Chapter 3

Structure of Interest Rates

Financial Markets and Institutions, 7e, Jeff Madura

Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Characteristics of debt securities that
cause their yields to vary
Explaining actual yield differentials
Estimating the appropriate yield
A closer look at the term structure
International structure of interest rates

Characteristics of Debt Securities

Credit (default) risk

Securities

with a higher degree of risk have to offer

higher yields to be chosen
Credit risk is especially relevant for longer-term
securities
Investors must consider the creditworthiness of the
security issuer

Can use bond ratings of rating agencies

The higher the rating, the lower the perceived credit risk
Ratings can change over time as economic conditions change
Ratings for different bond issues by the same issuer can vary

Characteristics of Debt Securities

(contd)

Credit (default) risk (contd)

Rating

Moodys Investor Service and Standard and Poors

Corporation are the most popular
Agencies use different methods to assess the
creditworthiness of firms and state governments

agencies

A particular bond issue could have different ratings from each

agency, but differences are usually small

Financial institutions may be required to invest only in

investment-grade bonds rated Baa or better by Moodys
and BBB or better by Standard and Poors
4

Characteristics of Debt Securities

(contd)

Description of Security

Ratings Assigned by:

Moodys

Standard and Poors

Highest quality

Aaa

AAA

High quality

Aa

AA

High-medium quality

Medium quality

Baa

BBB

Medium-low quality

Ba

BB

Low quality (speculative)

Poor quality

Caa

CCC

Very poor quality

Ca

CC

Lowest quality (in default)

DDD, D
5

Characteristics of Debt Securities

(contd)

Credit (default) risk (contd)

Shifts

in credit risk premiums

The risk premium corresponding to a particular

bond rating can chance over time

Accuracy

of credit ratings

In general, credit ratings have served as

reasonable indicators of the likelihood of default
Credit rating agencies do not always detect
financial problems of firms

Characteristics of Debt Securities

(contd)

Liquidity
Liquid

securities can be easily converted to

cash without a loss in value

Short-maturity securities with an active secondary

market are liquid

Securities

with lower liquidity have to offer a

higher yield to be preferred

Characteristics of Debt Securities

(contd)

Tax status
Investors

are more concerned with after-tax income

than before-tax income

Taxable securities have to offer a higher before-tax yield to

be preferred

The

after-tax yield is equal to:

Yat Ybt (1 T )
8

Characteristics of Debt Securities

(contd)

Tax status
Computing

the equivalent before-tax yield

The before-tax yield necessary to match the after-tax yield

on a tax-exempt security is:

Yat
Ybt
(1 T )

State taxes should be considered along with federal taxes

Computing the Equivalent

Before-Tax Yield
Assume a firm in the 30 percent tax bracket is
aware of a tax-exempt security that pays a
yield of 9 percent. To match this after-tax yield,
taxable securities (with similar maturity and
:risk) must offer a before-tax yield of
Yat
9%
Ybt

12.86%
(1 T ) (1 .3)
10

Characteristics of Debt Securities

(contd)

Term to maturity

The term structure of interest rates defines the relationship

between maturity and annualized yield

Special provisions

A call feature allows the issuer of bonds to buy the bonds

back before maturity

The yield on callable bonds should be higher than on noncallable

bonds

A convertibility clause allows investors to convert the bond

into a specified number of common stock shares

The yield on convertible bonds is lower than on nonconvertible

bonds

11

What is the 'Term Structure Of

The
term structure
of interest rates is the
Interest
Rates'
relationship between interest rates or bond
yields and different terms or maturities. The
term structure of interest rates is also known
as a yield curve and it plays a central role in
an economy.

