This document discusses factors that affect the risk structure of interest rates. It introduces three theories of the term structure of interest rates: expectations theory, market segmentation theory, and liquidity premium theory. Expectations theory holds that long-term interest rates equal the average expected short-term rates. Market segmentation theory sees bond markets as completely separate. Liquidity premium theory combines features of the first two theories, asserting long rates equal expected short rates plus a liquidity premium to compensate for less liquidity of long bonds. It best explains the empirical facts about how short and long rates typically move together and yield curve slopes.

1. FINANCIAL MARKET
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2. Risk Structure of Interest Rates
The relationship among term of maturity on bond
with different interest rates.
The risk and term structure of interest rates
contain useful information about overall economic
conditions.
These indicators are helpful in evaluating both the
present health of the economy and its likely future
course.
Risk spreads provide one type of information, the
term structure another.
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3. Risk Structure
of Long Bonds in the U.S.
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4. Factors Affecting Risk Structure
of Interest Rates
• Default Risk
• Liquidity
• Income Tax Considerations
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5. 1. Default Risk Factor
• One attribute of a bond that influences its interest rate is
its risk of default, which occurs when the issuer of the
bond is unable or unwilling to make interest payments
when promised or pay off the face value when the bond
matures.
• U.S. Treasury bonds have usually been considered to
have no default risk because the federal government can
always increase taxes to pay off its obligations (or just
print money). Bonds like these with no default risk are
called default-free bonds.
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6. Default Risk Factor (cont.)
• The spread between the interest rates on bonds with
default risk and default-free bonds, called the risk
premium.
– Indicates extra amount of interest that people must earn
in order to be willing to hold that risky bond.
• A bond with default risk will always have a positive
risk premium and an increase in its default risk will
raise the risk premium.
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7. Increase in Default Risk
on Corporate Bonds
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8. Analysis of Figure 5.2: Increase in Default on
Corporate Bonds
• Corporate Bond Market
– Re on corporate bonds ↓, Dc ↓, Dc shifts left
– Risk of corporate bonds ↑, Dc ↓, Dc shifts left
– Pc ↓, ic ↑
• Treasury Bond Market
 Relative Re on Treasury bonds ↑, DT ↑, DT shifts right
 Relative risk of Treasury bonds ↓, DT ↑, DT shifts right
 PT ↑, iT ↓
• Outcome
– Risk premium, ic - iT, rises
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9. Default Risk Factor (cont.)
• Default risk is an important component of the size of
the risk premium.
• Because of this, bond investors would like to know as
much as possible about the default probability of a
bond.
• One way to do this is to use the measures provided
by credit-rating agencies such as Moody’s and S&P,
Rating Agency Malaysia Berhad (RAM).
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10. Bond Ratings
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11. 2. Liquidity Factor
• Another attribute of a bond that influences its
interest rate is its liquidity.
• A liquid asset is one that can be quickly and
cheaply converted into cash if the need arises.
The more liquid an asset is, the more desirable
it is (higher demand), holding everything else
constant.
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12. Liquidity (cont..)
U.S Treasury bonds are the most liquid
compare to Corporate bonds.
• U.S Treasury are widely traded that easiest to sell
quickly and cost of sell it is low.
• Corporate bonds have fewer bonds for any one
corporation are traded that costly to sell
immediately because hard to find quick buyers.
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13. Decrease in Liquidity
of Corporate Bonds
Figure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds
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14. Analysis of Figure 5.1:
Corporate Bond Becomes Less Liquid
• Corporate Bond Market
 Liquidity of corporate bonds ↓, Dc ↓, Dc shifts left
 Pc ↓, ic ↑
• Treasury Bond Market
 Relatively more liquid of Treasury bonds, DT ↑, DT shifts right
 PT ↑, iT ↓
• Outcome
– Risk premium, ic - iT, rises
• Risk premium reflects not only corporate bonds' default risk
but also lower liquidity = risk and liquidity premium.
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15. 3. Income Taxes Factor
• Interest payments on municipal bonds are exempt
from federal income taxes, a factor that has the same
effect on the demand for municipal bonds as an
increase in their expected return.
• Treasury bonds are exempt from state and local
income taxes, while interest payments from
corporate bonds are fully taxable.
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16. Tax Advantages of Municipal Bonds
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17. Analysis of Figure 5.3:
Tax Advantages of Municipal Bonds
• Municipal Bond Market
– Tax exemption raises relative Re on municipal bonds, Dm
↑, Dm shifts right
– Pm ↑
• Treasury Bond Market
– Relative Re on Treasury bonds ↓, DT ↓, DT shifts left
– PT ↓
• Outcome
– im < iT
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18. Term Structure of Interest Rates
The relationship among interest rates on bonds with
different terms to maturity
Important empirical facts:
1. Interest rates for different maturities move together over
time
2. Yield curves tend to have step upward slope when short rates
are low and downward slope when short rates are high
5. Yield curve is typically upward sloping
NOTE: Yield curve is just a plot of i (earned on bonds)
against maturity times
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19. Interest Rates on Different
Maturity Bonds Move Together
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20. Three Theories of Term Structure
1. Expectations Theory
 The proposition that the interest rate on a long-term
bond will equal the average of the short-term rates that
people expect to occur over the life of the long-term
bond .
