9/09/2023

BỘ GIÁO DỤC VÀ ĐÀO TẠO

TRƯỜNG ĐẠI HỌC KINH TẾ - TÀI CHÍNH
THÀNH PHỐ HỒ CHÍ MINH

The Economics of Money, Banking,

and Financial Markets

Chapter 6: The Risk and Term Structure of

Interest Rate

TRẦN NGỌC THANH

[email protected]

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Đại học Kinh tế - Tài chính thành phố Hồ Chí Minh
www.uef.edu.vn
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Learning 0bjectives

● Identify and explain the three factors affecting the risk

structure of interest rates.
● List and explain the three theories of term structures of
interest rates.

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Table of contents

01 RISK STRUCTURE OF
INTEREST RATE 02 TERM STRUCTURE
OF INTEREST RATE

Why are the interest rates of Why are the interest rates of 1-year
corporate bonds and government bonds and 5-year bonds different?
bonds different? (1-year bonds) (corporate bonds)

Risk Structure of Interest Rates

Figure 1 Long-Term Bond Yields, 1919–2014

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Risk Structure of Interest Rates

● Relationships among interest rates on bonds that have different

characteristics but same maturity.
● Bonds with the same maturity have different interest rates due
to:
– Default risk
– Liquidity
– Tax considerations

Risk Structure of Interest Rates

● Default risk: probability that the

issuer of the bond is unable or
unwilling to make interest payments
or pay off the face value
– Government bonds are
considered default-free bonds.

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Risk Structure of Interest Rates

● Risk premium: The spread

between interest rates on
bonds with default risk and
interest rates on default-free
bonds, both of the same
maturity.

Risk Structure of Interest Rates

● A bond with default risk will always have a positive risk premium
● An increase in its default risk will raise the risk premium
=> Default-risk bonds have higher interest rates than default-free bonds.

MORE RISK MORE RETURN

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Junk Bonds with ratings

below Baa (or BBB)
have higher default risk
but have higher interest
rates

Risk Structure of Interest Rates

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

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Risk Structure of Interest Rates

● Liquidity: the relative ease with which an asset can be
converted into cash.
GOVERNMENT CORPORATE BONDS
BONDS
LIQUIDITY MOST LIQUID LESS LIQUID

DEMAND HIGHER LOWER

PRICE HIGHER LOWER

INTEREST RATE LOWER HIGHER

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Risk Structure of Interest Rates

● Income tax consideration:

Interest payments on municipal bonds are exempt from income
taxes.

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Risk Structure of Interest Rates

● Income tax exemption

MUNICIPAL BONDS CORPORATE BONDS

TAX EXEMPTION YES NO

DEMAND HIGH LOW

PRICE HIGH LOW

INTEREST RATE LOW HIGH

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Risk Structure of Interest Rates

Figure 1 Long-Term Bond Yields, 1919–2014

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2. Term structure of Interest Rates

● Term structure: Bonds with identical risk, liquidity, and tax

characteristics, but different maturity may have different interest
rates.

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YIELD CURVE

● Yield curve: a plot of

the interest rates of
bonds with differing
maturity terms but
same characteristics
(risk, liquidity and tax
considerations)

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YIELD CURVE

● Normal (upward slope): long-

term interest rates are above
short-term interest rate.
● Flat: short- and long-term
interest rates are the same
● Inverted: long-term interest
rates are below short-term
interest rates

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Term structure of Interest Rates

● Fact 1: Yield curves almost always slope upward.

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Term structure of Interest Rates

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Term structure of Interest Rates

● Fact 2: Interest rates on bonds of different maturities move

together over time.
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Term structure of Interest Rates

Long-term ● Fact 3:
bond

o When short-term interest rates

are low, yield curves are more
Short-term
bond
likely to have an upward slope;

o when short-term rates are high,

Short-term yield curves are more likely to
bond
Long-term
bond
slope downward.

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Term structure of Interest Rates

● Fact 1: Yield curves almost always slope upward.

