CHAPTER 5

How Do Risk and Term Structure Affect Interest Rates?

1. INTRODUCTION
In this chapter we are going to study about the risks related to interest rates. Two important
features of interest rate for bonds of same maturity are
1. Interest rate of different categories of bonds differ from one another in any given year
2. The difference between the interest rates varies over time.
Default risk is when the issuer of the bond is unable to or is unwilling to make interest payments
when promised or pay off the face value when the bond matures. Corporate organizations are at
high default risk if they have any loss in profit or goes through recession while Government
organization have low default risk as they can increase taxes to pay off its interest and this is
known as default free risk. The difference between the interest rate of default risk and default
free risk is called risk premium.

Corporate Bond Market

1. Expected Return on corporate bonds , Dc , Dc shifts left
2. Risk of corporate bonds , Dc , Dc shifts left
3. Pc , ic

Treasury Bond Market

1. Relative Expected Return on Treasury bonds , DT , DT shifts right
2. Relative risk of Treasury bonds , DT , DT shifts right
3. PT , iT

Outcome
1. Risk premium, ic - iT, rises

It can be concluded that a bond with default risk will always have positive risk premium and an
increase in its default risk will raise the risk premium.
Default risk is important to the size of the risk premium thus bond investors would like to know
as much as possible about the default probability of a bond. Information about this can be taken
from credit-rating agencies. Bonds with low default rate are above BBB or Baa and are called
investment grade securities and with high default rate are below BBB or Baa and are called junk
bond.
More liquid bonds are more desirable and U.S treasury bonds have high liquidity. Corporate
bonds are not so liquid.
According to the above diagram

Corporate Bond Market

1. Liquidity of corporate bonds , Dc , Dc shifts left
2. Pc , ic

Treasury Bond Market

1. Relatively more liquid Treasury bonds, DT , DT shifts right
2. PT , iT

Outcome
1. Risk premium, ic - iT, rises

Risk premium reflects not only corporate bonds' default risk but also lower liquidity
Interest payments on municipal bonds are exempt from federal income taxes it increase the
demand for municipal bonds as an increase in their expected return.

Municipal Bond Market

1. Tax

exemption

raises

relative

Re

on

municipal

bonds,

Dm , Dm shifts right
2. Pm

Treasury Bond Market

1. Relative Re on Treasury bonds , DT , DT shifts left
2. PT

Outcome
im < iT

There is also another factor that affect the interest rate and that is the maturity period of the bond.
We want to know that in different maturities why
1. Interest rates move together.
2. Yield curves tend to have steep upward slope when short rates are low and downward
slope when short rates are high.
3. Yield curve is typically upward sloping.
To find answers of these three question three theories can be used

Expectations Theory

Market Segmentation Theory

Liquidity Premium Theory

In expectation theory we consider Bonds of different maturities to be perfect substitutes of each

other. According to this theory the rate of return on bonds of different maturities are equal.
Expectation theory explains the movement of curve that when short term rates are expected to
rise in future therefore yield curve is upward sloping, when short rates expected to stay same in
future, average of future short rates same as todays, and yield curve is flat and when short rates
expected to fall will yield curve be downward sloping.
Pure expectations theory explains why that short and long rates move together
a. Short rate rises are persistent
b. If it today, iet+1, iet+2 etc. average of future rates int
c. Therefore: it int
(i.e., short and long rates move together)
Expectation theory explain that when short rates are low the will have upward slope and vice
versa. When they are low in short term they expected to rise to normal level in future and if they
are high in short term they are expected to drop in long term.

According to Market Segmentation theory

market for different maturity bonds are completely

different and segmented. Their interest rate is determined with demand and supply of bonds.
They are assumed to not be the substitute at all so its expected return wont have effect on
demand for a bond of another maturity. Its opposite of expectancy theory. Investors invest in
bond differently on the bases of its maturity its because if the maturity of bond and desire
withholding them are equal then it minimize the risk. Thats why people normally purchase short
term bond and it explain the 3rd point that due to lower demand of long term bond it have lower
price and high interest rate. Thus it have upward slope. It explains 3 rd point but do not explain 1 st
and 2nd point. To have answers of both questions we combine both theories.
According to liquidity premium theory interest rate of long term bong is equal to the average of
short term interest rate over life of the long term bong plus liquidity premium. Its assumptions
are that the bonds of different maturity are not perfect substitute of each other. Investor selects
the short term bonds due to its less interest risk. To incline them toward long term bonds they
have to be offered positive liquidity premium.

If interest rate of expectation theory is kept constant over years in the graph and they interest rate
of liquidity premium theory increase with maturity then the difference between the two is
liquidity premium.it should be kept in mind that expectation theory curve is always below
liquidity premium theory curve.
It explains fact 1 and fact 2 using same explanations as pure expectations theory because it has
average of future short rates as determinant of long rate and explains fact 3 by the usual upward
sloped yield curve by liquidity premium for long-term bonds. Following will be the curves if
interest rate increases, stay constant, fall moderate and fall sharply

According to initial research little useful information in the yield curve for predicting future
interest rates was found. according to recent research the yield curve has a lot of information
about very short-term and long-term rates, but says little about medium-term rates.

CONCLUSION:
If bonds have same maturity they will have different interest rates because of default, liquidity,
and taxes. If Default rate increase then interest rates increase, if liquidity increase then interest
rates decrease and if taxes are exempted then interest rates decrease. In Term Structure of Interest

Rates the expectation theory the long term interest rates are equal to that average of short term
interest rates over the life of long term bond in future. In market segmentation theory interest
rates is determined with the demand and supply of bonds in this short term bonds are purchased
as they are less risky. Liquidity premium theory combine the qualities of bot theories according
to it the long term interest rates are equal to that average of short term interest rates over the life
of long term bond in future plus a liquidity premium. Then four type of curves are discussed a
steep upward sloping, a mildly upward sloping, a flat curve and an inverted curve