12

Normal Yield Curve

If short-term yields are lower than long-term
yields, the curve slopes upwards and the
curve is called a positive (or "normal") yield
curve.
If short-term yields are higher than long-term
yields, the curve slopes downwards and the
curve is called a negative (or "inverted") yield
curve.
13

Normal and inverted curve

14

Flat yield curve

when there is little or no variation between short
and long-term yield rates

15

Explaining Actual Yield Differentials

A difference between amounts of things is called

differential
Yield differentials are often measured in basis points
Basis point is one hundredth of one percentage point
(used chiefly in expressing differences of interest
rates).
100

basis points equal 1 percent

Yield differentials of money market securities

Commercial

paper rates are higher than T-bill rates because

of higher credit risk and less liquidity.
Negotiable certificates of deposit offer slightly higher rates
than yields on Treasury bills (T-bills) with the same
maturity because of their lower degree of liquidity and higher
16
degree of credit risk.

Eurodollar deposit rates are higher than yields on other

money market securities

Market forces cause the yields of all securities to

move in the same direction.
Explanation

Assuming that budget deficit increases so govt has to issue

more T-bills to overcome that deficiency. To attract the
investors govt has to raise the yield rate on T-bills.
Investors will show more interest now in T-bills as
compared to private securities. So yield rate will be
increased on private securities
17

Explaining Actual Yield Differentials

(contd)

Yield differentials of capital market securities

Municipal

bonds have the lowest before-tax yield

After-tax

yield is higher than that of Treasury bonds

A municipal bond is a debt security issued by a
state, municipality or county to finance its capital
expenditures. Municipal bonds are exempt from
federal taxes and from most state and local taxes,
especially if you live in the state in which the bond
is issued

18

 Treasury

bonds have the lowest yield

No default risk
Very liquid

Investors

prefer municipal or corporate bonds over

Treasury bonds only if the after-tax yield compensates
for default risk and lower liquidity

19

Estimating the Appropriate Yield

The yield on a debt security is based on the risk-free

rate with adjustments to capture various
characteristics:
Yn Rf ,n DP LP TA CALLP COND

Yn=yield

of an n-day debt security

Rf,n=yield (return) 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 the difference in tax status
20

Maturity is controlled for by matching the

maturity of the risk-free security to that of
the security of concern

21

Computing the Appropriate Yield

A company wants to issue 180-day commercial paper. Sixmonth T-bills currently have a yield of 7 percent.
Assume that a default risk premium of 0.8 percent, a
liquidity premium of 0.1 percent, and a 0.2 percent tax
adjustment are necessary to sell the commercial paper
to investors. What is the appropriate yield the company
?should offer on its commercial paper
Yn Rf ,n DP LP TA CALLP COND
7 % .8 % . 1 % .2 %
8 .1 %
22

A Closer Look at the Term

Structure

Of all the factors that affect the yields

offered on debt securities, the one that is
most difficult to understand is term to
maturity. Various theories have been used
to explain the relationship between maturity
and annualized yield of securities. such as.
pure expectations theory
liquidity premium theory
segmented markets theory

23

Pure expectations theory

Pure

expectations theory suggests that the

shape of the yield curve is determined solely
by expectations of future interest rates
Assuming an initially flat yield curve:
The yield curve will become upward sloping if
interest rates are expected to rise
The yield curve will become downward sloping if
interest rates are expected to decline

24

Sudden Expectation of Higher

Interest Rates
Market for short-term risk-free debt

S1

Market for long-term risk-free debt

S2

S2

i1

S1

i2
D1

i2
D2

D2

i1
D1

25

Sudden Expectation of Higher

Interest Rates (contd)
Yield Curve

YC2
YC1

26

Sudden Expectation of Lower

Interest Rates
Market for long-term risk-free debt

S1

Market for short-term risk-free debt

S2

S2

i1

S1

i2
D1

i2
D2

D2

i1
D1

27

Sudden Expectation of Lower

Interest Rates (contd)
Yield Curve

YC1
YC2

28

A Closer Look at the Term Structure

(contd)

Pure expectations theory (contd)

