10/18/2020

The Economics of Money, Banking,

and Financial Markets
Eleventh Edition

Chapter 6
The Risk and
Term Structure of
Interest Rates

Learning Objectives
6.1 Identify and explain three factors explaining the risk
structure of interest rates.
6.2 List and explain the three theories of why interest
rates vary across maturities.

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Risk Structure of Interest Rates (1 of 3)

• Bonds with the same maturity have different interest
rates due to:
– Default risk
– Liquidity
– Tax considerations

Figure 1 Long-Term Bond Yields, 1919–2014

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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Risk Structure of Interest Rates (2 of 3)

• 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)
 So we compare with US Treasury bonds

• Risk premium: the spread between the interest

rates on bonds with default risk and the interest
rates on (same maturity) Treasury bonds

Figure 2 Response to an Increase in

Default Risk on Corporate Bonds

Step 1 An increase in default risk shifts the demand curve for corporate bonds left . . .
Step 2 and shifts the demand curve for Treasury bonds to the right . . .
Step 3 which raises the price of Treasury bonds and lowers the price of corporate
bonds, and therefore lowers the interest rate on Treasury bonds and raises the rate
on corporate bonds, thereby increasing the spread between the interest rates on
corporate versus Treasury bonds.

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Table 1 Bond Ratings by Moody’s,

Standard and Poor’s, and Fitch (1 of 2)
Rating Agency
Moody’s 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
Ba2 BB BB Speculative

Table 1 Bond Ratings by Moody’s,

Standard and Poor’s, and Fitch (2 of 2)
Rating Agency
Moody’s S&P Fitch Definitions
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
— — DDD Default

— — D Blank
— D D Blank

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Risk Structure of Interest Rates (3 of 3)

• 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
• Income tax considerations
– Interest payments on municipal bonds are exempt
from federal income taxes.

Figure 3 Interest Rates on Municipal

and Treasury Bonds

Step 1 Tax-free status shifts the demand for municipal bonds to the right . . .

Step 2 and shifts the demand for Treasury bonds to the left . . .

Step 3 with the result that municipal bonds end up with a higher price and a lower
interest rate than on 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%.
• Consistent with supply and demand analysis, the
increase in income tax rates for wealthy people
helped to lower the interest rates on municipal bonds
relative to the interest rate on Treasury bonds.
• Demand for municipal bonds went up and demand for
Treasury bonds went down => interest rate on
municipal bonds went down and interest rate on
Treasury bonds went up

Term Structure of Interest Rates (1 of 4)

• Bonds with identical risk, liquidity, and tax
characteristics
– may still have different interest rates because the
time remaining to maturity is different

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Term Structure of Interest Rates (2 of 4)

• 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

Term Structure of Interest Rates (3 of 4)

The theory of the term structure of interest rates must
explain the following empirical facts:
1. Interest rates on bonds of different maturities
move together over time.
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.
3. Yield curves almost always slope upward.

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Term Structure of Interest Rates (4 of 4)

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.

Figure 4 Movements Over Time of Interest Rates

on U.S. Government Bonds with Different
Maturities (Positive correlation)

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

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Expectations Theory (1 of 7)
• 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.

• 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.

Expectations Theory (2 of 7)
An example:
• Let the current rate on one-year bond be 6%.
• You expect the interest rate on a one-year bond to
be 8% next year.
• Then the expected return for buying two one-year
(6%  8%)
bonds averages  7%.
2
• The interest rate on a two-year bond must be 7%
for you to be willing to purchase it.

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Expectations Theory (3 of 7)
For an investment of $1
i t  today's interest rate on a one-period bond
i te1  interest rate on a one-period bond expected for next period
i 2t  today's interest rate on the two-period bond

Expectations Theory (4 of 7)
Expected return over the two periods from investing $1
in the two-period bond and holding it for the two periods
(1  i 2t )(1  i 2t )  1
 1  2i 2t  ( i 2t )2  1
 2i 2t  ( i 2t )2

Since ( i 2t )2 is very small the expected return for holding

the two-period bond for two periods is 2i 2t

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Expectations Theory (5 of 7)
If two one-period bonds are bought with the $1
investment
(1  i t )(1  i te1 )  1
1  i t  ite1  i t (ite1 )  1
it  ite1  i t (ite1 )

i t (i te1 ) is extremely small

Simplifying we get i t  i te1

Expectations Theory (6 of 7)
Both bonds will be held only if the expected returns are equal
2i 2t  i t  i te1
it  ite1
i2t 
2
The two-period rate must equal the average of the two
one-period rates. For Bonds with longer maturities
i t  i te1  i te2  ...  ite n 1
i nt 
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the
bond

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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)

Segmented Markets Theory

• Bonds of different maturities are not substitutes at all.
• The interest rate for each bond with a different maturity
is determined by the demand for and supply of that
bond.
• Investors have preferences for bonds of one maturity
over another.
• 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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Liquidity Premium and Preferred

Habitat Theories (1 of 2)
• 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.
• Bonds of different maturities are partial (not perfect)
substitutes.

Liquidity Premium Theory

it  i te1  ite2  ...  i te n 1
i nt   l nt
n
where l nt is the liquidity premium for the n-period bond
at time t
l nt : Is always positive
Int: Rises with the term to maturity

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Preferred Habitat Theory

• Investors have a preference for bonds of one maturity
over another.
• They will be willing to buy bonds of different maturities
only if they earn a somewhat higher expected return.
• Investors are likely to prefer short-term bonds over
longer-term bonds.

Figure 5 The Relationship Between the Liquidity

Premium (Preferred Habitat) and Expectations
Theory

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Liquidity Premium and Preferred

Habitat Theories (2 of 2)
• Interest rates on different maturity bonds move
together 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 slope upward; explained by a
larger liquidity premium as the term to maturity
lengthens

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

High interest rates:

- Downward sloping

Middle interest rate:

- Flat curve

Low interest rates:

- Upward sloping

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