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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
Liquidity Premium Modification
  • Investors know from experience that short-term
    securities provide greater marketability and have
    smaller price fluctuations than do long-term
    securities.
  • The liquidity premium is that premium demanded
    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
  • Reading the WSJ.
  • 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
  • Investors will expect higher return to compensate
    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)
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