Mishkin and Serletis 8ce Chapter 6

The Economics of Money, Banking, and
Financial Markets
Eighth Canadian Edition
Chapter 6
The Risk and Term Structure
of Interest Rates
Copyright © 2023 Pearson Canada Inc. 6-1

Learning Objectives
1. Identify and explain the three factors affecting the

risk structure of interest rates.
2. List and explain the three theories of why interest
rates vary across different maturities.

Risk Structure of Interest Rates (1 of 3)
• Yields of different bonds of the same maturity can

differ substantially
• Key factors explaining the difference in yields of
bonds of similar maturity:
– Risk of default
– Liquidity
– Tax considerations

Figure 6-1: Long-Term Bond Yields, 1978–2020
Interest rates on different categories of bonds differ from one another in any given year, and the spread
(or difference) between the interest rates varies over time.
Sources: Statistics Canada CANSIM series V122544, V122517 (extended with the average of provincial
bond interest rates from Bloomberg), and V122518 (extended with the 30-year A-rated corporate bond
interest rate from Bloomberg).

• Default Risk: probability that the issuer of the bond is
unable or unwilling to make interest payments or pay
off the face value
– Government of Canada bonds are considered default-
free bonds (while default is not impossible, the
government can raise taxes or print money to repay)
• Risk Premium: the spread between the interest rates
on corporate bonds and Canada bonds (that have the
same maturity)
• Credit-rating agencies assess and rate riskiness

• Liquidity:
– the ease with which an asset can be converted into
money (“cash”)
 cost of selling a bond
 number of buyers/sellers in a bond market
• Income Tax Considerations:

– Example: in the U.S. interest payments on municipal
bonds are exempt from federal income taxes

Countercyclical Default Risk and
Flight to Safety
• It stands to reason that default risk ought to be high when
economy is in recession
• When default risk is high, we might expect a “flight to
safety”: reduces demand for risky bonds and increases
demand for riskless bonds, which moves credit spreads up
• This is consistent with what we see in the previous slide:
credit spreads tend to rise during recessions; in fact, they
are countercyclical and coincident.
• Later, in our discussion of the term structure of interest
rates, we will argue that term spreads are countercyclical
and lagging.
Figure 6-2: Response to an Increase in Default Risk on
Corporate Bonds
Initially, Pc1 = PT1, ic1 = iT1, and the risk premium is zero. An increase in default risk on corporate bonds
shifts the demand curve from Dc1 to Dc2; simultaneously, it shifts the demand curve for Canada bonds from
DT1 to DT2. The equilibrium price for corporate bonds falls from Pc1 to Pc2, and the equilibrium interest rate
on corporate bonds rises to ic2. In the Canadas market, the equilibrium bond price rises from PT1 to PT2, and
the equilibrium interest rate falls to iT2 . The brace indicates the difference between ic2 and iT2, the risk
premium on corporate bonds. (Note that because Pc2 is lower than PT2, ic2 is greater than iT2.)

Corporate-Canada Bond Spread 1978 - 2008

U.S. Credit Spreads and the 2007-2009 Financial Crisis
Copyright © 2020 Pearson Canada Inc. 6 - 10

U.S. Credit Spreads During the Great Depression

Figure 6-3
Interest Rates on Municipal and Treasury Bonds in the United States

When a municipal bond is given tax-free status, demand for the municipal bond shifts rightward from Dm1 to Dm2 ,and
demand for the Treasury bond shifts leftward from DT1 to DT2. The equilibrium price of the municipal bond rises from Pm1 to
Pm2 so its interest rate falls, while the equilibrium price of the Treasury bond falls from PT1 to PT2 and its interest rate rises.
The result is that municipal bonds end up with lower interest rates than Treasury bonds.

