Money and Banking – ECO 233

Lecture 7
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

Copyright © 2019 Pearson Education, Ltd.

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.
– 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

Copyright © 2019 Pearson Education, Ltd.

Figure 4 Movements over Time of Interest Rates on
U.S. Government Bonds with Different Maturities

Sources: Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2/

Copyright © 2019 Pearson Education, Ltd.

Term Structure of Interest Rates
The theory of the term structure of interest rates must
explain the following facts:
1. 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 rates are high, yield curves are more likely to
slope downward and be inverted.
3. Yield curves almost always slope upward.

Copyright © 2019 Pearson Education, Ltd.

Term Structure of Interest Rates
Three theories to explain the three facts:
1. Expectations theory explains the first two facts but not
the third.
2. Segmented markets theory explains the third fact but
not the first two.
3. Liquidity premium theory combines the two theories to
explain all three facts.

Copyright © 2019 Pearson Education, Ltd.

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.

• For example, if people expect that short-term interest rates

will be 10% on average over the coming five years, the
expectations theory predicts that the interest rate on bonds
with five years to maturity will be 10% too.

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory
• If short-term interest rates were expected to rise even
higher after this five-year period so that the average short-
term interest rate over the coming 20 years is 11%, then
the interest rate on 20-year bonds would equal 11% and
would be higher than the interest rate on five-year bonds.
• The explanation provided by the expectations theory for
why interest rates on bonds of different maturities differ is
that short-term interest rates are expected to have different
values at future dates.

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory
• 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.

• Bond holders consider bonds with different maturities to be

perfect substitutes.

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory
• To see how the assumption that bonds with different
maturities are perfect substitutes leads to the expectations
theory, let us consider the following two investment
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.

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory
• Because both strategies must have the same expected
return if people are holding both one- and two-year bonds,
the interest rate on the two-year bond must equal the
average of the two one-year interest rates.

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory
An 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.

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite+1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t ) - 1
= 1 + 2i2t + (i2t ) 2 - 1
= 2i2t + (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory

If two one-period bonds are bought with the $1 investment

(1 + it )(1 + ite+1 ) - 1
1 + it + ite+1 + it (ite+1 ) - 1
it + ite+1 + it (ite+1 )
it (ite+1 ) is extremely small
Simplifying we get
it + ite+1

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory

Both bonds will be held only if the expected returns are equal
2i2t = it + ite+1
it + ite+1
i2t =
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it + ite+1 + ite+ 2 + ... + ite+ ( n -1)
int =
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the bond

Copyright © 2019 Pearson Education, Ltd.

Expectations Theory
• Expectations theory explains:
– Why the term structure of interest rates changes at
different times.
– Why interest rates on bonds with different maturities
move together over time (fact 1).
– Why yield curves tend to slope up when short-term
rates are low and slope down when short-term rates
are high (fact 2).
• Cannot explain why yield curves usually slope upward
(fact 3)

Copyright © 2019 Pearson Education, Ltd.

Segmented Markets Theory
• Bonds of different maturities are not substitutes at all.
• The segmented markets theory of the term structure sees
markets for different-maturity bonds as completely
separate and segmented.
• The interest rate for each bond with a different maturity is
determined by the demand for and supply of that bond.
• The argument for why bonds of different maturities are not
substitutes is that investors have strong preferences for
bonds of one maturity but not for another, so they will be
concerned with the expected returns only for bonds of the
maturity they prefer.
Copyright © 2019 Pearson Education, Ltd.
Segmented Markets Theory
• Investors have short desired holding periods and generally
prefer bonds with shorter maturities that have less interest-
rate risk, the segmented markets theory can explain fact 3
that yield curves typically slope upward.
• Because in the typical situation the demand for long-term
bonds is relatively lower than that for short-term bonds,
long-term bonds will have lower prices and higher interest
rates, and hence the yield curve will typically slope
upward.

Copyright © 2019 Pearson Education, Ltd.

Segmented Markets Theory
• It cannot explain facts 1 and 2.
• It views the market for bonds of different maturities as
completely segmented, there is no reason for a rise in
interest rates on a bond of one maturity to affect the
interest rate on a bond of another maturity.
• Therefore, it cannot explain why interest rates on bonds of
different maturities tend to move together (fact 1).

