CH 03

Financial Markets and Institutions
13th Edition
by Jeff Madura
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3 Structure of Interest Rates
Chapter Objectives
• Describe how characteristics of debt securities

cause their yields to vary.
• Demonstrate how to estimate the appropriate
yield for any particular debt security.
• Explain the theories behind the term structure of
interest rates (relationship between the term to
maturity and the yield of securities).
2
Why Debt Security Yields Vary (1 of 7)
The yields on debt securities are affected:

• Credit (default) risk
• Liquidity
• Tax status
• Term to maturity
3 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Credit (default) Risk

• Investors must consider the creditworthiness of the
security issuer.
• All else being equal, securities with a higher degree of
default risk must offer higher yields.
• Especially relevant for longer term securities.
Credit (default) Risk (continued)

Use of Ratings Agencies to Assess Credit Risk
• Rating Agencies — Investors can personally assess the creditworthiness of
corporations that issue bonds, but they may prefer to rely on bond ratings
provided by rating agencies.(Exhibit 3.1).
• Credit Ratings and Risk Premiums over Time — Rating agencies can
change bond ratings over time in response to changes in the issuing firm’s
financial condition.
• Accuracy of Credit Ratings — The ratings issued by the agencies are
opinions, not guarantees. Bonds that are assigned a low credit rating
experience default more frequently than bonds assigned a high credit rating,
which suggests that the rating can be a useful indicator of credit risk.
However, credit rating agencies do not always detect firms’ financial
problems.
• Oversight of Credit Rating Agencies — The Financial Reform Act of 2010
established an Office of Credit Ratings within the Securities and Exchange
Commission in order to regulate credit rating agencies. Rating agencies
must establish internal controls.
Exhibit 3.1 Rating Classification by
Rating Agencies
DESCRIPTION OF RATINGS ASSIGNED RATINGS ASSIGNED

SECURIT Y BY: MOODY ’S BY: STANDARD &
POOR’S
Highest quality Aaa AAA
High quality Aa AA
High–medium quality A A
Medium quality Baa BBB
Medium–low quality Ba BB
Low quality (speculative) B B
Poor quality Caa CCC
Very poor quality Ca CC
Lowest quality (in default) C DDD, D
Liquidity
• The lower a security’s liquidity, the higher the yield
preferred by an investor.
• Debt securities with a short-term maturity or an active
secondary market have greater liquidity.
Tax Status (Exhibit 3.2)

• Investors are more concerned with after-tax income.
• Taxable securities must offer a higher before-tax yield.
• The formulae for expected yields after-tax is calculated
as follows:
Yat = Ybt (1 − T)
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Exhibit 3.2 After-Tax Yields Based on Various
Tax Rates and Before-Tax Yields
BEFORE-TAX BEFORE-TAX BEFORE-TAX BEFORE-TAX BEFORE-TAX

YIELD TAX YIELD 2% YIELD 4% YIELD 6% YIELD 8%
RATE
10% 1.80% 3.60% 5.40% 7.20%
15 1.70 3.40 5.10 6.80
25 1.50 3.00 4.50 6.00
28 1.44 2.88 4.32 5.76
35 1.30 2.60 3.90 5.20
Tax Status (continued)

• Computing the Equivalent Before-Tax Yield:
Term to Maturity
• Maturity dates will differ between debt securities.
• The term structure of interest rates defines the
relationship between possible terms to maturity and the
annualized yield for a debt security at a specific moment
in time while holding other factors constant.
Modeling the Yield to be Offered on a
Debt Security
When a company wants to issue debt, it needs to consider all the

characteristics just described so that it can determine the appropriate
yield to offer that will entice investors to buy its debt securities. The
following model incorporates the key characteristics for determining the
appropriate yield to be offered on a debt security:
Yn = Rf,n + DP + LP + TA
where:
Yn = yield of an n-day debt security
Rf,n = yield of an n-day Treasury (risk-free) security
DP = default premium to compensate for credit risk
LP = liquidity premium to compensate for less liquidity
TA = adjustment due to difference in tax status
A Closer Look at the Term Structure (1 of 7)
Pure Expectations Theory

