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The Risk and Term Structure of Interest Rates: e C C C C C C

1. The document discusses three theories that aim to explain the term structure of interest rates: expectations theory, segmented markets theory, and liquidity premium theory. 2. Expectations theory holds that bonds of different maturities are perfect substitutes and long rates equal the average expected future short rates. It explains why yield curves change slope but not why they are usually upward sloping. 3. Segmented markets theory assumes bonds are not substitutes and markets are segmented, explaining the usual upward slope but not why long and short rates move together. 4. Liquidity premium theory combines features of the first two by allowing bonds to be imperfect substitutes. It explains all term structure facts by incorporating expectations of

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72 views4 pages

The Risk and Term Structure of Interest Rates: e C C C C C C

1. The document discusses three theories that aim to explain the term structure of interest rates: expectations theory, segmented markets theory, and liquidity premium theory. 2. Expectations theory holds that bonds of different maturities are perfect substitutes and long rates equal the average expected future short rates. It explains why yield curves change slope but not why they are usually upward sloping. 3. Segmented markets theory assumes bonds are not substitutes and markets are segmented, explaining the usual upward slope but not why long and short rates move together. 4. Liquidity premium theory combines features of the first two by allowing bonds to be imperfect substitutes. It explains all term structure facts by incorporating expectations of

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Nor Hafizah
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© © All Rights Reserved
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Chapter 6

THE RISK AND TERM STRUCTURE OF INTEREST RATES

Increase in Default Risk on Corporate Bonds

Corporate Bond Market


1. RETe on corporate bonds Ø, Dc Ø, Dc shifts left
2. Risk of corporate bonds ↑, Dc Ø, Dc shifts left
3. Pc Ø, ic ↑
Treasury Bond Market
4. Relative RETe on Treasury bonds ↑, DT ↑, DT shifts right
5. Relative risk of Treasury bonds Ø, DT ↑, DT shifts right
6. PT ↑, iT Ø
Outcome:
Risk premium, ic – iT, rises

Corporate Bonds Become Less Liquid


Corporate Bond Market
1. Less liquid corporate bonds Dc Ø, Dc shifts left
2. Pc Ø, ic ↑
Treasury Bond Market
1. Relatively more liquid Treasury bonds, DT ↑, DT shifts
right
2. PT ↑, iT Ø
Outcome:
Risk premium, ic – iT, rises
Risk premium reflects not only corporate bonds’ default risk, but also lower liquidity

1
Tax Advantages of Municipal Bonds

Municipal Bond Market


1. Tax exemption raises relative RETe on municipal bonds, Dm ↑, Dm shifts right
2. Pm ↑, im Ø
Treasury Bond Market
1. Relative RETe on Treasury bonds Ø, DT Ø, DT shifts left
2. PT Ø, iT ↑
Outcome:
im < iT

Term Structure Facts to be Explained


1. Interest rates for different maturities move together
2. Yield curves tend to have steep slope when short rates are low and downward slope
when short rates are high
3. Yield curve is typically upward sloping

Three Theories of Term Structure


1. Expectations Theory
2. Segmented Markets Theory
3. Liquidity Premium Theory
A. Expectations Theory explains 1 and 2, but not 3
B. Segmented Markets explains 3, but not 1 and 2
C. Solution: Combine features of both Expectations Theory and Segmented Markets
Theory to get Liquidity Premium Theory and explain all facts

2
Expectations Hypothesis
Key Assumption: Bonds of different maturities are perfect substitutes
Implication: RETe on bonds of different maturities are equal
Investment strategies for two-period horizon
1. Buy $1 of one-year bond and when it matures buy another one-year bond
2. Buy $1 of two-year bond and hold it

Expected return from strategy 2 is approximately 2(i2t).


Expected return from strategy 1 is approximately it + iet+1
From implication above expected returns of two strategies are equal: Therefore
2(i2t) = it + iet+1
Solving for i2t
i2t = (it + iet+1)/2

More generally expected return from strategy 1 for n-period bond:


int = (it + iet+1 + iet+2 + ... + iet+(n–1))/n

In words: Interest rate on long bond = average short rates expected to occur over life of
long bond

Numerical example:
One-year interest rate over the next five years 5%, 6%, 7%, 8% and 9%,
Interest rate on two-year bond:
(5% + 6%)/2 = 5.5%
Interest rate for five-year bond:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
Interest rate for one to five year bonds:
5%, 5.5%, 6%, 6.5% and 7%.

Expectations Hypothesis and Term Structure Facts


Explains why yield curve has different slopes:
1. When short rates are expected to rise in future, the average of future short rates = int is
above today’s short rate: therefore the yield curve is upward sloping
2. When short rates are expected to stay the same in future, the average of future short
rates is the same as today’s, and the yield curve is flat
3. Only when short rates are expected to fall will the yield curve be downward sloping
Expectations Hypothesis explains Fact 1 that short and long rates move together
1. Short rate rises are persistent
2. If it ↑ today, iet+1, iet+2 etc. ↑ fi average of future rates ↑ fi int ↑
3. Therefore: it ↑ fi int ↑, i.e., short and long rates move together
Explains Fact 2 that yield curves tend to have steep slope when short rates are low
and downward slope when short rates are high
1. When short rates are low, they are expected to rise to normal level, and long rate =
average of future short rates will be well above today’s 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
Doesn’t explain Fact 3 that yield curve usually has upward slope
Short rates are as likely to fall in the future as rise, so the average of future short rates
will not usually be higher than the current short rate: therefore, the yield curve will not

3
usually slope upward.

Segmented Markets Theory


Key Assumption: Bonds of different maturities are not substitutes at all
Implication: Markets are completely segmented: interest rate at each maturity is
determined separately
Explains Fact 3 that the yield curve is usually upward sloping
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 it assumes that long and short rates are
determined independently

Liquidity Premium Theory


Key Assumption: Bonds of different maturities are substitutes, but are not perfect
substitutes
Implication: Modifies Expectations Theory with features of Segmented Markets Theory
Investors prefer short rather than long bonds fi must be paid positive liquidity (term)
premium, lnt, to hold long-term bonds
Results in the following modification of Expectations Theory
int = (it + iet+1 + iet+2 + ... + iet+(n–1))/n + lnt

Relationship Between the Liquidity Premium and Expectations Theories


Numerical Example:
1. One-year interest rate over the next five years:
5%, 6%, 7%, 8% and 9%
2. Investors’ preferences for holding short-term bonds results in liquidity
premiums for one to five-year bonds:
0%, 0.25%, 0.5%, 0.75% and 1.0%.

Interest rate on the two-year bond:


(5% + 6%)/2 + 0.25% = 5.75%
Interest rate on the five-year bond:
(5% + 6% + 7% + 8% + 9%)/5 + 1.0% = 8%
Interest rates on one to five-year bonds:
5%, 5.75%, 6.5%, 7.25% and 8%.
Comparing with those for the expectations theory, liquidity premium theory produces
yield curves more steeply upward sloped

Liquidity Premium Theory: Term Structure Facts


Explains all 3 Facts
Explains Fact 3 of the usual upward sloped yield curve by investors’ preferences for
short-term bonds
Explains Fact 1 and Fact 2 using the same explanations as the expectations hypothesis
because it states that the long rate is determined by the average of future short rates

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