Algebraic

presentation

The relationship between interest rates on two-year and

one-year securities is:

(1 t i 2 )2 (1 t i1 )(1 t 1r1 )

The one-year interest rate in one year (the forward

rate) can then be estimated:

(1 t i 2 )2
1
t 1 r1
(1 t i1 )
29

t i2 = known annualized interest rate of a

two-year security as of time t
t i1 = known annualized interest rate of a
one-year security as of time t
T+1r1 = one-year interest rate that is
anticipated as of time t + 1(one year
ahead)

30

Computing the Forward Rate

Assume that the annualized two-year interest rate today is
8 percent. Furthermore, one-year securities currently
offer an interest rate of 5 percent. What is an estimate
?of the forward rate

(1 t i 2 )2
1
t 1 r1
(1 t i1 )
1.08 2

1
1.05
11 .09%
31

A Closer Look at the Term Structure

(contd)

Pure expectations theory (contd)

Algebraic

presentation (contd)

The one-year interest rate in two years (the forward

rate) can also be estimated:

(1 t i 3 )3
1
t 2 r1
(1 t i1 )(1 t 1r1 )

32

Computing the One-Year Interest

Rate Two Years from Now
Continuing with the previous example, assume that threeyear securities currently offer an interest rate of 10
percent. What is an estimate of the one-year interest
?rate that will prevail two years from now
(1 t i 3 )3
1
t 2 r1
(1 t i1 )(1 t 1r1 )
1.10 3

1
(1.05)(1.1109 )
14.11 %
33

A Closer Look at the Term Structure

(contd)

Pure expectations theory (contd)

Algebraic

presentation (contd)

Future annualized interest rates for periods other than

one year can also be computed using the yield curve
A one-year investment followed by a two-year
investment should offer the same yield as a three-year
security:

1 t 1r2

(1 t i 3 )3

(1 t i1 )
34

Computing the Two-Year Interest

Rate One Year from Now
Continuing with the previous example, what is an
estimate of the two-year interest rate that will prevail
? in one year

1 t 1r2

t 1 r2

(1.10 )3

(1.05 )
1.27
1.27 1
12.59%
35

A Closer Look at the Term Structure

(contd)

Pure expectations theory (contd)

The

theory assumes that forward rates are

unbiased estimators of future interest rates
If forward rates are biased, investors should
attempt to capitalize on the discrepancy

36

A Closer Look at the Term Structure

(contd)

Liquidity premium theory

According

to the liquidity premium theory, the

yield curve changes as the liquidity premium
changes over time due to investor preferences

Investors who prefer short-term securities will hold longterm securities only if compensated with a premium
Short-term securities are typically more liquid than longterm securities

The

preference for short-term securities places

upward pressure on the slope of the yield curve
37

A Closer Look at the Term Structure

(contd)

Liquidity premium theory (contd)

Estimation

of the forward rate based on a liquidity

premium

The yield on a security will not necessarily be equal to

the yield from consecutive investments in shorter-term
securities:

(1 t i 2 )2 (1 t i1 )(1 t 1r1 ) LP2

The relationship between the liquidity premium and the

term to maturity is:

0 LP1 LP2 LP3 ... LP20

38

A Closer Look at the Term Structure

(contd)

Liquidity premium theory (contd)

Estimation of the forward rate based on a liquidity premium

(contd)

The one-year forward rate can be derived as:

(1 t i 2 )2
1 LP2 /(1 t i1 )
t 1 r1
(1 t i1 )

A positive liquidity premium means that the forward rate

overestimates the markets expectations of the future interest
rate
A flat yield curve means the market is expecting a slight
decrease in interest rates
A slight upward slope means no expected change in interest
rates

39

Computing the Forward Rate

With A Liquidity Premium
Assume that one-year interest rates are currently 10
percent. Further assume that two year interest rates
are equal to 8 percent. The liquidity premium on a twoyear security is 0.7 percent. What is an estimate of the
?one-year forward rate
(1 t i 2 )2
1 LP2 /(1 t i1 )
t 1 r1
(1 t i1 )
1.08 2

