Chapter 6 - Risk and Term Structure of Interest Rates Risk structure of interest rates is the analysis of why interest

rates on bonds with the same maturity will vary, due to differences in risk. Term Structure of interest rates looks at why interest rates on bonds with the same risk (e.g. T-bills) will vary due to differences in term to maturity. Figure 1 on page 1 ! shows how interest rates on four bonds with the same maturity have moved over time from 1! "-1!!! - municipals (ta# free), T-bonds, $orporate %aa (medium &uality) bonds and $orporate 'aa (high &uality) bonds. (e want to e#plain the movement of (nominal) interest rates over time and the spread between (nominal) interest rates. )ome of the spread is e#plained by ta# treatment - munis are ta# free, corporates are completely ta#able and T-bonds are ta#able at the federal, but not state level. %ond yields also differ due to differences in default risk. *efault risk is the probability of+ ,,,,,,,,, interest payments, ,,,,,,,,, interest payments, ,,,,,,,,, payments or complete default-li&uidation. .isk-free bonds, like T-bonds, are default-free bonds. The spread between the risk-free rate on treasuries and the rate-yield on all other risky bonds is the risk premium. /unicipal bonds are usually very safe, but are not completely risk-free. There is a chance that a local municipality won0t make the payments on time or will make partial payments. 'll state governments, county governments and city governments have a credit rating, reflecting their creditworthiness. (e can show the risk premium on bonds using the ) 1 * for %onds framework (see page 12"). (e start by assuming that there is no risk of default for corporate bonds, so that T-bonds and corporate bonds sell for the same price (3 1) and have the same yield (i1) (assume that risk and maturity are identical). 4f we now make the more realistic assumption that the corporate bond is more risky than the Tbond, what would happen to the demand for Tbonds, price and interest rate5,,,,,,,,,,,,, (hat would happen to the demand for corporate bonds, price and interest rate5 ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, 4n e&uilibrium, the spread, or difference, between the Tbond and the corporate will be the risk premium (see page 12"). .isk premium is always positive for corporate and

muni bonds (on an after ta# basis), and the riskier the company-govt. agency, the greater the risk premium. /oody0s and )tandard 1 3oors are the two national bond rating services that do financial analyses on companies and municipalities (cities, counties, states) and based on their evaluation and assessment of creditworthiness and default probability, they assign a bond rating in one of nine categories, from 'aa-''' to $-*, using plusses and minuses. Financial statement analysis+ look at debt ratios, coverage ratios, cash flow ratios, etc. 6ast category $-*, is for a company in complete default, no interest payments being paid. The top four categories are considered 4nvestment 7rade, the bottom four categories are considered 8unk bonds. 9sing current market rates, the risk premiums range from about 1- : (;.!2-;.<;:) for =igh >uality corporates, 1"? years vs. Tbonds, to over @: (21.A: 7rand 9nion bond) vs. Tbond. Applications+ )tock market crash of 1!BA. @"" point, ": drop for the *84' (like a """ point drop today). 4nvestors became nervous about holding bonds of potentially weak companies. (hat happened to demand for Cunk bonds, price and interest rate5 ,,,,,,,,,,,,,,,,,,,, (hat happened to demand for Tbonds, price and interest rates5 ,,,,,,,,,,,,,,,,,,,,,,,,,,,. (hat happened to the default risk premium or spread5 ,,,,,,,,,,,,,,,,,,, 4nvestors sought safety and li&uidity. DFlight to &uality.D )ee pages 12 -122. (hat if T-%onds were no longer risk-free55 )ee application, page 122. LIQUIDITY =ow does an increase in li&uidity affect bond demand, price and interest rate5 ,,,,,,,,,,,,,,,,,,,, =ow does a decrease in li&uidity affect bond demand, price and int. rate5,,,,,,,,,,,,,,,,,,,,,,,,,,, Tbonds are considered more li&uid than corporate bonds, the market is thicker, it is easier to sell &uickly, more active market. $orporate bonds are not as li&uid, trading is thinner, not as active a market as e&uities or Tbonds. Therefore, it might be hard to li&uidate a corporate bond &uickly in an emergency, at full price. The risk analysis considered in Figure (page 12") could also be used to show graphically the difference in price-int rates between corporate bonds and Tbonds due to differences in li&uidity. The Drisk premiumD on corporate bonds is actually a combination of a default risk premium and a liquidit premium, or illi&uidity