● Fact 2: Interest rates on bonds of different maturities move
together over time.
● Fact 3:
- 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

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2.1. Expectations Theory

● The interest rate on a long-term bond will equal an average of

the short-term interest rates that occur over the life of the
long-term bond.

 Bonds with different maturities to be perfect substitutes.

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Expectations Theory
Expectations Theory can explains:

• Bonds with different maturities to be

perfect substitutes.

=> interest rates on bonds with

different maturities move together over
time (Fact 2)

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Expectations Theory

Long-term Expectations Theory can explains:

bond
● why yield curves tend to slope up
when short-term rates are low and
slope down when short-term rates
Short-term
bond are high (Fact 3)

Short-term
bond
Long-term
bond

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Expectations Theory
Expectations Theory can explains:

Cannot explain why yield

curves usually slope upward
(Fact 2)

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Segmented Markets Theory

● The interest rate on a bond of a particular maturity is

determined by the supply of and demand for that bond
● Not affected by expected interest rates of other bonds with
other maturities.
● Bonds of different maturities are not substitutes at all.

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Segmented Markets Theory

SHORT-TERM BOND LONG-TERM BOND

RISK LOW RISK HIGH RISK

BUYING PREFERENCE

PRICE

INTEREST RATE

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Segmented Markets Theory

SHORT- LONG-TERM
TERM BOND BOND
INTERST
LOW HIGH
RATE

✅ The Yield curves almost

always slope upward (Fact 1).

❌ Fact 2
❌ Fact 3

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Segmented Markets Theory

● Investors generally prefer bonds with shorter maturities that

have less interest-rate risk,
=> The demand for short-term bonds is typically relatively higher
than that for long-term bonds
=> Long-term bonds will have lower prices than short-term bonds.
=> Long-term bonds will have higher interest rates than short-terms
bonds.
=> The Yield curves almost always slope upward (Fact 3).
● Cannot explain Fact 1 and 2
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Liquidity Premium

● 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 rises with the term to maturity.
● Bonds of different maturities are not perfect substitutes.

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Liquidity Premium

● plus a liquidity premium that rises with the term to maturity.

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Liquidity Premium and Preferred Habitat Theories

SHORT-TERM BOND LONG-TERM BOND

RISK LOW RISK HIGH RISK

LIQUIDITY PREMIUM

BUYING PREFERENCE

● Preferred Habitat Theories

- Investors tend to prefer shorter-term bonds (less interest-rate risk) over that of
longer-term bonds.
- But long-term bonds are offered a positive liquidity premium to induce them to
hold longer-term bonds.

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Liquidity Premium and Preferred Habitat

Theories
Figure 8: The Relationship Between the Liquidity Premium (Preferred Habitat) and
Expectations Theory

✅ The Yield curves

almost always slope
upward (Fact 2).

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Liquidity Premium and Preferred Habitat

Theories

● Example: Bonds with one-year interest rates over the next five
years are expected to be 5%, 6%, 7%, 8%, and 9%.
The liquidity premiums for one- to five-year bonds are 0%,
0.25%, 0.5%, 0.75%, and 1.0%,
What are the interest rates of the one- to five-year bonds?

Fact 2: Yield curves almost always slope upward.

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Liquidity Premium and Preferred Habitat

Theories

(a): increasing expected short-term

interest rates + liquidity premium
(b): unchanged expected short-term
interest rates + liquidity premium
(c ): Moderately decreasing expected
short-term interest rates + liquidity
premium.
(d): Sharly decreasing expected short-
term interest rate + liquidity premium.

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Liquidity Premium and Preferred Habitat

Theories

The Liquidity Premium and Preferred Habitat theories can explain:

● Fact 1: Yield curves almost always slope upward
● Fact 2: Interest rates on bonds of different maturities move
together over time.
● Fact 3: 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.

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Why do we have to learn about the

3 theories?
PREDICTION TOOLS FOR BUSINESS CYCLE AND INFLATION

○ Upward slope => economic

growths and inflation
○ Flat slope => inflation
decreasing and recession
incoming
○ Downward slope =>
recession

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Figure 8: The yield curve (the spread between 2-year and 10-year bond yield) and
recession from 1978 to 20222022

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