1 .007 / 1.10
1.10
5.4 %
40

A Closer Look at the Term Structure

(contd)
Segmented market theory
According

to segmented markets theory, investors and

borrowers choose securities with maturities that satisfy their
forecasted cash needs

Pension funds and life insurance companies prefer long-term

investments
Commercial banks prefer short-term investments

Shifting

by investors or borrowers between maturity markets

only occurs if the timing of their cash needs change

According to segmented markets theory, the choice of longterm versus short-term maturities is determined more by
investors needs than by their expectations of future interest
rates.
41

Impact of Different Scenarios

Segmented Markets Theory
Investors Have Mostly
Short-Term Funds
Available; Borrowers
Want Long-Term Funds

Investors Have Mostly

Long-Term Funds
Available; Borrowers
Want Short-Term Funds

Upward pressure

Downward pressure

Demand for short-term funds by

borrowers

Downward pressure

Upward pressure

Yield on new short-term

securities

Downward pressure

Upward pressure

Supply of long-term funds

provided by investors

Downward pressure

Upward pressure

Demand for long-term funds

issued by borrowers

Upward pressure

Downward pressure

Yield on long-term securities

Upward pressure

Downward pressure

Supply of short-term funds

provided by investors

Shape of yield curve

Upward slope

Downward slope42

A Closer Look at the Term Structure

(contd)

Segmented market theory (contd)

Limitations

of the theory

Some borrowers and savers have the flexibility to choose

among various maturity markets

e.g., Corporations may initially obtain short term funds if

they expect long-term interest rates to decline
If markets were segmented, an adjustment in the interest
rate in one market would have no impact on other markets,
but evidence shows this is not true

43

A Closer Look at the Term Structure

(contd)

Segmented market theory (contd)

Implications

The preference for particular maturities can affect the

prices and yields of securities with different maturities
and therefore the shape of the yield curve
The preferred habitat theory is a more flexible
perspective

Investors and borrowers may wander from their markets

given certain events

44

A Closer Look at the Term Structure

(contd)

Research on term structure theories

Interest rate expectations have a strong influence on the

term structure
The forward rate from the yield curve does not accurately
predict future interest rates
Variation in the yield-maturity relationship cannot be
explained by interest rate expectations or liquidity
General research implications

Some evidence for pure expectations, liquidity premium, and

segmented markets theory

45

A Closer Look at the Term Structure

(contd)

Uses of the term structure

Forecast

Pure expectations and liquidity premium theories can be

used

Forecast

interest rates

recessions

A flat or inverted yield curve may indicate a recession in

the near future since lower interest rates are expected

46

A Closer Look at the Term Structure

(contd)

Uses of the term structure (contd)

Investment

Riding the yield curve involves investment in higheryielding long-term securities with short-term funds
Financial institutions whose liability maturities are
different from their asset maturities monitor the yield
curve

Financing

decisions

decisions

Assessing prevailing rates on securities for various

maturities allows firms to estimate the rates to be paid on
bonds with different maturities

47

A Closer Look at the Term Structure

(contd)

Impact of debt management on term structure

If the Treasury uses a relatively large proportion of long-term

debt, this places upward pressure on long-term yields
If the Treasury uses short-term debt, long-term interest rates
may be relatively low

Historical review of the term structure

Early 1980s: downward sloping yield curve

1982 to 2001: an upward sloping yield curve generally
persisted
September 11, 2001: investors shifted funds into short-term
securities and the Fed provided funds to the banking system,
causing the yield curve to become steeper

48

International Structure of Interest

Rates
Yield curves vary among countries
Interest rate movements across countries
tend to be positively correlated
Interest rates may vary across countries at
any particular point in time

Supply

and demand conditions across

countries cause differences
49