2/20/2025

Chapter 03
Structure of Interest Rates

Md. Kaysher Hamid

Lesson Outline
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o Why Debt Security Yields Vary

o Estimating the Appropriate Yield

o Theories of Term Structure

o Use of the Term Structure

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Why Debt Security Yields Vary

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 The yields on debt securities are affected:

o Credit (default) risk

o Liquidity

o Tax status

o Term to maturity

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Why Debt Security Yields Vary

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 Credit (Default) Risk

o Securities with a higher degree of default risk offer higher yields.

o Rating Agencies - Rating agencies charge the issuers of debt securities a

fee for assessing default risk.

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Why Debt Security Yields Vary

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 Credit (Default) Risk

National Credit Ratings Ltd.

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Why Debt Security Yields Vary

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 Credit (Default) Risk

o National Credit Ratings Ltd.

(http://www.ncrbd.com/services.php?nId=9&pId=14&nName=Services)

o Credit Rating Agency of Bangladesh Ltd. (https://crab.com.bd/credit-

rating-scales-and-definitions/)

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Why Debt Security Yields Vary

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 Credit (Default) Risk

o Rating Agencies

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Why Debt Security Yields Vary

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 Liquidity

o Debt securities with a short-term maturity or an active secondary

market have greater liquidity

o The lower a security’s liquidity, the higher the yield preferred by an

investor.

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Why Debt Security Yields Vary

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 Tax Status

o Investors are more concerned with after-tax income

o Taxable securities must offer a higher before-tax yield

o The extra compensation required on taxable securities depends on

the tax rates of individual and institutional investors.

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Why Debt Security Yields Vary

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 Tax Status

o Consider a taxable security that offers a before-tax yield of 8 percent.. If

the tax rate of the investor is 20 percent, then what is the after-tax yield?

o Suppose that a firm in the 20 percent tax bracket is aware of a tax-

exempt security that is paying a yield of 8 percent. To match this after-
tax yield, taxable securities must offer a before-tax yield of ………….

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 Exercise 01

You need to choose between investing in a one-year municipal bond with

a 7 percent yield and a one-year corporate bond with an 11 percent yield.
If your marginal federal income tax rate is 30 percent and no other
differences exist between these two securities, which would you invest in?

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Why Debt Security Yields Vary

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 Exercise 02

You need to choose between investing in a 10-year corporate bond with a 13.5
percent yield and a 10-year corporate bond with a 12 percent yield. If your
marginal governmental income tax rate is 15 percent and no other differences
exist between these two securities, which would you invest in? Why?

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Why Debt Security Yields Vary

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 Term to Maturity

o Maturity dates will differ between debt securities

o The term structure of interest rates defines the relationship between term
to maturity and the annualized yield

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Estimating the Appropriate Yield

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Yn = Rf,n + DP + LP + TA

where:

Yn = yield of an n-day debt security

Rf,n = yield of an n-day Treasury (risk-free) security

DP = default premium to compensate for credit risk

LP = liquidity premium to compensate for less liquidity

TA = adjustment due to difference in tax status

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Estimating the Appropriate Yield

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Suppose that the three-month T-bill’s annualized rate is 8 percent and

that Elizabeth Company plans to issue 90-day commercial paper.
Assume Elizabeth Company believes that a 0.7 percent default risk
premium, a 0.2 percent liquidity premium, and a 0.3 percent tax
adjustment are necessary to sell its commercial paper to investors.
Calculate the appropriate yield to be offered on the commercial paper?

Yn = Rf,n + DP + LP + TA

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Estimating the Appropriate Yield

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 Exercise 03
a) A corporation is planning to sell its 90-day commercial paper to
investors by offering an 8.4 percent yield. If the three-month T-
bill’s annualized rate is 7 percent, the default risk premium is
estimated to be 0.6 percent, and there is a 0.4 percent tax
adjustment, then what is the appropriate liquidity premium?
b) Suppose that, because of unexpected changes in the economy, the
default risk premium increases to 0.8 percent. Assuming that no
other changes occur, what is the appropriate yield to be offered
on the commercial paper?

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Theories of Term Structure

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o Pure Expectations Theory

o Liquidity Premium Theory

o Segmented Markets Theory

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Theories of Term Structure

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 Pure Expectations Theory

o Term structure reflected in the shape of the yield curve is determined

solely by the expectations of interest rates.

o An expected increase in rates leads to an upward sloping yield curve

o An expected decrease in rates leads to a downward sloping yield curve.

