Chapter 5

How Do Risk and Term Structure Affect Interest Rates?

Risk Structure of Interest Rates Default Risk Case: The Enron Bankruptcy and the Baa-Aaa Spread Liquidity Income Tax Considerations Summary Case: Effects of the Bush Tax Cut on Bond Interest Rates Term Structure of Interest Rates The Wall Street Journal: Following the News: Yield Curves Expectations Theory Market Segmentation Theory Liquidity Premium Theory Evidence on the Term Structure Mini-Case Box: The Yield Curve as a Forecasting Tool for Inflation and the Business Cycle Summary Case: Interpreting Yield Curves, 19802002 The Practicing Manager: Using the Term Structure to Forecast Interest Rates

Overview and Teaching Tips

Chapter 5 applies the tools the student learned in Chapter 4 to understanding why and how various interest rates differ. In courses that emphasize financial markets, this chapter is important because students are curious about the risk and term structure of interest rates. On the other hand, professors who focus on public policy issues might want to skip this chapter. The book has been designed so that skipping this chapter will not hinder the students understanding of later chapters. A particularly attractive feature of this chapter is that it gives students a feel for the interaction of data and theory. As becomes clear in the discussion of the term structure, theories are modified because they cannot explain the data. On the other hand, theories do help to explain the data, as the case on interpreting yield curves in the 19802004 period demonstrates. The Practicing Manager application at the end of the chapter shows how forecasts of interest rates from the term structure using the theories outlined here can be used by financial institutions managers to set interest rates on their financial instruments.

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Answers to End-of-Chapter Questions

1. The bond with a C rating should have a higher risk premium because it has a higher default risk, which reduces its demand and raises its interest rate relative to that on the Baa bond. 2. U.S. Treasury bills have lower default risk and more liquidity than negotiable CDs. Consequently, the demand for Treasury bills is higher, and they have a lower interest rate. 3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. 4. True. When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line. 5. If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the pure expectations theory. 6. The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on. 7. The steep upward-sloping yield curve at shorter maturities suggests that short-term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near future are above the current short-term interest rate. The downward slope for longer maturities indicates that short-term interest rates are eventually expected to fall sharply. With a positive risk premium on long-term bonds, as in the liquidity premium theory, a downward slope of the yield curve occurs only if the average of expected short-term interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on. 8. The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall. 9. The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds. 10. Lower brokerage commissions for corporate bonds would make them more liquid and thus increase their demand, which would lower their risk premium. 11. Abolishing the tax-exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall.

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How Do Risk and Term Structure Affect Interest Rates?

25

Quantitative Problems
1. a. The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.33% for a three-year bond, 6.5% for a four-year bond, and 6.6% for a five-year bond. (b) The yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4.33% for a three-year bond, 4.25% for a four-year bond, and 4.2% for a five-year bond. The upward-sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds because long-term bonds would then have a positive risk premium. The downward-sloping yield curve in (b) would be less steep and might even have a slight positive upward slope if the longterm bonds have a positive risk premium.

2. Government economists have forecasted one-year T-bill rates for the following five years, as follows: Year 1 2 3 4 5 1-year rate 4.25% 5.15% 5.50% 6.25% 7.10%

You have liquidity premium 0.25% for the next two years and 0.50% thereafter. Would you be willing to purchase a four-year T-bond at a 5.75% interest rate? Solution: Your required interest rate on a 4-year bond = Average interest on 4 one-year bonds + Liquidity Premium = (4.25% + 5.15% + 5.50% + 6.25%)/4 + 0.5% = 5.29% + 0.50% = 5.79% At a rate of 5.75%, the T-bond is just below your required rate. 3. What is the yield on a $1,000,000 municipal bond with a coupon rate of 8%, paying interest annually, versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying interest annually? Assume that you are in the 25% tax bracket. Solution: Municipal bond coupon payments equal $80,000 per year. No taxes are deducted; therefore, the yield would equal 8%. The coupon payments on a corporate bond equal $100,000 per year. But you only keep $75,000 because you are in the 25% tax bracket. Therefore your after-tax yield is only 7.5% 4. Consider the decision to purchase either a 5-year corporate bond or a 5-year municipal bond. The corporate bond is a 12% annual coupon bond with a par value of $1,000. It is currently yielding 11.5%. The municipal bond has an 8.5% annual coupon and a par value of $1,000. It is currently yielding 7%. Which of the two bonds would be more beneficial to you? Assume that your marginal tax rate is 35%.

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Solution: Municipal Bond Purchase Price = $1,061.50 After-tax Coupon Payment = $85 Par Value = $1,000 Calculated YTM = 7% Corporate Bond Purchase Price = $1,018.25 After-tax Coupon Payment = $78 Par Value = $1,000 Calculated YTM = 7.35% The corporate bond offers a higher yield, and is the better buy. 5. Debt issued by Southeastern Corporation currently yields 12%. A municipal bond of equal risk currently yields 8%. At what marginal tax rate would an investor be indifferent between these two bonds? Solution: Corporate Bonds (1 Tax Rate) = Municipal Bonds 12% (1 Tax Rate) = 8% 1 Tax Rate = 0.67, or Tax Rate = 0.33 6. 1-year T-bill rates are expected to steadily increase by 150 basis points per year over the next 6 years. Determine the required interest rate on a 3-year T-bond and a 6-year T-bond if the current 1-year interest rate is 7.5%. Assume that the Pure Expectations Hypothesis for interest rates holds. Solution: 3 year bond: year 1 interest rate = 7.5% year 2 interest rate = 9.0% year 3 interest rate = 10.5% number of years = 3 (7.5% + 9.0% + 10.5%)/3 = 9.0% 6 year bond: year 1 interest rate = 7.5% year 2 interest rate = 9.0% year 3 interest rate = 10.5% year 4 interest rate = 12% year 5 interest rate = 13.5% year 6 interest rate = 15% (7.5% + 9.0% + 10.5% + 12% + 13.5% + 15%)/6 = 11.25% 7. The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16%, 17.5%. Using the pure expectations theory, what will be the interest rates on a 3 year bond, 6 year bond, and 9 year bond? Solution: 3 year bond = [(3 + 4.5 + 6)]/(3) = 4.5% 6 year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5)]/(6) = 6.75% 9 year bond = [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/(9) = 9.333%