• According to pure expectations theory, the term structure of interest
rates is determined solely by expectations of interest rates.
• Impact of an Expected Increase in Interest Rates (Exhibit 3.3)
• Impact of an Expected Decline in Interest Rates (Exhibit 3.3)
• Algebraic Presentation — If the term structure of interest rates
is solely influenced by expectations of future interest rates, the
following relationships hold:
SCENARIO STRUCTURE OF EXPECTATIONS ABOUT THE

YIELD CURVE FUTURE INTEREST RATE
1. t+1 r1 > ti1 Upward slope Higher than today’s rate
2. t+1 r1 = ti1 Flat Same as today’s rate
3. t+1 r1 < ti1 Downward slope Lower than today’s rate
Rates of BD Govt Securities
Exhibit 3.3 How Interest Rate Expectations
Affect the Yield Curve
Pure Expectations Theory (continued)
Algebraic Presentation (continued)

According to pure expectations theory, a one-year investment followed
by a two-year investment should offer the same annualized yield over
the three-year horizon as a three year security that could be purchased
today. This relation is expressed as follows:
(1 + i3 ) = (1 + t i1 ) (1 + )
3 2
t t +1 2 i
Assumption that bonds with different maturities are perfect substitutes
leads to the expectations theory, let us consider the following two invest
ent strategies:
1. Purchase a one-year bond, and when it matures in one year, purchase
another
one-year bond.
2. Purchase a two-year bond and hold it until maturity.
19
Mishkin & Eakins - Financial Markets and Institutions, 7e (2012)
Chapter 5
Mishkin & Eakins - Financial Markets and Institutions, 7e (2012), Chapter 5
Liquidity Premium Theory(Exhibit 3.4)

• The preference for the more liquid short-term securities
places upward pressure on the slope of a yield curve.
Liquidity may be a more critical factor to investors at
some times than at others, and the liquidity premium will
accordingly change over time.
• The model that explains these movements is called
liquidity premium theory
Exhibit 3.4 Impact of Liquidity Premium on the
Yield Curve under Three Different Scenarios
Liquidity Premium Theory (continued)

Estimation of the Forward Rate Based on a Liquidity Premium —
When expectations theory is combined with liquidity theory, the yield on
a security will not necessarily be equal to the yield from consecutive
investments in shorter-term securities over the same investment
horizon.
Here,
LP2 denotes the liquidity premium on a two-year security.
The relationship between the liquidity premium and term to maturity can
be expressed as follows:
0 < LP1 < LP2 < LP3 < … LP20
Mishkin & Eakins - Financial Markets and Institutions, 7e (2012)
Segmented Markets Theory: Investors choose securities

with maturities that satisfy their forecasted cash needs.
• Limitation of the Theory:
• Some borrowers and savers have the flexibility to choose
among various maturities.
• Implications: Preferred Habitat Theory
• Although investors and borrowers may normally
concentrate on a particular maturity market, certain events
may cause them to wander from their “natural” or preferred
market.
Integrating the Term Structure Theories

• Evidence suggests that expectations theory, liquidity premium
theory, and segmented markets theory all have some validity.
• To understand how all three theories can simultaneously
affect the yield curve, first assume the following conditions:
• Investors and borrowers who select security maturities based on
anticipated interest rate movements currently expect interest rates
to rise.
• Most borrowers are in need of long-term funds, whereas most
investors have only short-term funds to invest.
• Investors prefer more liquidity to less.
• Then all three conditions place upward pressure on long-term
yields relative to short term yields leading to upward sloping
yield curve. (Exhibit 3.5)
Exhibit 3.5 Effect of Conditions in
Example of Yield Curve
Integrating the Theories of the Term
Structure (1 of 2)
Use of the Term Structure

