Chapter 6

The Risk and Term

Structure
of Interest Rates
 Risk & Term Structure
of Interest Rates
• This chapter looks at the relationship of the
various interest rates to one another to
understand why they differ from bond to
bond; thus, which bonds to purchase as
investment and which one to sell.
• It will consider:
– Risk structure of interest rates: why bonds with
the same maturity have different interest rates
– Term structure of interest rates: why bonds
with different terms to maturity have different
interest rates

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 Risk Structure of Interest Rates

• Bonds with the same maturity have

different interest rates due to:
– Default risk
– Liquidity
– Tax considerations

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 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

– Govt. Treasury bonds are considered default free

(government can raise taxes to pay off the debt).

– Risk premium: the spread between the interest

rates on bonds with default risk and the interest
rates on (same maturity) Treasury bonds

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 FIGURE 2 Response to an Increase
in Default Risk on Corporate Bonds
1. Assuming that initially, both bonds have
same default risk, thus initial equilibrium prices
and interest rates are equal (PC1=PT1 and
iC1=iT1), thus, risk premium (iC1=iT1) is zero.

2. An increase in default risk

shifts the demand curve for
corporate bonds left.

3. And shifts the demand curve

for Treasury bonds to the right.

4. This raises the price of Treasury bonds and lowers the price of Corporate bonds, and,
lowers the interest rate on Treasury bonds and raises the rate on Corporate bonds. Thus,
increasing the spread between the interest rates on Corporate vs Treasury bonds.

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 Table 1 Bond Ratings by Moody’s,
Standard and Poor’s, and Fitch

Investors need
to know if a Bonds with
corporation is rating below
likely to default BBB have
on its bonds; an higher default
information risk, called
provided by Junk Bonds
Credit Rating (thus, High-
Agencies. yield bonds)

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 Risk Structure of Interest Rates

• A bond with default risk will always have a

positive risk premium, and an increase in its
default risk will raise the risk premium.
• Corporate bonds always have higher interest
rates than Treasury bonds because they
always have some risk of default.
• BBB rated corporate bonds have a greater
default risk than the higher rated AAA bonds,
thus their risk-premium is greater and the
BBB rate always exceeds the AAA rate.

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 Risk Structure of Interest Rates
• Liquidity: the relative ease with which an asset
can be converted into cash
– Time & cost of selling a bond
– Number of buyers/sellers in a bond market
• The more liquid a bond is, the more desirable it is.
– Treasury bonds are the most liquid
– Lower liquidity of corporate bonds increases the spread
between the interest rates
• Figure 2 again
• Risk premium is more accurately a ‘risk & liquidity
premium’

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 Risk Structure of Interest Rates

• Income tax considerations

• Interest payments on municipal bonds
are exempt from federal income taxes.

• Investors can earn more on Municipal bonds

after taxes, so they are willing to hold the
riskier and less liquid municipal bond even
though it has a lower interest rate than the
Treasury bond.

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 FIGURE 3 Interest Rates on
Municipal and Treasury Bonds
1. Tax-free status shifts the
demand for Municipal bonds
to the right.

2. And shifts the

demand for
Treasury bonds to
the left.

3. Thus municipal
bonds end up with
a higher price and a
lower interest rate
than on Treasury
bonds.

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 Summary

• As the bond’s default risk increases, the risk

premium on that bond rises,
• Greater liquidity of Treasury bonds leads to
lower interest rates than those on less liquid
bonds

• If a bond has a favorable tax treatment, its

interest rates will be lower

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 Term Structure of Interest Rates

• Bonds with identical risk, liquidity, and tax

characteristics may have different interest
rates because the time remaining to
maturity is different.

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 Term Structure of Interest Rates

• Yield curve: a plot of the yield on bonds

with differing terms to maturity but the
same risk, liquidity and tax considerations
• May have different shapes:
– Upward-sloping (normal): long-term rates
are above short-term rates
– Flat: short- and long-term rates are the same
– Downward-sloping (Inverted): long-term
rates are below short-term rates

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 Three Facts that Theory of the Term
Structure of Interest Rates Must Explain

1. Interest rates on bonds of different maturities

move together over time (T1 & T3)

2. 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 (T1 & T3)

3. Yield curves usually slope upward (T2 & T3)

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 Three Theories to Explain the
Three Facts

1. Expectations theory explains the first

two facts but not the third
2. Segmented markets 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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 Expectations Theory
• The interest rate on a long-term bond will equal
an average of the short-term interest rates that
people expect to occur over the life of the long-
term bond
• Buyers of bonds do not prefer bonds of one
maturity over another; they will not hold
any quantity of a bond if its expected return
is less than that of another bond with a different
maturity
• Bond holders consider bonds with different
maturities to be perfect substitutes
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 Expectations Theory: Example
• Lets consider two investment strategies:
– Purchase a one-year bond, and when it matures in
one year, purchase another one-year bond
– Purchase a two-year bond and hold it until maturity
• Let the current rate on one-year bond be 6%
and you expect the interest rate on a one-year
bond to be 8% next year.
• Then the expected return for buying two one-
year bonds averages (6% + 8%)/2 = 7%.
• The interest rate on a two-year bond must be
7% for you to be willing to purchase it.
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 Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