premium, since corporate bonds are both more risky and less li&uid. )hould more accurately be called a Drisk and li&uidity premium.D ('lso, since corporate bonds are ta#ed at the federal and state level, and Tbonds are ta#ed only at the federal level (state ta#-e#empt), the risk premium for corp. bonds includes a premium for risk, illi&uidity and ta# treatment.) I!C"#$ T%& C"!SID$R%TI"!S Tbonds vs. /unis+ the spread between municipals and Tbonds can be e#plained by the difference in ta# treatment, see page 12@. /unis are totally ta#-e#empt to investors of the state where issued and Tbonds are ta#able (federal ta#). =ow does being ta# e#empt affect demand, price and int. rates of munis5 ,,,,,,,,,,,,,,,,,,,, =ow does being ta#able affect demand, price and yields for Tbonds5 ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, The spread between munis and Tbonds would reflect the marginal ta# rate of the marginal investor. The spread would adCust to make the marginal investor indifferent between non-ta#able muni and a federally ta#able Tbond. FORMULA: T'E'%6F G6* (1 - T'E .'TF) H 'FTF. T'E G4F6* /9I4 G6* - (1 - T'E .'TF) H F>94J'6FIT T'E'%6F G4F6* SU##%RY - The risk structure of interest rates (holding maturity constant) is e#plained by 2 factors+ a) default risk, b) li&uidity and c) income ta# treatment. The greater the risk, the greater the illi&uidity and the greater the unfavorable ta# treatment, the ,,,,,,,,,, the bond demand, the ,,,,,,,,, the price, and the ,,,,,,,,,,, the interest rate. The lower the risk, the greater the li&uidity and the more favorable the ta# treatment the ,,,,,,,,,,, the demand, the ,,,,,,,,,,, the price and the ,,,,,,,,,, the interest rate. APPLICATION: Fffect of the 1!!2 $linton ta# increase on bond int. rates5 $linton raised the top marginal ta# rate from 21 to <": in 1!!2. (hat happened to muni bond rates5 The ta#-free status of munis made them more attractive to investors in the high ta# brackets. (hat happened to bond demand, prices and int. rates for munis5 ,,,,,,,,,,,,,,,,, (hat about T%onds5 ,,,,,,,,,,,,,,,,,,,,,,,,, (see page 12;)

T$R# STRUCTUR$ "' I!T$R$ST R%T$S 'nother factor besides risk that influences interest rates is the term to maturit . ' plot of bond yields with the same risk, li&uidity and ta# considerations is called a Gield $urve. )ee handout and page 12A showing the Treasury Gield $urve. Treasury securities (T-bills, T-notes and T-bonds) have the same risk (none), li&uidity and ta# treatment, so we are isolating the effect that T4/F has on GT/ (interest rate). Gield curve is a graph of GT/ H f(time). 4n general, yield curves can have three general shapes+ a) upward sloping (steep or flat), when long term rates are higher than short term rates, b) flat - when short and long term rates are the same, and c) downward sloping (inverted) - when short term rates are higher than long term rates. Example: 1!B1, see page 1<B. )ee page 1<; for e#amples. There are several theories of the term structure-yield curve which we will e#amine. Theories should e#plain the real world, and based on empirical evidence there are several things we know about the term structure, which the theories should e#plain+ 1. 4nterest rates of different maturities tend to move together over time, see page 12B. 2 month, 2-@ year averages, and long term ( "-2" year) treasury yields tend to move together over time. . (hen short term rates are very low (historically), yield curves are more likely to have an upward slopeK when short-term rates are very high (historically), yield curves are more likely to slope downward. 2. Gield curves almost always slope upward. Iormal yield curve is upward sloping. There are three theories that economists use to e#plain the term structure of interest rates+ 1) e#pectations hypothesis, ) segmented markets theory and 2) the li&uidity premium (preferred habitat) theory. F#pectations hypothesis does a good Cob of e#plaining the first two facts about the term structure, but not the third. F#plains why int. rates move together and why we have upward and downward sloping yield curves. *oesn0t e#plain why yield curves usually slope upward. )egmented markets e#plains L2, but not L1 and L . 6i&uidity premium e#plains L1, L and L2.