Copyright © 2019 Pearson Education, Ltd.

Segmented Markets Theory
• Second, because it is not clear how demand and supply
for short- versus long-term bonds change with the level of
short-term interest rates, the theory cannot explain why
yield curves tend to slope upward when short-term interest
rates are low and to be inverted when short-term interest
rates are high (fact 2).

Copyright © 2019 Pearson Education, Ltd.

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 partial (not perfect)
substitutes.
• The liquidity premium theory’s key assumption is that
bonds of different maturities are substitutes, which means
that the expected return on one bond does influence the
expected return on a bond of a different maturity, but it
allows investors to prefer one bond maturity over another.

Copyright © 2019 Pearson Education, Ltd.

Liquidity Premium Theory

it + it+1
e
+ it+2
e
+ ...+ it+(
e

int = n-1)
+ lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity

Copyright © 2019 Pearson Education, Ltd.

Preferred Habitat Theory
• Investors have a preference for bonds of one maturity over
another.
• They will be willing to buy bonds of different maturities only
if they earn a somewhat higher expected return.
• Investors are likely to prefer short-term bonds over longer-
term bonds because these bonds bear less interest-rate
risk.
• For these reasons, investors must be offered a positive
liquidity premium to induce them to hold longer term
bonds.

Copyright © 2019 Pearson Education, Ltd.

Figure 5: The Relationship Between the Liquidity
Premium (Preferred Habitat) and Expectations Theory

Copyright © 2019 Pearson Education, Ltd.

Preferred Habitat Theory
• We see that because the liquidity premium is always
positive and typically grows as the term to maturity
increases
• The yield curve implied by the liquidity premium theory is
always above the yield curve implied by the expectations
theory and generally has a steeper slope.

Copyright © 2019 Pearson Education, Ltd.

Liquidity Premium & Preferred Habitat
Theories
• Interest rates on different maturity bonds move together
over time; explained by the first term in the equation
• Yield curves tend to slope upward when short-term rates
are low and to be inverted when short-term rates are high;
explained by the liquidity premium term in the first case
and by a low expected average in the second case
• Yield curves typically slope upward; explained by a larger
liquidity premium as the term to maturity lengthens

Copyright © 2019 Pearson Education, Ltd.

Liquidity Premium & Preferred Habitat
Theories
• Suppose that the one-year interest rate over the next five
years is expected to be 5, 6, 7, 8, and 9%, while investors’
preferences for holding short-term bonds means that the
liquidity premiums for one- to five-year bonds are 0, 0.25,
0.5, 0.75, and 1.0%, respectively.
• The interest rate on the two-year bond would be:

Copyright © 2019 Pearson Education, Ltd.

Liquidity Premium & Preferred Habitat
Theories
• while for the five-year bond it would be:

• Doing a similar calculation for the one-, three-, and four-

year interest rates, you should be able to verify that the
one- to five-year interest rates are 5.0, 5.75, 6.5, 7.25, and
8.0%, respectively.

Copyright © 2019 Pearson Education, Ltd.

Figure 6 :Yield Curves and the Market’s Expectations of
Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory

Copyright © 2019 Pearson Education, Ltd.

Yield Curves
• A steeply rising yield curve, as in panel (a) of Figure 6,
indicates that short-term interest rates are expected to rise
in the future.
• A moderately steep yield curve, as in panel (b), indicates
that short-term interest rates are not expected to rise or fall
much in the future.
• A flat yield curve, as in panel (c), indicates that short-term
rates are expected to fall moderately in the future.
• Finally, an inverted yield curve, as in panel (d), indicates
that short-term interest rates are expected to fall sharply in
the future.

Copyright © 2019 Pearson Education, Ltd.

The Economics of Money, Banking, and
Financial Markets
Twelfth Edition, Global Edition

Chapter 8
An Economic Analysis of
Financial Structure

Copyright © 2019 Pearson Education, Ltd.

Preview
• A healthy and vibrant economy requires a financial system
that moves funds from people who save to people who
have productive investment opportunities.

Copyright © 2019 Pearson Education, Ltd.

Learning Objectives
• Identify eight basic facts about the global financial system.
• Summarize how transaction costs affect financial
intermediaries.
• Describe why asymmetric information leads to adverse
selection and moral hazard.
• Recognize adverse selection and summarize the ways in
which they can be reduced.