Term Structure of Interest Rates
• Risk structure looks at multiple bonds with same
maturity. Now look at single type of bond with different
maturity dates
– Example: Canada bonds with different maturity dates
– Bonds usually have different interest rates because the
time remaining to maturity is different
• Yield Curve: a plot of the yield on bonds with differing
terms to maturity but the same risk, liquidity and tax
considerations
– Graphical representation of the term structure

The Yield Curve for Canada Bonds as of August 2022
4
3.5
3
2.5
Interest Rate (%)
2
1.5
1
0.5
0
1m 3m 6m 1y 2y 3y 5y 10y Long
term
Maturity
Sources: Statistics Canada CANSIM series V122531, V122532, V122533, V122538, V122539, V122540,
V122543, and V122544, and the authors’ calculations.

Yield curve terminology
• Bond prices change all the time
– Therefore, the term structure / yield curve changes all
the time
• Describing the 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

Facts That the Theory of the Term Structure
of Interest Rates Must Explain
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

Three Theories to Explain the Three Facts
We will explore three theories:
1. Expectations theory
– explains the first two facts but not the third
2. Segmented markets theory
– explains fact three but not the first two
3. Liquidity premium theory
– combines the two theories to explain all three facts

Expectations Theory (1 of 6)
• The interest rate on a long-term bond equals the
average of the expected present and future short-term
interest rates over the lifetime of the bond
– Bond holders consider bonds with different maturities to
be perfect substitutes
– Thus, they do not prefer bonds of one maturity over
another and will not invest in a bond if its expected
return is less than that of another bond with a different
maturity

• For an investment of $1
it = today’s interest rate on a one-period bond
iet+1 = interest rate on a one-period bond expected for

next period
i2t = today’s interest rate on the two-period bond

• Expected return over the two periods from investing $1
in the two-period bond and holding it for two periods
(1  i2t )(1  i2t )  1

 1  2i2t  (i2t )  1 2
 2i2t  (i2t ) 2
• Since (i 2t)2 is very small the expected return for

holding the two-period for two perids is
If two one-period bonds are bought with the $1
investment
(1  it )(1  i )  1
e
t 1
1  it  i  it (i )  1
e
t 1
e
t 1
it  i  it (i )
e
t 1
e
t 1
e
it (i ) is extremely small
t 1
Simplifying we get
it  ite1
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
Expectations Theory: Example (6 of 6)
• Let the current rate on one-year bond be 9%

• You expect the interest rate on a one-year bond to
be 11% next year
• Then the expected return for buying two one-year
bonds averages (9% + 11%)/2 = 10%
• The interest rate on a two-year bond must be 10%
for you to be willing to purchase it

Expectations Theory -- Application
The 1 year interest rate over the next 5 years is expected to
be 5, 6, 7, 8 and 9 percent. What is i2t and i5t? What is
happening to the yield curve?
it  ite1  ite 2  ...  ite ( n 1)

i nt 
n
it  ite1 .05  .06
i2t    .055 (or 5.5%)
Hence, 2 2
.05  .06  .07  .08  .09

i5t   .07 (or 7%)
5
Using the same equation we can show that i3t = 6%, i4t = 6.5%.
Thus, the yield curve is upward slopping.
Expectations Theory and the Term
Structure of Interest Rate Facts
• Explains why the term structure of interest rates
changes at different times
• Explains why interest rates on bonds with different
maturities move together over time (fact 1)
• Explains 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)

Segmented Markets Theory
• No substitution between demand for bonds of different
maturities
– The interest rate for each bond is determined by the
demand for and supply of that bond (no spillover from
other segments of the bond market)
• Investors have preferences for bonds of one maturity
over another
– If investors generally prefer bonds with shorter
maturities (that have less interest-rate risk) then this
explains why yield curves usually slope upward (fact 3)

Liquidity Premium Theory (1 of 2)
• 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
– Liquidity premium also referred to as a term premium
• Bonds of different maturities are partial (imperfect)
substitutes

Liquidity Premium Theory (2 of 2)
it  ite1  ite 2  ...  ite ( n1)

int   lnt
n
• where lnt is the liquidity premium for the n-period bond
at time t
• lnt is generally positive and increasing in the term to
maturity n

Preferred Habitat Theory (PHT)
• Closely related to the liquidity premium 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
• The PHT has the same prediction as the liquidity
preference theory if most investors prefer short-term
bonds over longer-term bonds

Figure 6-5: The Relationship Between the Liquidity
Premium (Preferred Habitat) and Expectations Theory
Because the liquidity premium is always positive and grows as the term to maturity increases, the yield
curve implied by the liquidity premium and preferred habitat theories is always above the yield curve
implied by the expectations theory and has a steeper slope. For simplicity, the yield curve implied by the
expectations theory shown here assumes unchanging future one-year interest rates.

