The risk and term structure of interest rates

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The risk and term structure of interest rates

• Mishkin, Chap 6

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• Chap 5 discusses
• The risk structure of interest rates
• The term structure of interest rates
  expectations theory, segmented markets theory,
  liquidity premium theory

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price of the bond

Price of the bond
quantity of corporate bonds
quantity of Treasury bonds
Start with the same demand and supply of both.
Assume an increase in corporate default risk
and/or lower liquidity. Conclusion?
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price of the bond

Price of the bond
quantity of Municipal bonds
quantity of Treasury bonds
Start with the same demand and supply of both.
Assume an increase in federal tax rates.
Conclusion?
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Two bonds with identical risk, liquidity and tax
characteristics, such as may have different YTMs
because An yield curve is yield curves are
upward sloping if yield curves downward sloping
if yield curves are flat if
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Empirical behavior of interest rates

• Historically interest rates on bonds of different
  maturities
• Historically, when short-term interest rates are
  low, yield curves
• when short-term rates are high, yield curves
• 3. Historically, yield curves almost always

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• Expectations Theory of term structure
• Bonds are _________ substitutes of each other
  buyers are
• current interest rate on a one-year bond short
  term interest rate
• short term interest rate next year
• average interest rate earned by investing on two
  one year bonds in sequence
• hence interest rate on a two-year bond must be
• Expectations Theory interest rate on a long
  term bond equals

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Expectations theory algebraically current
interest rate on a one-period bond (today)
expected interest rate on a one-period bond next
year current interest rate on a two-period bond
Return from investing 1 on a two period
bond
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Expectations theory algebraically
(contd.) Return from investing 1 two
one-period bonds in sequence Since both
bonds are perfect substitutes for bonds with
longer term to maturity
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Expectations theory explains 1. why interest
rates on bonds of different maturities 2. why
yield curves are ________ sloping, when
___________ interest rates are _______ and
_________ sloping, when ______ interest rates are
________ cannot explain why
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• Segmented Markets theory
• bonds of different maturities are
• investors have different preferences
• interest rate for each bond determined by
• investors generally have
• Segmented Markets theory explains why
• cannot explain

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• Liquidity premium and preferred habitat theories
• bonds of different maturities are
• investors have different preferences
• interest rate for each bond determined by
• investors generally have

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• Liquidity premium and preferred habitat theories
  explain why
• interest rates on bonds of different maturities
• yield curves are ________ sloping, when
  ___________
• interest rates are _______ and _________ sloping,
  when ______ interest rates are ________
• yield curves typically slope

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