Copyright © 2019 Pearson Education, Ltd.

Learning Objectives
• Recognize the principal-agent problem arising from moral
hazard in equity contracts and summarize the methods for
reducing it.
• Summarize the methods used to reduce moral hazard in
debt contracts.

Copyright © 2019 Pearson Education, Ltd.

Basic Facts About Financial Structure
Throughout the World
• This chapter provides an economic analysis of how our
financial structure is designed to promote economic
efficiency.
• The bar chart in Figure 1 shows how American businesses
financed their activities using external funds (those
obtained from outside the business itself) in the period
1970–2000 and compares U.S. data to those of Germany,
Japan, and Canada.

Copyright © 2019 Pearson Education, Ltd.

Figure 1: Sources of External Funds for Nonfinancial
Businesses: A Comparison of the United States with
Germany, Japan, and Canada

Source: Andreas Hackethal and Reinhard H. Schmidt, “Financing Patterns: Measurement Concepts and Empirical
Results,” Johann Wolfgang Goethe-Universitat Working Paper No. 125, January 2004. The data are from 1970–2000 and
are gross flows as percentage of the total, not including trade and other credit data, which are not available.

Copyright © 2019 Pearson Education, Ltd.

Basic Facts About Financial Structure
Throughout the World
1. Stocks are not the most important sources of external
financing for businesses.
2. Issuing marketable debt and equity securities is not the
primary way in which businesses finance their
operations.
3. Indirect finance is many times more important than direct
finance
4. Financial intermediaries, particularly banks, are the most
important source of external funds used to finance
businesses.

Copyright © 2019 Pearson Education, Ltd.

Basic Facts About Financial Structure
Throughout the World
5. The financial system is among the most heavily
regulated sectors of the economy.
6. Only large, well-established corporations have easy
access to securities markets to finance their activities.
7. Collateral is a prevalent feature of debt contracts for both
households and businesses.
8. Debt contracts are extremely complicated legal
documents that place substantial restrictive covenants
on borrowers.

Copyright © 2019 Pearson Education, Ltd.

Collateral
• Collateral is property that is pledged to the lender to
guarantee payment in the event that the borrower is
unable to make debt payments.
• Collateralized debt (also known as secured debt to
contrast it with unsecured debt, such as credit card debt,
which is not collateralized) is the predominant form of
household debt and is widely used in business borrowing
as well.

Copyright © 2019 Pearson Education, Ltd.

Transaction Costs
• Transaction costs are a major problem in financial markets.
• Say you have $5,000 you would like to invest, and you
think about investing in the stock market.
• Because you have only $5,000, you can buy only a small
number of shares.
• The stockbroker tells you that your purchase is so small
that the brokerage commission for buying the stock you
picked will be a large percentage of the purchase price of
the shares.

Copyright © 2019 Pearson Education, Ltd.

Transaction Costs
• If instead you decide to buy a bond, the problem is even
worse, because the smallest denomination for some bonds
you might want to buy is as much as $10,000, and you do
not have that much to invest.
• You also face another problem because of transaction
costs. Because you have only a small amount of funds
available, you can make only a restricted number of
investments. That is, you have to put all your eggs in one
basket, and your inability to diversify will subject you to a
lot of risk.

Copyright © 2019 Pearson Education, Ltd.

How Financial Intermediaries Reduce
Transaction Costs
• Bundling investors’ funds together, financial intermediaries
have evolved to reduce transaction costs.
– Economies of scale
– Expertise
• A mutual fund is a financial intermediary that sells shares
to individuals and then invests the proceeds in bonds or
stocks.

Copyright © 2019 Pearson Education, Ltd.

How Financial Intermediaries Reduce
Transaction Costs
• Financial intermediaries are also better able to develop
expertise to lower transaction costs.
• Their expertise in computer technology enables them to
offer customers convenient services like being able to call
a toll-free number for information on how well their
investments are doing and to write checks on their
accounts.
• An important outcome of a financial intermediary’s low
transaction costs is the ability to provide its customers with
liquidity services, services that make it easier for
customers to conduct transactions.

Copyright © 2019 Pearson Education, Ltd.