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 Expectations Theory (cont’d)

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

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 Expectations Theory (cont’d)

If two one-period bonds are bought with the $1 investment

(1  it )(1  i )  1
e
t 1

1  it  i  it (i )  1
e
t 1
e
t 1

it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1

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 Expectations Theory (cont’d)

Both bonds will be held only if the expected returns are equal
2i2t  it  ite1
it  ite1
i2t 
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it  ite1  ite 2  ...  ite ( n 1)
int 
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

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 Expectations Theory
• Explains why the term structure of interest rates
changes at different times.
• Explains why interest rates on bonds with different
maturities move together over time [fact 1]
– short-term rates have had the characteristic that if
they increase today, they will tend to be higher in
the future
– Thus rise in short-term rates will raise people’s
expectations of future short-term rates
– As long term rates are the average of expected
future short-term rates, a rise in short-term rates
will also raise long-term rates; causing short-term
and long-term rates to move together.
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 Expectations Theory

• Explains why yield curves tend to [fact 2]

– slope up when short-term rates are low (thus
expected to rise in the future) and
– slope down when short-term rates are high (thus
expected to fall in the future),
– and flat when short-term rates are not expected
to change, on average, in the future.
• Cannot explain why yield curves usually slope
upward [fact 3]

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 Segmented Markets Theory
• Markets for different-maturity bonds are
completely separated and segmented

• The interest rate for each bond with a

different maturity is determined by the
demand for and supply of that bond

• Bonds of different maturities, thus, are not

substitutes at all

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 Segmented Markets Theory (contd.)

• Investors have preferences for bonds of one maturity

over another
• So, they are concerned with the expected returns only
for bonds of the maturity they prefer.
• They also have a particular holding period in mind, so
they can obtain a certain return with no risk at all (by
matching the holding period with the maturity of the
bond)
– If they have a short holding period, they prefer short-term
bonds, and vice-versa.
• If investors generally prefer bonds with shorter
maturities that have less interest-rate risk, then, this
explains why yield curves usually slope upward (fact 3)
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 Segmented Markets Theory (contd.)

• This theory can explain Fact 3, but not Fact 1 or Fact 2

• It views the market for bonds of different maturities as
completely segmented:
– There is no reason for a rise in interest rates on a bond of one
maturity to affect the interest rate on a bond of another
maturity
– The theory thus can not explain why interest rates on bonds of
different maturities tend to move together (Fact 1)
• It is not clear how demand & supply for short-vs-long
term bonds change with the level of short-term interest
rates
– The theory, thus, can not explain why yield curves tend to slope
upward when short-term interest rates are low and to be
inverted when short-term interest rates are high.

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 Liquidity Premium &
Preferred Habitat Theories
• 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 responds to supply and demand
conditions for that bond
• Bonds of different maturities are partial (not
perfect) substitutes

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 Liquidity Premium Theory

it  it1
e
 it2
e
 ... it(
e

int  n1)
 lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
Investors tend to prefer shorter-term bonds (for less
interest-rate risk), thus a positive liquidity premium is
required to induce them to hold longer-term bonds.

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 Preferred Habitat Theory
• Investors have a preference for bonds of
one maturity over another
• They will be willing to buy bonds that do not
have the preferred maturity only if they
earn a somewhat higher expected return
– Investors are likely to prefer short-term bonds
over longer-term bonds
– They are willing to hold long-term bonds only if
they have higher expected return
– Same equation as in Liquidity Premium Theory

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 FIGURE 5 The Relationship Between the
Liquidity Premium (Preferred Habitat) and
Expectations Theory

1. Yield curve in
expectations theory is
drawn under the
assumed scenario of
unchanging future
one-year interest
rates.

2. As liquidity
premium is always
positive, and grows
as the term to
maturity increases,
the yield curve in LP
& PH theories is
always above the
yield curve in Exp.
Theory, and has a
steeper slope.

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 Liquidity Premium and Preferred
Habitat Theories

• Interest rates on different maturity bonds move

together over time; explained by the first term in
the equation
• Yield curves tend to slope upward when short-term
rates are low and to be inverted when short-term
rates are high; explained by the liquidity premium
term in the first case and by a low expected
average in the second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens

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 FIGURE 6 Yield Curves and the Market’s Expectations of
Future Short-Term Interest Rates According to the Liquidity
Premium (Preferred Habitat) Theory

a. Steeply rising c. Flat yield curve

yield curve indicates that
indicates that short-term
short-term interest rates are
interest rates are expected to fall
expected to rise moderately in
in the future. the future.

b. Moderately steep a. Inverted Yield

yield curve curve indicates
indicates that that short-term
short-term interest rates are
interest rates are expected to fall
not expected to sharply in the
rise or fall much future.
in the future.

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