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How Do Risk and Term Structure Affect Interest Rates

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Eeruj Malik
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22 views5 pages

How Do Risk and Term Structure Affect Interest Rates

Uploaded by

Eeruj Malik
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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how do risk and term structure affect interest rates?

default risk:

risk that the issuer of the bond will be unable or unwilling to make interest payments
when promised or to pay off the face value when the bond matures

u.s. treasury bond:

 no default risk
 also known as "default-free bonds"
 lower interest rates

corporate bonds:

 carry default risk


 higher interest rates

risk premium:

 difference between the interest rates on bonds with default risk (corporate bonds)
and bonds with no default risk
 indicates how much additional interest people must earn in order to be willing to
hold that risky bond

response to an increase in default risk on corporate bonds:

initially: (same risk / same interest rate / risk premium = 0) and same maturity

default risk of corporate bonds ⬆ > demand of corporate bonds ⬇ > demand curve
shifts left > price of corporate bonds ⬇ > interest rate on corporate bonds ⬆

default risk of corporate bonds ⬆ > demand of u.s. treasury bonds ⬆ > demand curve
shifts right > price of u.s. treasury bonds ⬆ > interest rate on u.s. treasury bonds ⬇

result: risk premium > 0

u.s treasury bonds are more (actually, most) liquid than corporate bonds

response to a decrease in liquidity on corporate bonds:

initially: same liquidity, (same risk, same interest rate, risk premium = 0), and same
maturity

liquidity of corporate bonds ⬇ > demand of corporate bonds ⬇ > demand curve shifts left
> price of corporate bonds ⬇ > interest rate on corporate bonds ⬆
liquidity of corporate bonds ⬇ > demand of u.s. treasury bonds ⬆ > demand curve shifts
right > price of u.s. treasury bonds ⬆ > interest rate on u.s. treasury bonds ⬇

result: risk premium > 0

risk premium is both "risk and liquidity premium"

term structure of interest rates:

1. interest rates for different maturities move together


2. when short rates are low, yield curves tend to have upward slope; when short
rates are high, yield curves tend to have a downward slope
3. yield curve is typically upward sloping

theories:

expectation theory explains facts (1) and (2)

market segmentation theory only explains fact (3)

liquidity premium theory explains all three facts

expectation theory:

key assumption: bonds of different maturities are perfect substitutes

implication: interest rate on bonds of different maturities are equal

expectation theory states that the interest rate on a long-term bond equals the
average of short rates expected to occur over life of the long term bond

result: interest rates for different maturities move together


expectation theory states:

1. when short rates are expected to increase in future, long rates will increase
more (result: yield curve will be upward sloping)
2. when short rates are expected to decrease in future, long rates will
decrease more (result: yield curve will be downward sloping)
3. when short rates are expected to stay same in future, long rates will also
stay same (result: yield curve will be flat)

market segmentation theory:

key assumption: bonds of different maturities are not substitutes at all

implication: interest rate at each maturity are determined separately

market segmentation theory states: the demand for long-term bonds < demand
for short-term bond > interest rates on long term bonds are higher

result: yield curve typically slopes upward

liquidity premium theory:

key assumption: bonds of different maturities are substitutes, but are not perfect
substitutes

implication: modifies expectations theory with features of market segmentation theory

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 (also referred to as a term premium)
that responds to supply-and-demand conditions for that bond
results:

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