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Risk and Term Structure of Interest Rates
Risk and Term Structure of Interest Rates
Risk and Term Structure of Interest Rates
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics,
1941–1970; Federal Reserve Bank of St. Louis FRED database: http://research.stlouisfed.org/fred2
P2T
Risk
P c1 T
Premium P1
P 2c
i 2c D2T
c c D1T
D2 D1
Quantity of Corporate Bonds Quantity of Treasury Bonds
(a) Corporate bond market (b) Default-free (U.S. Treasury) bond market
ST
Sm
P m2
P 1m P 1T
P 2T
D m2
D m1
D1T
D2T
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.
For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
Both bonds will be held only if the expected returns are equal
2i2t it ite1
it ite1
i2t
2
The two-period rate must equal the average of the two one-period rates
For bonds with longer maturities
it ite1 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
it it1
e
it2
e
... it(
e
int n1)
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
Liquidity
Premium, lnt
Expectations Theory
Yield Curve
0 5 10 15 20 25 30
Years to Maturity, n
Term Interest
Rates According Yield to Yield to
Maturity Maturity
to the Liquidity
Premium
(Preferred
Habitat) Theory
Flat yield curve Downward-
sloping yield curve