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1、chapter 5 The Risk and Term Structure of Interest Rates,Instructor: Xiajing Dai,Year 2007-08,Economics,preview,In our supply and demand analysis of interest-rate behavior in Chapter 5, we examined the determination of just one interest rate. Yet we saw earlier that there are enormous numbers of bond
2、s on which the interest rates can and do differ. In this chapter, we complete the interest-rate picture by examining the relationship of the various interest rates to one another,Year 2007-08,Economics,Figure 1 shows the yields to maturity for several categories of long-term bonds from 1919 to 2002.
3、 It shows us two important features of interest-rate behavior for bonds of the same maturity: (1)Interest rates on different categories of bonds differ from one another in any given year (2)the spread (or difference) between the interest rates varies over time.,Year 2007-08,Economics,Year 2007-08,Ec
4、onomics,Default risk,One attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures. By contrast, U.S. Treasury bonds have usuall
5、y been considered to have no default risk because the federal government can always increase taxes to pay off its obligations. Bonds like these with no default risk are called default-free bonds.,Year 2007-08,Economics,The spread between the interest rates on bonds with default risk and default-free
6、 bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond,Year 2007-08,Economics,Year 2007-08,Economics,Conclusion A bond with default risk will always have a positive risk premium, and an increase in its default risk will
7、 raise the risk premium.,Year 2007-08,Economics,Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. Two major investment advisory firms, Moodys Investors Service and Standard and Poors Corpora
8、tion, provide default risk information by rating the quality of corporate and municipal bonds in terms of the probability of default,Year 2007-08,Economics,Year 2007-08,Economics,Liquidity The differences between interest rates on corporate bonds and Treasury bonds (that is, the risk premiums) refle
9、ct not only the corporate bonds default risk but its liquidity, too. This is why a risk premium is more accurately a “risk and liquidity premium,” but convention dictates that it is called a risk premium.,Year 2007-08,Economics,Income Tax ConsiderationsWhy is it, then, that these bonds have had lowe
10、r interest rates than U.S. Treasury bonds for at least 40 years, as indicated in Figure 1? The explanation lies in the fact that interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expe
11、cted return.,Year 2007-08,Economics,Year 2007-08,Economics,Summary,The risk structure of interest rates is explained by three factors: default risk, liquidity, and the income tax treatment of the bonds interest payments. As a bonds default risk increases, the risk premium on that bond (the spread be
12、tween its interest rate and the interest rate on a default-free Treasury bond) rises. The greater liquidity of Treasury bonds also explains why their interest rates are lower than interest rates on less liquid bonds. If a bond has a favorable tax treatment, its interest rate will be lower.,Year 2007
13、-08,Economics,Term Structure of Interest Rates,A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds.Yield curves can be classifi
14、ed as upward-sloping, flat, and downward-sloping (the last sort is often referred to as an inverted yield curve).,Year 2007-08,Economics,Year 2007-08,Economics,A good theory of the term structure of interest rates must explain the following three important empirical facts: 1. As we see in Figure 4,
15、interest rates on bonds of different maturities move together over time. 2. 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. 3. Yield curves almost al
16、ways slope upward, as in the “Following the Financial News” box.,Year 2007-08,Economics,Three theories have been put forward to explain the term structure of interest rates; that is, the relationship among interest rates on bonds of different maturities reflected in yield curve patterns: (1) the expectations theory (2) the segmented markets theory (3) the liquidity premium theory,Year 2007-08,Economics,Expectation Theory,The expectations theory of the term structure states the following commonsense proposition: The interest rate on a long-term bond will equal an average of short-term.,