The Liquidity Premium Theory and the
Facts about the Term Structure
• Interest rates on different bonds move together
– Explained by first term in the equation
• Yield curves upward-sloping when short-term rates are
low; and sometimes inverted when short-term rates are
high
– Explained by the liquidity premium term in the first case;
and lower expected future interest rates in the 2nd case
• Yield curves typically upward-sloping
– Explained by liquidity premiums which increase in the
term to maturity

Figure 6-6: Yield Curves and the Market’s Expectations
of Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory (1 of 2)
A steeply rising yield curve, as in panel (a), 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.

Figure 6-6: Yield Curves and the Market’s Expectations
of Future Short-Term Interest Rates According to the
Liquidity Premium (Preferred Habitat) Theory (2 of 2)
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.

Figure 6-7: Yield Curves for Government of Canada
Bonds
Yield curves for government of Canada bonds for different dates from 1986 to 2021.
Sources: Statistics Canada CANSIM series V122531, V122532, V122533, V122538, V122539, V122540,
V122543, and V122544, and the authors’ calculations.

Application – Forecasting Interest Rates
What is the expected 1-year interest rate for next year?
Assume that the expected return over two periods from investing $1 in
a two-period bond must equal the expected return from investing $1 in
one-period bonds. That is,
(1 + i2t) (1 + i2t) ‑ 1 = (1 + it) (1 + iet+1) ‑1
By solving the equation for iet+1 yields
(1  i2t ) 2
i e
t 1  1
1  it
Thus, if it = 5% and i2t = 5.5%, then it+1e = 6%. This is the expected
one-year interest rate one year in the future.

(Cont’d)
• What is the expected 1-year interest rate two years hence?
For a 3-year holding period, we have
(1 + i3t) (1 + i3t) (1 + i3t) ‑ 1 = (1 + it) (1 + iet+1) (1 + iet+2) ‑1
Solving this equation for iet+2 yields

(1  i ) 3
ite 2  3t
1
(1  i2t ) 2

(Cont’d)
• What is the expected 1-year interest rate n years hence?
It is
(1  in 1,t ) n 1
ite n  1
(1  int ) n
If we introduce the idea of liquidity premium ℓ nt, then the formula

n 1
becomes (1  in 1,t   n 1,t )
it  n 
e
1
(1  int  nt ) n
Thus, managers of financial institutions can easily produce

interest-rate forecasts. First they need to estimate ℓnt, for various
n. Then they need merely apply the second formula in this slide
to derive the market’s forecasts of future interest rates.
Forecasting Interest Rates: An Example
Suppose that ℓ1t = 0, ℓ2t = 0.25%, it = 5%, and i2t = 5.75%.
Then
(1  i  l ) 2
(1  . 0575  . 0025) 2
ite1  2t 2t
1   1  0.06 (or 6%)
(1  it ) (1  .05)

A First Look at Quantitative Easing and
Unconventional Monetary Policy
• The interest rates relevant for most investment and consumption

decisions are long term (e.g. mortgage) and risky (e.g. Baa corporate
bond)
• Conventional monetary policy targets short term and riskless interest
rates (e.g. the overnight interest rate in Canada and the federal funds
rate in the United States)
• In practice, something like the interest rate on a 10-year Canada bond
serves as a benchmark interest rate for all other kinds of interest rates
--- mortgage rates, credit card rates, student loan rates
• These are the rates relevant for economic decisions on spending and
saving
• Our theory of bond pricing helps us understand the connection
between these different kinds of interest rates

