The Merge of NYSE and Deutsche

Börse
• NYSE: founded in 1817, the biggest stock exchange
in the world.
• Merged with Euronext (based in Netherland) in 2006
to form NYSE Euronext
• Agreed with Deutsche Borse on a merge deal on Feb
9th 2011.
• LSE merged with Toronto Stock Exchange on the same
day.
• NASDAQ attempted to acquiare London Stock Exchange
(LSE) and failed in 2007.
• NASDAQ OMX and IntercontinentalExchange (ICE)
jointly launched an unsolicited takeover bid for
NYSE Euronext

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 The World’s biggest Stock
Exchanges by Market Capitalization
Rank Name Economy
1 NYSE Euronext U.S/Europe
2 NASDAQ OMX U.S/Europe
3 Tokyo Stock Exchange Japan
4 London Stock Exchange United Kingdom
5 Shanghai Stock Exchange China
6 Hong Kong Stock Exchange Hong Kong, China
7 Toronto Stock Exchange Canada
8 Bombay Stock Exchange India
9 National Stock Exchange of India
India
10 BM&F Bovespa Brazil
11 Australian Securities Australia
Exchange
12 Deutsche Börse
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Germany 6-2
Chapter 6

The Risk and Term

Structure
of Interest Rates

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 FIGURE 1 Long-Term Bond
Yields, 1919–2008

Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal
Reserve: www.federalreserve.gov/releases/h15/data.htm.

6-4
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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

6-5
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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
– U.S. Treasury bonds are considered default
free (government can raise taxes).
– 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

6-7
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 Table 1 Bond Ratings by
Moody’s, Standard and Poor’s,
and Fitch

6-8
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 Application: The Subprime Collapse
and the Baa-Treasury Spread

Corporate Bond Risk Premium and Flight to

Quality

10
8
6
4
2
0
7

8
7

8
07

08
07

08

09
7

8
7

8
l-0

l-0
-0

-0
-0

-0
-0

-0
p-

p-
n-

n-

n-
ay

ay
ar

ar
ov

ov
Ju

Ju
Se

Se
Ja

Ja

Ja
M

M
M

M
N

N
Corporate bonds, monthly data Aaa-Rate
Corporate bonds, monthly data Baa-Rate
10-year maturity Treasury bonds, monthly data

6-9
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
 Risk Structure of Interest
Rates
• Liquidity: the relative ease with
which an asset can be converted into
cash
– Cost of selling a bond
– Number of buyers/sellers in a bond market
• Income tax considerations
– Interest payments on municipal bonds are
exempt from federal income taxes.

6-10
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 FIGURE 3 Interest Rates on
Municipal and Treasury Bonds

6-11
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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

6-12
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 FIGURE 4 Movements over Time of Interest
Rates on U.S. Government Bonds with
Different Maturities

Sources: Federal Reserve: www.federalreserve.gov/releases/h15/data.htm.

6-13
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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
– Upward-sloping: long-term rates are above
short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term
rates
– http://stockcharts.com/charts/YieldCurve.html

6-14
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 Facts Theory of the Term Structure
of Interest Rates Must Explain

1. Interest rates on bonds of different

maturities move together over time
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
3. Yield curves almost always slope
upward
6-15
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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

6-16
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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

6-17
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 Expectations Theory:
Example
• Let the current rate on one-year bond
be 6%.
• 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

6-20
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 Expectations Theory
(cont’d)

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

e
(1  it )(1  i )  1
t 1
e e
1  it  i  it (i )  1
t 1 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)
• Explains why yield curves tend to slope up
when short-term rates are low and slope
down when short-term rates are high (fact
2)
• Cannot explain why yield curves usually
slope upward (fact 3)
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 Segmented Markets Theory

• Bonds of different maturities are not

substitutes at all
• The interest rate for each bond with a
different maturity is determined by the
demand for and supply of that bond
• Investors have preferences for bonds of
one maturity over another
• 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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 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

e e e
it  it1  it2  ... it( n 1)
int   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

6-26
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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 of
different maturities only if they
earn a somewhat higher expected
return
• Investors are likely to prefer short-
term bonds over longer-term bonds

6-27
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 FIGURE 5 The Relationship Between the
Liquidity Premium (Preferred Habitat)
and Expectations Theory

6-28
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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
6-29
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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

6-30
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 FIGURE 7 Yield Curves for
U.S. Government Bonds

Sources: Federal Reserve Bank of St. Louis; U.S. Financial Data, various issues; Wall Street
Journal, various dates.

6-31
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