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## The Risk and Term Structure of Interest Rates

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### 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 ... – PowerPoint PPT presentation

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Title: The Risk and Term Structure of Interest Rates

1
The Risk and Term Structure of Interest Rates
• Chapter 5

2
The Term Structure of Rates and the Yield Curve
• Term Structure
• Relationship among yields of different maturities
of the same type of security.
• Yield Curve
• Graphical relationship between yield and maturity.

3
Empirical Facts
• 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 interest rates are high, yield
curves are more likely to slope downward and be
inverted.
• Yield curves almost always slope upward.

4
Different Theories of the Shape of the Yield Curve
• Supply and Demand
• Determined by relative supply/demand of different
maturities
• Deals with each maturity by itself and ignores
the interrelationships between different
maturities of the same security

5
Expectations Hypothesis
• The shape of the yield curve is determined by the
investors expectations of future interest rate
movements.
• The interest rate on the 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.
• If the one-year interest rate over the next five
years is expected to be 5, 6, 7, 8, 9 percent,
• then the interest rate on the two-year bond would
be 5.5.
• While for the five-year bond it would be 7.
• Investors are indifferent between short and
long-term securities.

6
• Investors know from experience that short-term
securities provide greater marketability and have
smaller price fluctuations than do long-term
securities.
for holding long-term securities.
• Therefore, a two-year security would have to
yield more than the average of the two one-year
securities as a reward for bearing more risk.

7
The Preferred Habitat Approach
• 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 term (liquidity) premium that responds to
supply and demand conditions for that bond.
• If investors prefer the habitat of short-term
bonds over long-term bonds, they might be willing
to hold short-term bonds even though they have a
lower expected return. This means that investors
would have to be paid a positive term premium to
be willing to hold a long-term bond.

8
Real-World Observations
• When interest rates are high relative to past
rates, investors expect them to decline and the
price of bonds to rise in the future resulting in
big capital gains
• Investors would then favor long-term securities,
which drives up price and lowers yielddownward
sloping yield curve

9
Real-World Observations
• If interest rates are low relative to
pastresults in an upward sloping curve
• Historically, over the business cycle short-term
rates fluctuate more than longer-term rates
• Yield curves tend to be upward sloping more
often, suggesting the liquidity premium is the
dominate theory

10
Summary of Term Structure Theory
• Expectations theory forms the foundation of the
slope of the curve
• Liquidity premium theory makes a long-term
permanent modification that suggests an upward
sloping curve
• Over short periods, relative supplies of
securities have an impact on yields, altering the
shape of the curve

11
Government Bonds
• Current coupon or on the run issue.

12
Marketability
• Recently issued government bonds (current
couponon the run) are more marketable than
older issues (off the run)
• Because these newly issued bonds are highly
marketable, they carry somewhat lower yields to
maturity as compared to older issues

13
Default Risk
• Other than US Federal government securities,
bonds carry a risk of default
• Risk on municipal bonds used to be considered
very low
• However, experience of New York City (1975),
Cleveland (1978) and Orange Country, California
(1995) suggest these bonds are becoming riskier
• Corporate bonds generally have a higher default
risk than municipal bonds
for increased default risk

14
Default Risk
• Standard and Poors and Moodys Investors Service
rate the default risk on bonds which serve as a
guide to investors
• The introduction of risk in the yield curve will
cause the curve to shift since another variable
other than maturity has changed
• The higher the perceived risk, the greater the
upward shift of the curve for that particular
security

15
Risk and Tax Structure of Rates
• Investors are concerned about the after tax
return on bonds
• Although municipal bonds are riskier than federal
government bonds, tax exempt status of municipal
bonds will generally result in a lower yield
(downward shift of the curve)