Risk Structure of Interest Rates
Default risk—occurs 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 premium—the spread between the interest rates on bonds with default risk and the interest rates on T-bonds
Liquidity—the ease with which an asset can be converted into cash
Income tax considerations
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 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
Facts Theory of the Term Structure of Interest Rates 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 almost always slope upward
Three Theories to Explain the Three Facts
- 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
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.
- 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 and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3)
- 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 substitutes but not perfect substitutes
