Chapter 6: The Risk and Term Structure of Interest Rates

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Chapter 6 The Risk and Term Structure of
Interest Rates
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• 1. Risk Structure of Interest Rates

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Default Risk

• Default risk is the risk that bond issuer will be
  unable to make interest payments or return face
  value at maturity.
• Diagram

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Liquidity

• Liquidity is ability to convert into means of
  payment.
• Diagram

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Income Tax Considerations

• Municipal bonds are state and local government
  bonds that are free of federal income tax.
• Diagram

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• 2. Term Structure of Interest Rates

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Yield Curve

• The yield curve shows the yield to maturity for
  bonds of different maturities.
• Diagram

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Expectations Theory

• Assumes bond holders have no preference for one
  maturity over another (perfect substitutes).
• Theory states long-term bond interest rates are
  the average of the short-term interest rates
  expected over the life of the bond.

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Expectations Theory Equation

• i2 (i1 iet1)/2
• i2 interest rate on two year bonds
• i1 interest rate on one year bonds
• iet1 interest rate on one-year bonds
  expected one year from now.
• Use equation to generate expected future interest
  rates.

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Expectations Theory

• Advantages and disadvantages
• Explains why interest rates of
  different maturities move together.
• Does not explain why yield curves
  usually slope upwards.

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Segmented Markets Theory

• Assumes bond holders have very strong preferences
  for bonds of one maturity but not another.
• Theory states the interest for each maturity is
  determined by the supply and demand for that
  maturity bond.
• A change in the expected return for one bond
  maturity will have no effect on the return of
  other maturities.
• Diagram

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Segmented Markets Theory

• Advantages and disadvantages
• Does not explain why interest rates of
  different maturities move together.
• Does explain why yield curves usually
  slope upwards.

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Liquidity Premium Theory

• Assumes bond holders have some but not complete
  preference for short-term bonds.
• Theory states long-term bond interest rates are
  the average of the short-term interest rates
  expected over the life of the bond plus a
  liquidity premium.
• The liquidity premium exists because long-term
  bonds a more risky than short-term bonds (larger
  price changes).

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Liquidity Premium Theory Equation

• i2 (i1 iet1)/2 l2t
• i2 interest rate on two year bonds
• i1 interest rate on one year bonds
• iet1 interest rate on one-year bonds
  expected one year from now.
• l2t liquidity premium for 2-year bonds

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Liquidity Premium Theory

• Advantages and disadvantages
• Does explain why interest rates of
  different maturities move together.
• Does explain why yield curves usually
  slope upwards.

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Interpreting Yield Curves

• Diagram

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EndChapter 6