Master of Business Administration

in Finance
MBAFI5221 - Financial Markets

Risk and Term Structure of Interest Rates

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Risk Structure of Interest Rates

• Risk Structure of Interest Rates refers to the variations in interest

rates that arise due to differences in the risk associated with
different types of debt instruments
• It explains why securities of similar maturities might have
different yields based on factors like credit risk, liquidity, and
taxation, even if the basic time-to-maturity is the same

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 Risk Structure of Long-term Bonds

FIGURE 1:

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Factors affecting Risk Structure of Interest Rates

▪ Default Risk
▪ Liquidity
▪ Income Tax Considerations

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Default Risk Factor

▪ Default Risk occurs when the issuer of the bond is unable or

unwilling to make interest payments when promised

▪ Default-free bonds: Treasury bonds are usually considered to

have no default risk because in principle the government can
always increase taxes to pay off its obligations

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Default Risk Factor (cont.)

▪ Spread between the interest rates on bonds with default risk

and default-free bonds, called the risk premium, indicates how
much additional interest people must earn in order to be willing
to hold that risky bond
▪ A bond with default risk will always have a positive risk
premium, and an increase in its default risk will raise the risk
premium

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 Increase in Default Risk on Corporate Bonds

1. Risk of corp. bonds , Dc , 1. Relative risk of T bonds , DT ,

Dc shifts DT shifts right
2. Excess Supply  Pc , ic  2. Excess Demand  PT , iT 
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Default Risk Factor (cont.)

• Default risk is an important component of the size of the risk

premium
• Because of this, bond investors would like to know as much as
possible about the default probability of a bond
• One way to do this is to use the measures provided by credit-
rating agencies: Moody’s and S&P etc.

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Bond Ratings

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Case: The Global Financial Crisis and the Baa-Treasury Spread
• Starting in August 2007, the collapse of the subprime mortgage market led to large losses in financial
institutions
• As a consequence of the subprime collapse and the subsequent global financial crisis, 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
• Perceived increase in default risk for Baa bonds made them less desirable and shifted the demand curve
for Baa bonds to the left
• Interest rates on Baa bonds rose by 280 basis points (2.80 percentage points) from 6.63% at the end of
July 2007 to 9.43% at the most lethal stage of the global financial crisis in mid-October 2008
• Increase in perceived default risk for Baa bonds in October 2008 made default-free US Treasury bonds
relatively more attractive and shifted the demand curve for these securities to the right, an outcome
described by some analysts as a “flight to quality”
• Interest rates on Treasury bonds fell by 80 basis points, from 4.78% at the end of July 2007 to 3.98% in
mid-October 2008
• Spread between interest rates on Baa and Treasury bonds rose by 360 basis points, from 1.85% before
the crisis to 5.45% afterward
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Liquidity Factor

▪ A liquid asset is one that can be quickly and cheaply converted

into cash
▪ The more liquid an asset is, the more desirable it is (higher
demand), holding everything else constant
▪ Treasury bonds are the most liquid of all long-term bonds because
they are so widely traded that they are easy to sell quickly and the
cost of selling them is low

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Liquidity Factor (cont.)

• Corporate bonds are not as liquid because fewer bonds for any one
corporation are traded
• Thus, it can be costly to sell these bonds because it may be hard to find
buyers quickly
• Differences between interest rates on corporate bonds and
T-bonds (that is, the risk premiums) reflect not only the corporate bond’s
default risk but its liquidity risk too
• This is why a risk premium is sometimes called a liquidity premium

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 Decrease in Liquidity of Corporate Bonds

1. Liquidity of Corp. bonds , 1. Relatively more liquid T bonds,

Dc , Dc shifts left DT , DT shifts right
2. Pc , ic  2. PT , iT 
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Income Taxes Factor

▪ A n odd feature of Figure 1 is that municipal bonds tend to have a

lower rate than Treasuries
▪ State and local governments have defaulted on the municipal bonds
they have issued in the past
▪ Municipal bonds are not as liquid as Treasuries

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Income Taxes Factor (cont.)

▪ Interest payments on municipal bonds are exempt from

federal income taxes
▪ For the same before tax yield, their expected after tax
returns are higher
▪ Treasury bonds are exempt from state and local income taxes,
while interest payments from corporate bonds are fully
taxable

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Income Taxes Factor (cont.)

• Imagine that you have a high enough income to put you in the 35% income tax bracket,
where for every extra dollar of income you have to pay 35 cents to the government
• If you own a $ 1,000-face-value US T-bond that sells for $ 1,000 and has a coupon payment
of $ 100, you get to keep only $ 65 of the payment after taxes
• Although the bond has a 10% interest rate, you actually earn only 6.5% after taxes
• Suppose, however, that you put your savings into a $ 1,000 face-value municipal bond
that sells for $ 1,000 and pays only $ 80 in coupon payments
• Its interest rate is only 8%, but because it is a tax-exempt security, you pay no taxes on
the $ 80 coupon payment, so you earn 8% after taxes
• Clearly, you earn more on the municipal bond after taxes, so you are willing to hold the
riskier and less liquid municipal bond even though it has a lower interest rate than the US
Treasury bond
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Term Structure of Interest Rates

• Apart from risk, liquidity, taxes, another important factor

influencing interest rates is the maturity
• Bonds with different maturities tend to have different
required rates, all else equal

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 Interest Rates on Different Maturity Bonds Move Together

FIGURE 2:

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Yield Curve
• Yield curve, or term structure of interest rates, plots yield to maturity against term to
maturity of a security
• Yield curve is upward sloping when investors expect short-term interest rates to
increase in the future
• Yield curve is downward sloping if investors expect short-term interest rates to decline

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Term Structure: Facts to Be Explained

Besides explaining the shape of the yield curve, a good theory

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

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Pure Expectations Theory

▪ Key Assumption: Bonds of different maturities are perfect

substitutes
▪ Implication: Re on bonds of different maturities are equal
▪ Investment strategies for two-period horizon
1. Buy $1 of one-year bond and when matures buy another one-
year bond
2. Buy $1 of two-year bond and hold it

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Pure Expectations Theory (cont.)

