rates are 1. Exp. one-year interest rate over the next five years: 5%, 6%, 7%, 8% and 9%
same as todays, and yield curve is flat 2. Investors preferences for holding short-term bonds.
3. When short rates expected to fall will yield curve be downward sloping Term premiums for one to five-year bonds are: 0%, 0.25%, 0.5%, 0.75% and 1%
=> Interest rate on the two-year bond: 0.25% +(5%+6%)/2 = 5.75%
Expectations Theory explains Fact 1 that short and long rates move together => Interest rate on the five-year bond: 1.0%+(5%+6%+7%+8%+9%)/5=8%
1. Short rate rises are persistent Interest rates on one to five-year bonds: 5%, 5.75%, 6.5%, 7.25% and 8%.
2. if it today, it+1, it+2 etc. tomorrow =>average of future short rates => int
3. Therefore: if it then int, i.e. short and long rates move together Comparing with those for the expectations hypothesis, yield curves are more
steeply upward sloped here =>Liquidity Premium Theory Explains all 3 Facts:
Expectations Theory explains Fact 2 that yield curves tend to have steep slope
Explains Fact 3 of usual upward sloped yield curve by preferred habitat for short bonds
when short rates are low and downward slope when short rates are high
(because of existence of positive term premium in case of long bonds).
1. When short rates are low, they are expected to rise to normal level, and long rate =
Explains Fact 1 and Fact 2 using same explanations as expectations hypothesis because
average of future short rates will be well above todays short rate: yield curve will
it has average of future short rates as determinant of long rate
have steep upward slope
2. When short rates are high, they will be expected to fall in future, and long rate will Use the Liquidity Premium Theory
be below current short rate: yield curve will have downward slope Review
Doesnt explain Fact 3 that yield curve usually has upward slope Risk Structure of interest rates
Short rates as likely to fall in future as rise, so average of future short rates will not Term Structure of interest rates
usually be higher than current short rate: therefore, yield curve will not usually slope Default Risk of a bond
Yield curve
upward
Risk Premium of a bond
B.2 Segmented Markets Theory Expectations Theory of interest rates
Investment Grade vs. Junk
Key Assumption: Bonds of different maturities are not substitutes at all. BondsSegmented Markets Theory of interest
Implication: Markets are completely segmented: interest rate at each rates
maturity determined separately (not influenced by RETe on Information costs of a bond
assets with different maturity) Liquidity Premium Theory of interest rates
Liquidity Premium of a bond
Explains Fact 3 that yield curve is usually upward sloping: Term Premium of a bond
People typically prefer short holding periods, hence higher demand for short-term No-Arbitrage Condition of tax free bonds
bonds, which have higher price and lower interest rates than long bonds + What facts the three theories above explain
Remember and know how to apply equations 2
Does not explain Fact 1 or Fact 2 because assumes long and short rates and 3 (e.g. solve examples 2 and 3)
determined independently (which is not the case)
28