 Assumes that bonds with different maturities are perfect
substitutes
 Pure Expectations Theory explains 1 and 2, but not 3
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21. 1. Expectations Theory
Key Assumption: Bonds of different maturities are
perfect substitutes.
Implication: RETe on bonds of different
maturities are equal.
Investment strategies for two-period horizon
1. Buy $1 of one-year bond and when it matures buy
another one-year bond
2. Buy $1 of two-year bond and hold it
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22. Expectations Theory
• Expected return from strategy 1
(1 + it )(1 + i ) − 1 = 1 + it + i
e
t +1
e
t +1
+ it (i ) − 1
e
t +1
Since it(iet+1) is also extremely small, expected
return is approximately
it + iet+1
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23. Expectations Theory
• Expected return from strategy 2
(1 + i2t )(1 + i2t ) − 1 = 1 + 2(i2t ) + (i2t )2 − 1
Since (i2t)2 is extremely small, expected return is
approximately
2(i2t)
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24. Expectations Theory
• From implication above expected returns of two
strategies are equal
• Therefore
2(i2t ) = it + i e
t +1
Solving for i2t
it + ite+1
i2t = (1)
2
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25. Expectations Theory
• To help see this, here’s a picture that describes
the same information:
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26. More generally for n-period bond…
it + it +1 + it + 2 + ... + it + (n−1)
int = (2)
n
In words: Interest rate on long bond = average short rates expected to occur over
life of long bond
Numerical example:
One-year interest rate over the next five years 5%, 6%, 7%, 8% and 9%:
Interest rate on two-year bond:
(5% + 6%)/2 = 5.5%
Interest rate for five-year bond:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
Interest rate for one to five year bonds:
5%, 5.5%, 6%, 6.5% and 7%.
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27. Expectations Theory
and Term Structure Facts
• Explains why yield curve has different slopes
– When short rates are expected to rise in future, average
of future short rates = int is above today's short rate;
therefore yield curve is upward sloping.
– When short rates expected to stay same in future,
average of future short rates same as today's, and yield
curve is flat.
– Only when short rates expected to fall will yield curve be
downward sloping.
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28. Expectations Theory
and Term Structure Facts
• Pure expectations theory explains fact 1 that short
and long rates move together:
– Short rate rises are persistent
– If it ↑ today, iet+1, iet+2 etc. ↑ ⇒
average of future rates ↑ ⇒ int ↑
– Therefore: it ↑ ⇒ int ↑
(i.e., short and long rates move together)
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29. Expectations Theory
and Term Structure Facts
• Explains fact 2 that yield curves tend to have step
slope when short rates are low and downward slope
when short rates are high.
– When short rates are low, they are expected to rise to
normal level, and long rate = average of future short
rates will be well above today's short rate; yield curve
will have step upward slope.
– When short rates are high, they will be expected to fall
in future, and long rate will be below current short
rate; yield curve will have downward slope.
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30. Expectations Theory
and Term Structure Facts
• Doesn't explain fact 3 that yield curve usually
has upward slope
– Short rates are as likely to fall in future as rise, so
average of expected future short rates will not
usually be higher than current short rate:
therefore, yield curve will not usually
slope upward.
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31. Three Theories of Term Structure
1. Market Segmentation Theory
 A theory of term structure that sees markets for
different maturity bonds as completely separated and
segmented such that the interest rate for bonds of a
given maturity is determined solely by supply of and
demand for bonds of that maturity.
 Assumes that bonds of different maturities are not
substitutes at all
 Market Segmentation Theory explains 3, but not 1 and
2
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32. 2. Market Segmentation Theory
• Key Assumption: Bonds of different maturities are
not substitutes at all
• Implication: Markets are completely segmented;
interest rate at each maturity are
determined separately
Explains Fact 3 that yield curve is usually upward sloping
– People typically prefer short holding periods and thus have higher
demand for short-term bonds, which have higher price and lower
interest rates than long bonds.
Does not explain Fact 1 or Fact 2 because assumes long and
short rates determined independently
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33. Three Theories of Term Structure
1. Liquidity Premium Theory
 The theory 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 positive term (liquidity) premium
 Solution: Combine features of both Pure Expectations
Theory and Market Segmentation Theory to get Liquidity
Premium Theory and explain all facts
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34. 3. Liquidity Premium Theory
• Key Assumption: Bonds of different maturities
are substitutes, but are not
perfect substitutes
• Implication: Modifies Pure Expectations
Theory with features of Market
Segmentation Theory
Investors prefer short rather than long bonds ⇒ must be paid
positive liquidity (term) premium, lnt, to hold long-term bonds
Results in following modification of Expectations Theory:
it + ite+1 + ite+ 2 + ... + ite+ (n−1)
int = + l nt
n
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35. Liquidity Premium Theory
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36. Liquidity Premium Theory:
Term Structure Facts
• Explains All 3 Facts:
Explains fact 3 that usual upward sloped yield
curve by liquidity premium for long-term bonds
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
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37. NEXT CHAPTER 5:
FISCAL POLICY
– Please find government budget 2011/2012
– TQ
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