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Economics 370 Money and Banking

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Explains why interest rates on bonds with different maturities move together ... Explains why yield curves tend to slope up when short-term rates are low and ... – PowerPoint PPT presentation

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Title: Economics 370 Money and Banking


1
Economics 370Money and Banking
  • Instructor
  • Ryan Herzog

2
Overview
  • Homework 1
  • Chapter 6

3
Chapter 6 The Risk and Term Structure of
Interest Rates
  • Risk Structure of Interest Rates
  • Default Risk
  • Term Structure of Interest Rates
  • Expectations Theory
  • Segmented Markets Theory
  • Liquidity Premium and Preferred Habitat Theories
  • Evidence of the Term Structure

4
Risk Structure of Interest Rates
  • Risk Structure of Interest Rates
  • Relationship among interest rates
  • Default riskoccurs when the issuer of the bond
    is unable or unwilling to make interest payments
    or pay off the face value
  • U.S. T-bonds are considered default free
  • Risk premiumthe spread between the interest
    rates on bonds with default risk and the interest
    rates on T-bonds (see graph)

5
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6
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7
Enron and the Bond Market
  • The bankruptcy increased the spread between Baa
    and Aaa rated bonds.
  • Aaa bonds became more desirable
  • Rates fell from 6.97 to 6.77
  • Baa bonds became less desirable
  • Rates increased from 7.81 to 8.07
  • The spread increased from .84 to 1.28

8
Other factors
  • Liquidity
  • Demand increases with liquidity
  • U.S. long term bonds are very liquid
  • Corporate bonds are less liquid
  • There are fewer bonds for any one corporation
  • Income Taxes and Municipal Bonds
  • Not risk free and less liquid than U.S. bonds
  • Tax free status increases the demand for muni
    bonds

9
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
  • Yield curvea 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

10
Facts of Interest Rates (KEY)
  • Theory of the term structure must explain
  • Interest rates on bonds of different maturities
    move together over time
  • 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
  • Yield curves are almost always upward sloping

11
Three Theories
  • Expectations Theory
  • Explains the first two facts but not the third
  • Segmented Markets Theory
  • Explains fact three but not the first two
  • Liquidity Premium Theory
  • Combines the two theories to explain all three
    facts

12
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13
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
  • Bonds like these are said to be perfect
    substitutes

14
Expectations TheoryExample
  • 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.

15
Expectations Theory In General
  • Purchase a one-year bond, and when it matures
    purchase another one-year bond
  • Purchase a two year bond and hold it until
    maturity

16
Expectations Theory In General
17
Expectations Theory In General
18
Expectations Theory In General
19
Expectations Theory and Yield Curve
  • A rising trend in short term rates increases the
    long term bond rates
  • When the yield curve is upward sloping
  • Short term rates are expected to rise in the
    future, long term rates increase today
  • When the yield curve is downward sloping
  • The average of future short terms rates is
    expected to be lower than current short term
    rates
  • When the yield curve is flat
  • Short term rates are not expected to change on
    average

20
Expectations Theory
  • Explains why interest rates on bonds with
    different maturities move together over time
    (fact 1)
  • An increase in short term rates today will
    increase future expected short term rate and thus
    long term rates today
  • 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)
  • When interest rates are low (high), people
    expected higher (lower) future short term rates
    and higher (lower) current long term rates, thus
    the yield curve is upward sloping.
  • Cannot explain why yield curves usually slope
    upward (fact 3)

21
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 have short desired holding periods,
    as it seems, they generally prefer bonds with
    shorter maturities that have less interest-rate
    risk
  • Demand decreases for long term bonds, decreasing
    price but increasing the interest rate
  • Then this explains why yield curves usually slope
    upward (fact 3)

22
Liquidity Premium Preferred Habitat Theories
  • Liquidity Premium
  • 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 substitutes but
    not perfect substitutes

23
Liquidity Premium
  • Bonds are substitutes
  • Returns on short terms bonds will influence long
    term rates
  • Because bonds are not perfect substitutes it
    allows investors to prefer one bond maturity over
    the another
  • Investors prefer short term bonds
  • Less interest rate risk and are more liquid
  • Investors are credited with a liquidity premium
    for holding long term bonds

24
Liquidity Premium Theory
25
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

26
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27
Explanation of the Facts
  • 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

28
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