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The Risk & Term Structures of Interest

Rate
Definitions
The relationship between interest rates on
bonds with same term to maturity is called the
risk structure of interest rate though risk,
liquidity and income tax rules, all play
important role in determining the risk structure.

The relationship between interest rates on


bonds with different terms to maturity is called
the term structure of interest rate.
Risk Structure of Interest Rates
Factors affecting risk structure
Default risk

Liquidity, and

The income tax treatment of a bonds interest


payments
Default Risk
Default risk or risk of default occurs when the
issuer of a bond is unable to make interest
payments or pay off the face value when the
bond matures or both.
Bonds having no default risk, like government
bonds, are called default-free bonds.
The spread between the interest rates on bonds
with default risk and default-free bonds of same
maturity are called the risk premium.
Risk premium indicates how much additional
interest people must earn to be willing to hold
that risky bond.
PC 0 PT D2T
D1C ST
SC D1T
D2C i2T P2T
P1C P1T
P2C i2C

QC i QT

(i2C i2T) is the positive risk premium.


So, a bond with default risk will always have a positive
risk premium and the risk premium increases with
increase in default risk.
Similarly liquidity and income tax treatment also affect
risk premium.
Term Structure of Interest Rates
Bonds with identical risk, liquidity and tax
characteristics may have different interest rates
because of different terms to maturity. This is
known as the term structure of interest rate.
A plot of the yields on bonds with different
maturities but same risk, liquidity and tax
considerations is called a yield curve.
It describes the term structure of interest rates.
An Ideal Yield Curve
Yield

Yield curve

Maturity
Yield Curve
It has been observed that
Interest rates on bonds of different maturities move together
over time.
Yield curves are usually upward sloping, but they can be flat or
downward sloping (often referred to as inverted yield curve) as
well. They can also take U or an inverted-U shape as well.
Yield curves almost always slope upward.
Theories that explain the shapes and movements of yield curves:
The Expectation Theory first two statements
The Segmented Market Theory third statement
The Liquidity Premium Theory all three statements
Expectations Theory
The theory assumes that the expected returns or
interest rates from different bonds determine
which one should be held; maturity does not
play any role.
The interest rates on long term bonds equal
average interest rates on short term bonds.
Otherwise, people will not hold any amount of
the bond which has lower expected interest rate.

1 + 1+1
+ 1+2 + + 1+(1
=

Movements of Interest Rates on Government Securities with Different Maturities
12.0000

10.0000

8.0000

6.0000

4.0000

2.0000

0.0000
2002- 2003- 2004- 2005- 2006- 2007- 2008- 2009- 2010- 2011-
03Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11 Apr 12 Apr
15-91 Days 5 Year 20 Year
Segmented Market Theory
It sees markets for different-maturity bonds as
completely separate and segmented.
Bonds of different maturities are not substitutes at all
Investors have very strong preferences for bonds of one
maturity but not for another
Differing yield curve patterns are accounted for by
supply and demand differences associated with bonds of
different maturities
Investors have short desired holding periods and
generally prefer bonds with shorter maturities that have
less interest-rate risk
It explains the third observation.
Liquidity Premium Theory
It states that 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 (also referred to as a term premium)
that responds to supply and demand conditions for that
bond
Key assumption is that bonds of different maturities are
substitutes, but not perfect substitutes
Investors tend to prefer shorter-term bonds
investors must be offered a positive liquidity premium
(ln) to induce them to hold longer-term bonds

1 + 1+1
+ 1+2 + + 1+(1
= +

Preferred Habitat Theory
It assumes that investors have a preference for
bonds of one maturity over another, a particular
bond maturity (preferred habitat) in which they
prefer to invest.
Because they prefer bonds of one maturity over
another, they will be willing to buy bonds that do
not have the preferred maturity (habitat) only if
they earn a somewhat higher expected return.
This reasoning leads to the same equation implied
by the liquidity premium theory with a term
premium that typically rises with maturity.
Feature of Liquidity Premium /
Preferred Habitat Theory
They tell you what the market is predicting about future
short-term interest rates just from the slope of the yield
curve.
A steeply rising yield curve indicates that short-term interest
rates are expected to rise in the future.
A moderately steep yield curve indicates that short-term
interest rates are not expected to rise or fall much in the future.
A flat yield curve indicates that short-term rates are expected
to fall moderately in the future.
Finally, an inverted yield curve indicates that short term
interest rates are expected to fall sharply in the future.
US Treasury Yield Curve on Jan 30, 2017

Source: US Treasury Website


Comparison of US Treasury Yield Curves
for 2007 and 2009

Source: US Treasury Website


Yield Curves of Indian Government
Securities
9.5

8.5

8 Mar-12
Mar-13
Mar-14
7.5
Mar-15
Mar-16
7 Jan-17

6.5

6
91-day 182-day 364-day 1 year 5 year 10 year 15 year
treasury bills treasury bills treasury bills residual residual residual residual
auction auction auction maturity maturity maturity maturity
Yield Curves of Indian Corporate
Bonds (AAA)
10.5

10

9.5
Mar-12
9 Mar-13
Mar-14
8.5 Mar-15
Mar-16
8
Jan-17
7.5

7
1 years 3 years 5 years 10 years
Risk Premium between Govt. Dated Securities, AAA
& AA Corporate Bonds
11

10

6
Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Jan-17
1 year-AAA 1 year-G Sec 1 years-AA

11 10
10
9
9
8
8
7
7

6 6
Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Jan-17 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Jan-17
5 years-AAA 5 year-Gsec 5 years-AA 10 years-AAA 10 year-Gsec 10 years-AA