() $&*$CT%TI"!S +Y*"T+$SIS ,$+%ssumptions. 1. %onds of different maturities are perfect substitutes. . 4nvestors are risk neutral - no risk premium is re&uired for long term bonds. 2. )hape of yield curve is determined by investors' expectations of future interest rates, future inflation. <. 9pward sloping yield curve means short term interest rates are e#pected to rise in the future. *ownward sloping yield curve means short term interest rates are e#pected to fall in the future. Flat yield curve means short term interest rates will remain unchanged in the future. 'ssume that your time horiMon is two years. Gou consider two strategies+ a) %uy a one-year bond, hold it for one year (G. 1), reinvest the proceeds in another one-year bond, one year from now during G. . b) %uy a two-year bond, hold it for two years (G. 1 and G. ). 'ccording to the e#pectations hypothesis, both strategies should be e#actly the same, since investors are indifferent to bonds of different maturities, and bonds are perfect substitutes. 'nother way to say this+ The int. rate on a long term bond (two year bond in this case) should e&ual an average of short term interest rates (one year interest rates during G. 1 and G. ). Example: The one-year bond yield is !: during G. 1 and the e#pected one-year bond yield is 11: during G. . 'ccording to the F=, the interest on the long-term bond ( year bond in this case) should e&ual the average of short-term bond rates over the ne#t two years, i.e. (!: ? 11:) - H 1":. Therefore .1 H !: and . H 1": and FN.1?1O H 11:. .1 and . are the one-year and two-year nominal Dspot ratesD and the FN.1?1O is e#pected one-year bond rate one year in the future, during G. . FN.1?1O is also called the Dforward rateD, sometimes noted as f . 4n the above e#ample, the yield curve is upward sloping %F$'9)F short-term rates are e#pected to .4)F. Pne-year rates are !: today (during G. 1) and are e#pected to be 11: 4I one year (during G. ). )ee diagram on board and page 1<". F#pectations of future short term int. rates determine the shape of the yield curve in the F=. )pecifically, the nominal interest rate for a bond with a maturity of t years, should be e&ual to the average of one-year interest rates over the life of the bond.

Example: The two-year bond rate should be e&ual to the average of the one-year nominal interest rate (spot rate) and the e#pected one-year rate during G. Example: The three-year bond rate should e&ual to the average of the one year rate, the e#pected one-year rate during G. , and the e#pected one-year rate during G. 2. Example: )uppose the one-year rate is @:, and we know that the e#pected one-year rates in t e !uture are+ ;: during G. , A: during G. 2, B: during G. < and !: during G. @. (e can calculate the two-year interest rate (. ) H (@: ? ;:) - H @.@: (e can calculate the three-year interest rate (. 2) H (@ ? ; ? A) - 2 H ;: (e can calculate the four-year interest rate (. <) H (@ ? ; ? A ? B) - < H ;.@: (e can calculate the five-year interest rate (. @) H (@ ? ; ? A ? B ? !) - @ H A: SU##%RY. The yield curve reflects spot rates, nominal rates (. 1 to .t), which reflect e#pectations of future one year spot rates. (hen the yield curve is upward sloping, it is because future short term interest rates are e#pected to 4I$.F')F. (hen the yield curve is downward sloping, it is because future short term interest rates are e#pected to *F$.F')F. Example: 4f one-year rates are ;:, two-year rates are B: and three-year rates are 1":, we can calculate the future e#pected one year rates. B: H ( ;: ? f ) - , f H 1": (F#pected one-year rate during G. ) 1": H (;: ? 1": ? f2) - 2, f2 H 1<: (F#pected one-year rate during G. 2) Example: 4f one-year rates are 1 :, two-year rates are 11: and three-year rates are 1":, we can calculate the future e#pected one year rates. 11: H ( 1 : ? f ) - , f H 1": (F#pected one-year rate during G. ) 1": H (1 : ? 1": ? f2) - 2, f2 H A: (F#pected one-year rate during G. 2) 93('.* )6P34I7 G4F6* $9.JF+ 1. 6ong-term rates are above short-term rates. . )hort-term rates are e#pected to rise in the future.