▪ Expected return from strategy 1

▪ Since is also extremely small, expected return is

approximately

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Pure Expectations Theory (cont.)

▪ Expected return from strategy 2 (Buy $1 of two-year bond and hold it)

▪ Since (i2t)2 is extremely small, expected return is

approximately 2(i2t)

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Pure Expectations Theory (cont.)

▪ Since bonds of different maturities are perfect substitutes

and therefore Re on bonds of different maturities are equal.
▪ Therefore
t

Solving for i2t

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Pure Expectations Theory (cont.)

• Following picture describes the same information:

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Pure Expectations Theory (cont.)

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More generally for n-period bond…

▪ Equation above simply states that

the interest rate on a long-term bond equals the
average of short-term rates expected to occur over
life of the long-term bond.

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Expectations Theory: Numerical Example

The one-year interest rates over the next five years are expected to
be 5%, 6%, 7%, 8% and 9%.
Given this information, what are the interest rates on a two-year
bond and a five-year bond? Explain what is happening to the
yield curve.

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Numerical Example: Solution

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Expectations Theory and Term Structure Facts

• Explains why yield curve has different slopes

1. When short-term rates are expected to rise in future, average of
future short rates = int is above today's short rate; therefore yield
curve is upward sloping
2. When short-term rates expected to stay same in future,
average of future short rates would be same as today’s, and
yield curve is flat
3. Only when short-term rates expected to fall will yield curve
be downward sloping

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Expectations Theory and Term Structure Facts (cont.)

• Pure expectations theory explains fact 1 – that short and

long-term rates move together
1. Short term rate rises are persistent
2. If it  today, iet+1, iet+2 etc.  
average of future rates   int 
3. Therefore: it   int 
(i.e., short and long term rates move together)

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Expectations Theory and Term Structure Facts (cont.)
• Explains fact 2 – that yield curves tend to have steep upward slope
when short-term rates are low and downward slope when short-term
rates are high
1. When short-term rates are low, they are expected to rise to normal
level
2. Long-term rate = average of future short-term rates: yield curve will
have steep upward slope
3. When short-term rates are high, they will be expected to fall in future
to their normal level
4. Long-term rate will be below current short-term rate: yield curve will
have downward slope

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Expectations Theory and Term Structure Facts (cont.)

• Doesn't explain fact 3 – that yield curve usually has an

upward slope
– Short-term rates are as likely to fall in future as rise, so
average of expected future short-term rates will not
usually be higher than current short-term rate
– Therefore, yield curve will not usually slope upward

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Market Segmentation Theory (Preferred Habitat Theory)

▪ Key Assumption: Bonds of different maturities are not

substitutes at all
▪ Implication: Markets are completely segmented; interest
rate at each maturity are determined separately

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Market Segmentation Theory

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Market Segmentation Theory (cont.)

▪ Explains fact 3 – that yield curve is usually upward

sloping
– People typically prefer short holding periods and thus have
higher demand for short-term bonds, which have higher
prices and lower interest rates than long-term bonds
▪ Does not explain fact 1 or fact 2 because it assumes long-
term and short-term rates are determined independently

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Liquidity Premium Theory

▪ Key Assumption:
• Bonds of different maturities are substitutes, but are not perfect
substitutes.
▪ Implication:
• Modifies Pure Expectations Theory with features of Market
Segmentation Theory
▪ Investors prefer short-term rather than long-term bonds.
▪ This implies that investors must be paid positive liquidity
premium, int, to hold long term bonds.

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Liquidity Premium Theory (cont.)

• Results in following modification of Expectations Theory,

where int is the liquidity premium.

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Liquidity Premium Theory (cont.)

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Numerical Example

Suppose that the one-year interest rates over the next five
years are expected to be 5%, 6%, 7%, 8%, and 9%.
Investors’ preferences for holding short-term bonds have the
liquidity premiums for one-year to five-year bonds as 0%, 0.25%,
0.5%, 0.75%, and 1.0%, respectively.
What is the interest rate on a two-year bond and a five year
bond?
Compare these findings with the answer for the Example
discussed under the pure expectations theory.
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Numerical Example: Solution

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Liquidity Premium Theory: Term Structure Facts

• Explains all 3 Facts

– Explains fact 3—that usual upward sloped yield curve by
liquidity premium for long-term bonds.
– Explains fact 1 and fact 2 using same explanations as pure
expectations theory because it has average of future short-
term rates as determinant of long-term rate.

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Yield Curves and the Market’s Expectations of Future Short-Term
Interest Rates According to the Liquidity Premium Theory

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Summary of the Three Theories to Explain the Three Facts

1. Expectations theory explains the first two facts but not the
third
2. Markets segmentation theory explains fact three but not the
first two
3. Liquidity premium theory combines the two theories to explain
all three facts

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Thank you…

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