Monetary Policy in Normal Times
• Think of a world where the liquidity premium theory holds

• A central bank lowers (raises) short term interest rates and
is expected to keep these low (high) for some time
• This ought to also lower (raise) longer term rates to the
extent to which longer term rates are the average of
expected shorter term rates
• Holding risk factors constant, substitutability between
bonds means that riskier yields also ought to fall
(increase)

Nominal Interest Rates in the United States
(2001:M1-2021:M11)
8.00
7.00 30-year conventional morgage rate

30-year Treasury securities
6.00
Monthly interest rate (%)
5.00
4.00
3.00
10-year Treasury notes
2.00
1.00 Federal funds rate
0.00
2001 2001 2002 2003 2004 2005 2006 2006 2007 2008 2009 2010 2011 2011 2012 2013 2014 2015 2016 2016 2017 2018 2019 2020 2021

Term Structure Puzzle?
• In the 1990s other rates tracked the policy rate reasonably closely, but
this falls apart in the 2000s (see the figure in the previous slide)
• This has been referred to as the “term structure puzzle”
• From the perspective of the expectations hypothesis, would expect
longer maturity, riskier rates to move along with shorter maturity rates.
Not what we see in 2000s
• But two key issues:
• Forecastability: if people expected the central bank to raise rates
starting in 2004/2005 from the perspective of 2002/2003, this
would have been incorporated into long rates before the policy
rate started to move. Most people think central bank policy has
become more forecastable
• Persistence: behavior of long rates depends on how persistent
changes in short rates are expected to be

Unconventional Monetary Policy
• In a world where the policy rate is at or very near zero,

conventional monetary loosening isn’t on the table
• Unconventional monetary policy:

• Quantitative Easing (or Large Scale Asset
Purchases): purchases of longer maturity government
debt or risky private sector debt. Idea: raise demand
for this debt, raise price, and lower yield.
• Forward Guidance: promises to keep future short
term interest rates low. Idea is to work through
expectations hypothesis and to lower long term yields
immediately.

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The Economics of Money, Banking, and

Copyright © 2023 Pearson Canada Inc. 6-1

1. Identify and explain the three factors affecting the

Copyright © 2023 Pearson Canada Inc. 6-2

• Yields of different bonds of the same maturity can

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• Income Tax Considerations:

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Interest Rates on Municipal and Treasury Bonds in the United States

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1. Interest rates on bonds of different maturities move

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it = today’s interest rate on a one-period bond

iet+1 = interest rate on a one-period bond expected for

i2t = today’s interest rate on the two-period bond

Copyright © 2023 Pearson Canada Inc. 6 - 19

(1  i2t )(1  i2t )  1

• Since (i 2t)2 is very small the expected return for

• Let the current rate on one-year bond be 9%

Copyright © 2023 Pearson Canada Inc. 6 - 23

it  ite1  ite 2  ...  ite ( n 1)

.05  .06  .07  .08  .09

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it  ite1  ite 2  ...  ite ( n1)

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By solving the equation for iet+1 yields

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• What is the expected 1-year interest rate two years hence?

For a 3-year holding period, we have

(1 + i3t) (1 + i3t) (1 + i3t) ‑ 1 = (1 + it) (1 + iet+1) (1 + iet+2) ‑1

Solving this equation for iet+2 yields

Copyright © 2023 Pearson Canada Inc. 6 - 36

If we introduce the idea of liquidity premium ℓ nt, then the formula

Thus, managers of financial institutions can easily produce

Suppose that ℓ1t = 0, ℓ2t = 0.25%, it = 5%, and i2t = 5.75%.

Copyright © 2023 Pearson Canada Inc. 6 - 38

• The interest rates relevant for most investment and consumption

Copyright © 2023 Pearson Canada Inc. 6 - 39

• Think of a world where the liquidity premium theory holds

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7.00 30-year conventional morgage rate

1.00 Federal funds rate

Copyright © 2023 Pearson Canada Inc. 6 - 41