*P(I('.* )6P34I7 G4F6* $9.JF+ 1. 6ong-term rates are below short-term rates. . )hort-term rates are e#pected to be lower in the future. F= problems+ 1) 7iven the 1, , 2, < and @ year spot rates of interest, we can determine what the , 2, <, and @ year forward rates are - f to f@. Those forward rates reflect the e#pectation of what one year spot rates will be in years -@. 7iven a yield curve, we can calculate the forward rates of interest. Those forward rates will reflect the e#pectations of future spot interest rates. Example: .1 H 2: . H< .2 H @ .< H ; .@ H A f H f2 H f< H f@ H ) 7iven the one year spot rate of ;: and the e#pected one year spot interest rates in the future, f -f@, we can calculate the spot rates of interest for years - @. Example: f H ;.@: f2 H A f< H A.@ f@ H B . H .2 H .< H .@ H

Shortcomin/. yield curves are usually upward sloping, meaning that interest rates are usually e#pected to increase in the future. 4n reality, interest rates are Cust as likely to rise or fall, so the e#pectations hypothesis has a maCor shortcoming. 'ccording to the e#pectations hypothesis then, the typical yield curve should be flat, IPT upward sloping. F= does e#plain well why interest rates of different maturities tend to move together over time. 'ccording to the formula+ . H (.1 ? f ) .2 H (.1 ? f ? f2 ) - 2 4f .1 goes up, . and .2 will go up. 6ong term rates are directly related to short term rates now and the e#pectation of future rates, so changes in today0s short term rates or future short term rates will increase long term rates. 6ong-term rates are the average of e#pected future short-term rates, so a rise in short-term rates will raise long-term rates, so that short and long term rates will tend to rise together - this is what has actually happened and can be e#plained by F=. F= also e#plains Fact L - that when int. rates are low, yield curves are upward sloping and when int. rates are high, yield curves are usually downward sloping. Reason: 4f int. rates are lower than the historical average, there is the e#pectation that they will eventually rise back to normal, so the yield curve slopes upward to reflect that e#pectation. 4f int. rates are above average historically, there will usually be the e#pectation that they will come down to normal, so the yield curve will slope downward. Conclusion: The pure form of the F= does not usually hold. 4nvestors are risk averse, they demand some risk premium for going long term. 3art of the normal upward sloping yield curve reflects risk premium. %onds of different maturities are IPT perfect substitutes. Main point: The relative steepness or flatness of the yield curve reflects something about investor0s e#pectations of future interest rates-inflation. Jery flat yield curves indicate interest rate stability. Jery steep yield curves reflect e#pectations of potentially higher rates in the future. *ownward sloping yield curves reflect e#pectations of lower interest rates in the future. =ow accurate is the term structure at predicting future int. rate movements5 Pn average, over time, it predicts fairly well.

0) #%R1$T S$2#$!T%TI"! or S$2#$!T$D #%R1$TS ,S#- $redit markets are segmented, separate and distinct, and the conditions of ) and * in each market determine int. rates at different maturities. Ppposite of F= - bonds are IPT substitutes. )ome lenders-borrowers only want short term bonds, others want long term. 4nvestors and borrowers are concerned with specific maturities only. 4nterest rates are determined independently in separate markets with different maturities, without affecting other segments of the credit market. 4nvestors or bond issuers only care about one segment of the bond market. Examples+ 6ong-term credit market, 2" year bonds-mortgage markets. %orrowers+ 6enders+ /edium term 1" year credit market+555 )hort term 2-A year credit markets+555 )egmented markets can e#plain why yield curves are usually upward sloping. 4nvestors are risk-averse, so they prefer the safety of short term bonds, because there is less+ ,,,,,,,,,,,,,,,,,,,,. =ow does that affect the demand for short term bonds compared to long-term bonds5 ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, (hat about the demand for long-term bonds5 ,,,,,,,,,,,,,,, Pr+ investors are willing to accept a lower rate of return on short term bonds for the safety. %orrowers are willing to pay a higher int. rate to lock in long- term funds. )/ does IPT e#plain facts L1 and L . *oesn0t e#plain why interest rates tend to move together over time. 3redicts independent movement of interest rates, not comovement. 'lso offers no insight into why yield curves slope upward when int. are very low and vice-versa. )/ does e#plain some yield curve movements when int. rates don0t move together, like when yield curve flattens or steepens or is Dhump-shapedD like it is currently, inverted from 1"-2" years, but upward sloping from 1-1" years. 3) LIQUIDITY *R$#IU# ,L*- -

