The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Topic 4 (Chapter 6)
The Risk and Term
Structure of Interest Rates

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Learning Objectives
• LO1: Examine factors affecting the interest rates of bonds
with the same maturity.
• LO2: Explain the differences in interest rates of bonds with
different term to maturity using expectation theory,
segmented market theory and liquidity premium theory.
• LO3: Forecast future short-term interest rates using term
structure of interest rates.

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Figure 1 Long-Term Bond Yields, 1919–2017

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal
Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2

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I. Risk Structure of Interest Rates (1 of 3)
• Bonds with the same maturity have different interest rates
due to:
– Default risk
– Liquidity
– Tax considerations

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I. Risk Structure of Interest Rates (2 of 3)
1. Default risk: probability that the issuer of the bond is
unable or unwilling to make interest payments or pay off the
face value
– U.S. Treasury bonds are considered default-free
(government can raise taxes).
– Risk premium: the spread between the interest rates
on bonds with default risk and the interest rates on
(same maturity) Treasury bonds.

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Figure 2 Response to an Increase in Default
Risk on Corporate Bonds

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Table 1 Bond Ratings by Moody’s, Standard
and Poor’s, and Fitch (1 of 2)
Moody’s Rating Agency S&P Fitch Definitions
Aaa AAA AAA Prime Maximum Safety
Aa1 AA+ AA+ High Grade High Quality
Aa2 AA AA Blank
Aa3 AA– AA– Blank
A1 A+ A+ Upper Medium Grade
A2 A A Blank
A3 A– A– Blank
Baa1 BBB+ BBB+ Lower Medium Grade
Baa2 BBB BBB Blank
Baa3 BBB– BBB– Blank
Ba1 BB+ BB+ Noninvestment Grade

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Table 1 Bond Ratings by Moody’s, Standard
and Poor’s, and Fitch (2 of 2)
Moody’s Rating Agency S&P Fitch Definitions
Ba2 BB BB Speculative
Ba3 BB– BB– Blank
B1 B+ B+ Highly Speculative
B2 B B Blank
B3 B– B– Blank
Caa1 CCC+ CCC Substantial Risk
Caa2 CCC — In Poor Standing
Caa3 CCC– — Blank
Ca — — Extremely Speculative
C — — May Be in Default
— — D Default

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Fiinratings scale (Vietnam)
(in collaboration with S&P Global Ratings)

Source: fiinratings.vn
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Fiinratings scale (Vietnam)
(in collaboration with S&P Global Ratings)

Source: fiinratings.vn
Copyright © 2019 Pearson Education, Ltd.
The Global Financial Crisis and the Baa–
Treasury Spread
• Starting in August 2007, the collapse of the subprime
mortgage market led to large losses among financial
institutions. As a consequence, many investors began to
doubt the financial health of corporations with low credit
ratings such as Baa and even the reliability of the ratings
themselves. The perceived increase in default risk for Baa
bonds made them less desirable at any given price.

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I. Risk Structure of Interest Rates (3 of 3)
2. Liquidity: the relative ease with which an asset can be
converted into cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market
3. Income tax considerations
– Interest payments on municipal bonds are exempt from
federal income taxes.

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Figure 3 Interest Rates on Municipal and
Treasury Bonds

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Effects of the Obama Tax Increase on Bond
Interest Rates
In 2013, Congress approved legislation favored by the
Obama administration to increase the income tax rate on
high-income taxpayers from 35% to 39%. What was the
effect of this income tax increase on interest rates in the
municipal bond market relative to those in the Treasury bond
market?

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II. Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax characteristics
may have different interest rates because the time
remaining to maturity is different

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Figure 4 Movements over Time of Interest Rates on
U.S. Government Bonds with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

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II. Term Structure of Interest Rates
• Yield curve: a plot of the yield on bonds with differing
terms to maturity but the same risk, liquidity, and tax
considerations
– Upward-sloping: long-term rates are above
short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term rates
– Humped: the yield curve slopes up then slopes down
or vice versa.

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II. Term Structure of Interest Rates

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II. Term Structure of Interest Rates

Source: http://www.worldgovernmentbonds.com/
Copyright © 2019 Pearson Education, Ltd.
II. Term Structure of Interest Rates
The theory of the term structure of interest rates must
explain the following facts:
1. Interest rates on bonds of different maturities move
together over time. (fact 1)
2. When short-term interest rates are low, yield curves
are more likely to have an upward slope; when short-
term rates are high, yield curves are more likely to
slope downward and be inverted. (fact 2)
3. Yield curves almost always slope upward. (fact 3)

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II. Term Structure of Interest Rates
Three theories to explain the three facts:
1. Expectations theory: explains the first two facts but
not the third.
2. Segmented markets theory: explains the third fact
but not the first two.
3. Liquidity premium theory: combines the two theories
to explain all three facts.

