I.

Risk Structure of
Interest rates

II. Term Structure of

Interest rates
1.DEFAULT RISK
2. LIQUIDITY
3. INFORMATION COSTS is
the cost of acquiring
information.
4. TAXATION
 Borrowers differ in their ability to repay
in full the principle and interest required
by a loan agreement.

Measuring the default risk

 The default risk premium on a bond is
the difference between its yield and the
yield on a default risk free instrument of
comparable maturity, and it measures
the default risk.
 Investors care about liquidity, they are
willing to accept a lower interest rate on
more liquid investments than on less
liquid – illiquid – investments, all other
things being equal.
 The activity of an investor who devotes
resources – time and money – to acquire
information on an asset reduces the
expected return on that financial asset.
The cost of using those recourses thus is
included in the borrowing cost charged
by lender, just as the cost of labor is
included in the price of sweater.
 If two assets have equal default risk and
liquidity, investors prefer to hold the
asset with lower information cost
 If returns on all instruments were taxed
identically, the differences among
instruments in terms of default risk,
liquidity and information cost would be
the only sources of variation in the risk
structure
The risk structure of interest rates (the
relationship among interest rates on bonds
with the same maturity) is explained by three
factors: default risk, liquidity, and the income
tax treatment of the bond’s interest
payments. As a bond’s default risk increases,
the risk premium on that bond (the spread
between its interest rate and the interest rate
on a default-free Treasury bond) rises. The
greater liquidity of Treasury bonds also
explains why their interest rates are lower
than interest rates on less liquid bonds. If a
bond has a favorable tax treatment, as do
municipal bonds, whose interest payments
are exempt from federal income taxes, its
interest rate will be lower.
 Expectations theory
 Segmented Market
Theory
 The Liquidity Premium
Theory
 The interest rate on a long term bond will
equal an average of short term interest rates
that people expect to occur over the life of the
long-term bond.
 For example, if people expect that short-term
interest rates will be 10% on average over the
coming five years, the expectations theory
predicts that the interest rate on bonds with
five years to maturity will be 10% too. If short-
term interest rates were expected to rise even
higher after this five-year period so that the
average short-term interest rate over the
coming 20 years is 11%, then the interest rate
on 20-year bonds would equal 11% and would
be higher than the interest rate on five-year
 of the term structure sees markets for
different maturity bonds are completely
separate and segmented. The interest rate
for each bond with a different maturity is
then determined by the supply of and
demand for that bond with no effect from
expected returns on other bonds with other
maturities
 The key assumption in the segmented
markets theory is that bonds of different
maturities are not substitutes at all, so the
expected return from holding a bond of one
maturity has no effect on the demand for a
bond of another maturity. This theory of the
term structure is at the opposite extreme to
the expectations theory, which assumes that
bonds of different maturities are perfect
 The liquidity premium theory is the most
widely accepted theory of the term
structure of interest rates because it
explains the major empirical facts about the
term structure so well.

 It combines the features of both the

expectation theory and the segmented
markets theory by asserting that a long-
term interest rate will be the sum of
liquidity (term) premium and the average of
the short-term interest rates that are
expected to occur over the life of the bond.
 of the term structure 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 term premium) that responds
to supply and demand conditions for that
bond.
 Main assumption of the theory: is that bonds
of different maturities are substitutes, which
means that the expected return on one
bond does influence the expected return on
maturity on a bond with of a different
maturity, but it allows investors to prefer
one bond maturity over another.
 It assumes that investors have a preference
for bonds of one maturity over another, a
particular bond maturity (preferred habitat) in
which they prefer to invest.
 Because they prefer 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.
 Because investors are likely to prefer the
habitat of short-term bonds over that of
longer-term bonds, they are willing to hold
long-term bonds only if they have higher
expected returns.
Suppose that the one-year interest rate over
the next five years is expected to be 5, 6, 7, 8,
and 9%, while investors’ preferences for
holding short-term bonds means that the
liquidity premiums for one- to five-year bonds
are 0, 0.25, 0.5, 0.75, and 1.0%, respectively.
Equation 3 then indicates that the interest rate
on the two-year bond would be:
 The liquidity premium and preferred habitat theories
are the most widely accepted theories of the term
structure of interest rates because they explain the
major empirical facts about the term structure so
well. They combine the features of both the
expectations theory and the segmented markets
theory by asserting that a long-term interest rate will
be the sum of a liquidity (term) premium and the
average of the short-term interest rates that are
expected to occur over the life of the bond. The
liquidity premium and preferred habitat theories
explain the following facts:
 (1) Interest rates on bonds of different maturities
tend to move together over time,
 (2)yield curves usually slope upward, and (3) when
short-term interest rates are low, yield curves are
more likely to have a steep upward slope, whereas
when short-term interest rates are high, yield curves
are more likely to be inverted.
1. Bonds with the same maturity will
have different interest rates because of
three factors: default risk, liquidity, and tax
considerations. The greater a bond’s default
risk, the higher its interest rate relative to
other bonds; the greater a bond’s liquidity,
the lower its interest rate; and bonds with
tax-exempt status will have lower interest
rates than they otherwise would. The
relationship among interest rates on bonds
with the same maturity that arise because
of these three factors is known as the risk
structure of interest rates.
2. Four theories of the term structure
provide explanations of how interest rates on
bonds with different terms to maturity are
related. The expectations theory views long-
term interest rates as equaling the average of
future short-term interest rates expected to
occur over the life of the bond; by contrast, the
segmented markets theory treats the
determination of interest rates for each bond’s
maturity as the outcome of supply and
demand in that market only. Neither of these
theories by itself can explain the fact that
interest rates on bonds of different maturities
move together over time and that yield curves
usually slope upward.
3. The liquidity premium and preferred habitat
theories combine the features of the other two
theories, and by so doing are able to explain the
facts just mentioned. They view long-term
interest rates as equaling the average of future
short-term interest rates expected to occur over
the life of the bond plus a liquidity premium.
These theories allow us to infer the market’s
expectations about the movement of future
short-term interest rates from the yield curve. A
steeply upwardsloping curve indicates that future
short-term rates are expected to rise, a mildly
upward-sloping curve indicates that short-term
rates are expected to stay the same, a flat curve
indicates that short-term rates are expected to
decline slightly, and an inverted yield curve
indicates that a substantial decline in short-term
rates is expected in the future.