6ike the F=, the 63 theory says that long-term rates will e&ual an average of e#pected future short-term rates but the 63 modifies the F= by assuming that a) investors are risk-averse and b) therefore will demand a Liquidity Premium for long-term bonds because of interest rate risk. 4t would more accurately be a Risk *remium4 but is usually called a Liquidit or Term *remium) (e further assume c) that there is an increasing li&uidity premium, and the longer the maturity the greater the premium, see page 1<<. Example on pa"e #$$: 'ssume that one-year interest rates over the ne#t @ years are e#pected to be @: (.1), ;: (f ), A: (f2), B: (f<), !: (f@). 'lso assume that the 6i&uidity (risk) 3remiums for 1-@ year bonds are+ ", . @:, .@:, .A@:, and 1:. (e can then calculate the spot rates (. - .@)+ . H ( (@ ? ;) ) ? . @: H @.A@:

.2 H ( (@ ? ; ? A) - 2 ) ? .@" H ;.@: .< H ( (@ ? ; ? A ? B) - < ) ? .A@ H A. @: .@ H ( (@ ? ; ? A ? B ? !) - @ ) ? 1." H B.": SU##%RY. (e can now e#plain all three facts by combining F= with 63. 1) F= e#plains why int. rates of different maturities move together. 4f short-term interest rates are e#pected to rise in the future, f , f2, f<, etc. will increase, which will increase . , .2, .<, etc. 6ong term rates are the average of e#pected future short-term rates, and a rise in short-term rates will raise long-term rates. ) (hen int. rate are very low historically, the e#pectations part of the e&uation will reflect the e#pectation of rising short term int. rates in the future by sloping upward. 'nd adding the risk premium will add to the increasing slope. (hen int. rates are high, the e#pectation is that rates will fall in the future leading to the downward slope, despite the 63. The e#pectations effect dominates the risk premium. (hen+ a) short term rates are e#pected to fall in the future and b) long term rates are the average of e#pected future short-term rates, the yield curve will slope downward and long-term rates are %F6P( current short-term rates. Example: downward sloping yield curve of early 1!B"s (p. 1<B). Example: $urrent one-year rate is 1@:, but ne#t year (G. ) the one-year rate is e#pected to fall to 12: and to 11: by G. 2. (hat are the spot rates5 (hat does the

yield curve look like55 'ssume a 63 (risk premium) of . @: for a two year bond and .@": for a three-year bond. .1 H 1@: f H 12: .3 H . @: f2 H 11: .32 H .@: . H ( ( 1@: ? 12: ) ) ? . @: H 1<. @:

.2 H ( (1@ ? 12 ? 11) - 2 ) ? .@": H 12.@": 2) 63 e#plains why yield curves usually slope upward. Fven when int. rates are stable and e#pected to stay the same, the increasing 63 e#plains the upward slope..... $ombining the F=, 63 and some of the segmented markets theory, we can e#plain the shape of the yield curve and e#plain its movements. 'lso, according to F= and 63 the shape implies something about the e#pectations of future int. rates and future inflation.....see e#amples on page1<;. The )/ hypothesis helps us e#plains unusual conditions, like the inverted yield curve of the last year (upward sloping from 2 mo 1" years, downward sloping from 1"-2" years). F/34.4$'6 FJ4*FI$F+ Gield curve contains fairly accurate information about the future movement of short-term rates, especially in the short run (ne#t several months) and the long run (over several years), but is not as accurate over the intermediate term. 'I'6G)4) PF T=F .F$FIT 4IJF.TF* G4F6* $9.JF+