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1. Expectations Theory
• The expectations theory states that: the interest rate on a
long-term bond will equal an average of the short-term
interest rates that people expect to occur over the life of
the long-term bond.

• Assumption: Buyers of bonds do not prefer bonds of one

maturity over another → They will not hold any quantity of
a bond if its expected return is less than that of another
bond with a different maturity.
→ Bond holders consider bonds with different maturities
to be perfect substitutes, then the expected returns on
those bonds must be equal.

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1. Expectations Theory

An investor with $1 and 2-year investment horizon has

two possible options available: Invest in a two-year bond
and hold it to maturity or invest in two one-year bonds,
one after another.
o Return from two-year bond investment with the
interest rate (YTM) of i2: $1x(1 + i2)2
o Return from two one-year investment with the
interest rate (YTM) of 𝑖1 and 𝑖2𝑒 , respectively:
$1x(1 + i1) x (1 + 𝑖2𝑒 )

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1. Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite+1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

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1. Expectations Theory

• According to the expectations theory, because investors

will be indifferent between these two strategies, they
must have the same return.

(1 + i2)2 = (1 + i1) x (1 + 𝑖2𝑒 )

𝑖1 + 𝑖2𝑒
• OR: i2 =
2

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1. Expectations Theory

General formula
𝑒 𝑒 𝑒
𝑖𝑡 + 𝑖𝑡+1 + 𝑖𝑡+2 +⋯+ 𝑖𝑡+(𝑛−1)
int =
𝑛
• it = today’s interest rate on a n-period bond (at time t)
𝑒
• 𝑖𝑡+1 = interest rate on a n-period bond expected for next
period (time t + 1)
• int = today’s n-period interest rate on the n-period bond (at
time t)

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1. Expectations Theory (2 of 7)
Example: Suppose that the one-year interest rates over the
next three years are expected to be 5%, 6%, 7%. Calculate
the interest rate of two-year bond and three-year bond. Draw
the yield curve.

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1. Expectations Theory (7 of 7)
• Expectations theory explains:
– Why the term structure of interest rates changes at
different times.
– Why interest rates on bonds with different maturities
move together over time (fact 1).
– Why yield curves tend to slope up when short-term
rates are low and slope down when short-term rates
are high (fact 2).
• Cannot explain why yield curves usually slope upward
(fact 3)

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2. Segmented Markets Theory
• The segmented markets theory sees markets for different-
maturity bonds as completely separate and segmented.
The interest rate on a bond of a particular maturity is then
determined by the supply of and demand for that bond and
is not affected by expected returns on other bonds with
other maturities.
• Assumption: Bonds of different maturities are not
substitutes at all. → The expected return from holding a
bond of one maturity has no effect on the demand for a
bond of another maturity.

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2. Segmented Markets Theory
• Investors have very strong preferences for bonds of one
maturity as opposed to another
→They are concerned only with the expected returns on
bonds of the maturity they prefer.
• If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then this
explains why yield curves usually slope upward (fact 3).

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3. Liquidity Premium Theory
• The liquidity premium theory states that: The interest
rate on a long-term bond will equal an average of short-
term interest rates expected to occur over the life of the
long-term bond plus a liquidity premium that responds to
supply and demand conditions for that bond.
• Assumption: Bonds of different maturities are partial (not
perfect) substitutes.
• Investors tend to prefer shorter-term bonds because these
bonds bear less interest-rate risk.
→ Investors must be offered a positive liquidity premium to
induce them to hold longer term bonds.
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3. Liquidity Premium Theory

it + it+1
e
+ it+2
e
+ ...+ it+(
e

int = n−1)
+ lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

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Figure 5 The Relationship Between the Liquidity
Premium and Expectations Theory

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3. Liquidity Premium Theory (2 of 2)
• Interest rates on different maturity bonds move together
over time (fact 1); 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
(fact 2); explained by the liquidity premium term in the first
case and by a low expected average in the second case
• Yield curves typically slope upward (fact 3); explained by a
larger liquidity premium as the term to maturity lengthens

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Figure 6 Yield Curves and the Market’s Expectations of
Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory

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Figure 7 Yield Curves for U.S. Government
Bonds

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Summary
• Risk structure of interest rates
– Default risk
– Liquidity
– Income tax treatment
• Term structure of interest rates:
– Expectations theory
– Segmented markets theory
– Liquidity premium theory

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