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Theories of Term Structure

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 Pure Expectations Theory

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Theories of Term Structure

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 Pure Expectations Theory

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 Pure Expectations Theory

o If investors were indifferent to maturities, the return of any security

should equal the compounded yield of consecutive investments in
shorter-term securities. That is, a two-year security should offer a
return that is similar to the anticipated return from investing in two
consecutive one-year securities and so on.

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Theories of Term Structure

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 Pure Expectations Theory

o If the term structure of interest rates is solely influenced by

expectations of future interest rates, the following relationships hold:

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Theories of Term Structure

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 Liquidity Premium Theory

o Investors prefer short-term liquid securities but will be willing to

invest in long-term securities if compensated with a premium for
lower liquidity.

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Theories of Term Structure

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 Liquidity Premium Theory

where LP2 is the liquidity premium on the 2 year security

The relationship between the liquidity premium and term to maturity

can be expressed as follows:

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Theories of Term Structure

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 Exercise 04
a) Assume that, as of today, the annualized two-year interest rate is
13 percent and the one year interest rate is 12 percent. Use this
information to estimate the one-year forward rate.
b) Assume that the liquidity premium on a two-year security is 0.3
percent. Use this information to estimate the one-year forward rate.

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Theories of Term Structure

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 Segmented Markets Theory

o Investors choose securities with maturities that satisfy their forecasted
cash needs.
o If investors and borrowers participate only in the maturity market that
satisfies their particular needs, then markets are segmented. That is,
investors (or borrowers) will shift from the long-term market to the
short-term market, or vice versa, only if the timing of their cash needs
changes.
o The choice of long-term versus short-term maturities is determined more
by investors’ needs than by their expectations of future interest rates.

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Theories of Term Structure

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 Segmented Markets Theory

o Limitations of the theory

 Some borrowers and savers have the flexibility to choose among various
maturities

o Implications: Preferred Habitat Theory

 Although investors and borrowers may normally concentrate on a particular

maturity market, certain events may cause them to wander from their “natural”
or preferred market.

 Preferred habitat theory acknowledges that natural maturity markets may

influence the yield curve, but it also recognizes that interest rate expectations
could entice market participants to stray from their natural, preferred markets.
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Integrating the Theories of the Term Structure

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 If we assume the following conditions:

o Investors and borrowers who select

security maturities based on anticipated
interest rate movements currently
expect interest rates to rise.

o Most borrowers are in need of long-

term funds, while most investors have
only short-term funds to invest Then all three conditions place
upward pressure on long-term yields
o Investors prefer more liquidity to less. relative to short term yields leading to
upward sloping yield curve.

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Use of the Term Structure

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 Forecasting Interest Rates

o The shape of the yield curve can be used to assess the general
expectations of investors and borrowers about future interest rates.

o The curve’s shape should provide a reasonable indication (especially

once the liquidity premium effect is accounted for) of the market’s
expectations about future interest rates.

 Forecasting Recessions

o Some analysts believe that flat or inverted yield curves indicate a

recession in the near future.

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Use of the Term Structure

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 Making Investment Decisions

o If the yield curve is upward sloping, some investors may attempt to

benefit from the higher yields on longer-term securities even though
they have funds to invest for only a short period of time.

 Making Decisions about Financing

o Firms can estimate the rates to be paid on bonds with different

maturities. This may enable them to determine the maturity of the
bonds they issue.

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Exercises
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5. a. Determine the forward rate for various one-year interest rate scenarios
if the two-year interest rate is 8 percent, assuming no liquidity premium. Explain
the relationship between the one-year interest rate and the one-year forward rate
while holding the two-year interest rate constant.
b. Determine the one-year forward rate for the same one-year interest rate
scenarios described in question (a) while assuming a liquidity premium of 0.4
percent. Does the relationship between the one-year interest rate and the forward
rate change when the liquidity premium is considered?
c. Determine how the one-year forward rate would be affected if the
quoted two-year interest rate rises; hold constant the quoted one-year interest rate as
well as the liquidity premium. Explain the logic of this relationship.
d. Determine how the one-year forward rate would be affected if the
liquidity premium rises and if the quoted one-year interest rate is held constant.
What if the quoted two-year interest rate is held constant? Explain the logic of this
relationship.

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Exercises
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6. If ti1 > ti2, what is the market consensus forecast about the one-year
forward rate one year from now? Is this rate above or below today’s one-
year interest rate? Explain.

7. Determine how the after-tax yield from investing in a corporate bond is

affected by higher tax rates, holding the before-tax yield constant. Explain
the logic of this relationship.

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