• Forecasting Interest Rates
• The shape of the yield curve can be used to assess the
general expectations of investors and borrowers about
future interest rates.
• The curve’s shape should provide a reasonable indication
(especially once the liquidity premium effect is accounted
for) of the market’s expectations about future interest rates.
• Forward Rates
Forward Rates
Mishkin & Eakins - Financial Markets and
Institutions, 7e (2012)
Integrating the Theories of the Term
Structure (2 of 2)
Use of the Term Structure (continued)

• Forecasting Economic Conditions
• Making Investment and Decisions —
• If the yield curve is upward sloping, some investors may
attempt to benefit from the higher yields on longer-term
securities even though they have funds to invest for only a
short period of time.
• Firms can estimate the rates to be paid on bonds with
different maturities. This may enable them to determine the
maturity of the bonds they issue.
How the Yield Curve Has Changed over Time

• The yield curve is usually upward sloping, but a slight
downward slope has sometimes been evident. The yield
curves for the last few years have been very low,
reflecting a low annualized interest rate at any possible
time to maturity.
Exhibit 3.6 Impact of Liquidity Premium on the
Yield Curve under Three Different Scenarios
Source: Federal Reserve.

International Structure of Interest Rates
• Factors that affect the shape of the yield curve can vary
among countries, and the yield curve’s shape at any
given time also varies among countries.
• Interest rate movements across countries tend to be
positively correlated as a result of internationally
integrated financial markets. Actual interest rates may
vary significantly across countries at a given point in
time.
SUMMARY (1 of 2)
• Quoted yields of debt securities at any given time may

vary for the following reasons. First, securities with higher
credit (default) risk must offer a higher yield. Second,
securities that are less liquid must offer a higher yield.
Third, taxable securities must offer a higher before-tax
yield than do tax-exempt securities. Fourth, securities
with longer maturities offer a different yield (not
consistently higher or lower) than securities with shorter
maturities.
• Any particular debt security can be estimated by first
determining the risk-free yield that is currently offered by
a Treasury security with a similar maturity. Then
adjustments are made that account for credit risk,
liquidity, tax status, and other provisions.
SUMMARY (2 of 2)
• The term structure of interest rates can be explained by

three theories. The pure expectations theory suggests
that the shape of the yield curve is dictated by interest
rate expectations. The liquidity premium theory suggests
that securities with shorter maturities have greater
liquidity and therefore should not have to offer as high a
yield as securities with longer terms to maturity. The
segmented markets theory suggests that investors and
borrowers have different needs that cause the demand
and supply conditions to vary across different maturities.
Consolidating the theories suggests that the term
structure of interest rates depends on interest rate
expectations, investor preferences for liquidity, and the
unique needs of investors and borrowers in each maturity
market.

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Financial Markets and Institutions

• Describe how characteristics of debt securities

The yields on debt securities are affected:

Credit (default) Risk

Credit (default) Risk (continued)

DESCRIPTION OF RATINGS ASSIGNED RATINGS ASSIGNED

Tax Status (Exhibit 3.2)

BEFORE-TAX BEFORE-TAX BEFORE-TAX BEFORE-TAX BEFORE-TAX

15 1.70 3.40 5.10 6.80

25 1.50 3.00 4.50 6.00

28 1.44 2.88 4.32 5.76

35 1.30 2.60 3.90 5.20

Tax Status (continued)

When a company wants to issue debt, it needs to consider all the

Pure Expectations Theory

SCENARIO STRUCTURE OF EXPECTATIONS ABOUT THE

Pure Expectations Theory (continued)

Algebraic Presentation (continued)

Liquidity Premium Theory(Exhibit 3.4)

Liquidity Premium Theory (continued)

Segmented Markets Theory: Investors choose securities

Integrating the Term Structure Theories

Use of the Term Structure

Use of the Term Structure (continued)

How the Yield Curve Has Changed over Time

Source: Federal Reserve.

• Quoted yields of debt securities at any given time may

• The term structure of interest rates can be explained by

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