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How Do Risk and Term Structure Affect Interest Rates?

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8. Using the information for the previous question, now assume that the investor prefers holding shortterm bonds. A liquidity premium of 10 basis points is required for each year of a bonds maturity. What will be the interest rates on a 3 year bond, 6 year bond, and 9 year bond? Solution: To solve this problem, you will need to use the following equation:
it + ite+1 + ite+ 2 + +ite+ n 1 n 3 year bond = (0.30) + [(3 + 4.5 + 6)]/(3) = 4.8% 6 year bond = (0.60) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5)]/(6) = 7.35% 9 year bond = (0.90) + [(3 + 4.5 + 6 + 7.5 + 9 + 10.5 + 13 + 14.5 + 16)]/(9) = 10.233% int = lnt +

9. Which bond would produce a greater return if the pure expectations theory was to hold true, a 2-year bond with an interest rate of 15% or two 1 year bonds with sequential interest payment of 13% and 17%? Solution: Both of the bonds would produce the same return. Two 2 year bonds: = (13% + 17%)/2 = 15% 10. Little Monsters Inc. borrowed $1,000,000 for two years from NorthernBank Inc. at an 11.5% interest rate. The current risk-free rate is 2% and Little Monsterss financial condition warrants a default risk premium of 3% and a liquidity risk premium of 2%. The maturity risk premium for two-year loan is 1% and inflation is expected to be 3% next year. What does this information imply about the rate of inflation in the second year? Solution: If inflation were expected to remain constant at 3% over the life of the loan, the interest rate on the two-year loan would be 11%. Since the actual two-year interest rate is 11.5%, the one-year interest rate in year 2 must be 12%, since 11.5 = (11 + 12)/2. The required rate of 12% = Rf + DRP + LP + MRP + Inflation Premium. = 2% + 3% + 2% + 1% + Inflation Premium. So, the Inflation Premium in year 2 is 4%. But this is an average premium over two years. Inflation Premium 4% = (Year 1 Inflation + Year 2 Inflation)/2 = (3% + x)/2 or, x = 5% 11. One year T-bill rates are 2% currently. If interest rates are expected to go up, after 3 years, by 2% every year, what should be the required interest rate on a 10-year bond issued today? Solution: I (10 year bond) =
2 + 2 + 2 + 2(1.02) + 2(1.02)2 + + 2(1.02)7 10 = 21.165 /10 = 2.1165%

12. One year T-bill rates over the next 4 years are expected to be 3%, 4%, 5%, & 5.5%. If 4-year T-bonds are yielding 4.5%, what is the liquidity premium on this bond? Solution: 4.5% = (3% + 4% + 5% + 5.5%)/4 + LP 4.5% = 4.375% + LP 0.125% = LP

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13. At your favorite bond store, Bonds-R-Us, you see the following prices: a. 1-year $100 zero selling for $90.19 b. 3-year 10% coupon $1000 par bond selling for $1000 c. 2-year 10% coupon $1000 par bond selling for $1000 Assume that the pure expectations theory for the term structure of interest rates holds, no liquidity or maturity premium exists, and the bonds are equally risky. What is the implied 1-year rate two years from now? Solution: From (a), you know that the 1-year rate today is 10.877%. Using this information, (c) tells you that: 1000 = 100/1.10877 + 1100/(1 + 2-year rate)2 So, the 2-year rate today is 9.95%. Using these two rates, (b) tells you that: 1000 = 100/1.10877 + 100/1.09952 + 1100/(1 + 3-year rate)3 So, the 3-year rate today is 9.97% 1-year rate 2 years from now = (3 9.97% 2 9.95%) = 10.01% 14. You observe the following market interest rates, for both borrowing and lending: one-year rate = 5% two-year rate = 6% one-year rate one year from now = 7.25% How can you take advantage of these rates to earn a riskless profit? Assume that the Pure Expectation Theory for interest rates holds. Solution: Borrow $100 today at the two-year rate. You will be required to payback $100 (1.06) , or $112.36 in two years. Simultaneously, lend the $100 you borrowed at the one-year rate of 5%. A year later, you will have $105. Again, lend the $105 at the one-year rate of 7.25%. At the end of that year, you will have $105 (1.0725) = $112.6125. Use the $112.6125 to payoff the $112.36 you owe. This leaves $0.2525 in profit. Recall that this required no cash upfront. As long as the future rate of 7.25% is guaranteed, you can risklessly make a profit.
2

15. The expected one-year interest rate two years from now is
ite+ 2 = [(1 + i3t k3t) /(1 + i2t k2t) ] 1
3 2

= [(1 + 0.06 0.0035) /(1 + 0.05 0.0025) ] 1

3 2

= 0.075 = 7.5%.