Chapter 6 The Risk and Term Structure of Interest Rates I Risk Structure of Interests Rates term to maturity and different interests risks the relationships between bonds with the same a Default Risk ableto pay back face value of the bond the risk of bond issuer missing interests payments or un US Treasureres i Defalult Free Bonds ii Risk Premium the spread between interests rates on bonds with default risk and default free bonds of the same maturity 1 higher the default risk higher the risk premium 2 a bond with a default risk will always have a risk premium iii Credit Ratings 1 x BBB investment Grade 2 x BBB Junk Bonds High Yield how quickly an asset can be converted and cheaply into cash b Liquiduty i The more liquid an asset is the more desirable it is ii Lower liquidity of bonds increases the Premium 1 Called the Risk Premium as well factored in c Income Tax Considerations i Munis are exempt from federal income taxes 1 Thus have lower Coupon interests Rates because they doent pay taxes on it II Term Structure of Interest Rates a Yield Curve risk liquidity and tax considerations yields on bonds with different terms to maturity but the same long term interst rates are higher than short term i Upward Sloping interest rates ii Things to Consider 1 Interst 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 interest rates are high yield curves are more likely to slope downward and be inverted 3 Yield Curves almost always slope upward b Expectations Theory average of the short term interests rates that people expect to occur over the life of the long term bond interest rate on a long term bond will equal an i Buyers of bonds do not prefer one maturity to another ii Will not hold any quantities of a bond if its expected return is less that of another bond 1 Perfect Subsitutes 2 Example a Expected returns on bonds are equal a Purchase a 1 year bond and when it matures purchase another 1 year bond b Purchase a 2 year bond and hold it till maturity iii int it 1e 1 2 t 1 1e t n 1 n int interest Rate in n years 5 6 7 8 9 5 7 a 1 year interest rates over the next 5 years is expected to be 5 6 9 then a 5 year bond would be 7 see iii 1 iv A rise in short term interest rates will raise peoples expectations of future short term rates v Since yield curve is expected to be upward sloping then if short term interest rates are high they will be expected to come down in the future c Segmented Market Theory completely separate and segmented Interest rate is solely from the Suppluy Demand of the bond with no effect from expected returns on other bonds with other maturities sees markets for different maturity bonds as i Bonds are Not Perfect Subsitutes ii Opposite of Expectations Theory iii People have specific time fram in mind and thus will only buy bonds with similar holding periods 1 if HPR and Time frame is the same there is virtually no risk iv Interst Rates are determined through supply and demand 1 Investors generally prefer high liquidity bonds with low low holding periods Demand is high driving prices down d Liquidity Premium Preferred Habitat Theories i Liquidity Premium Theory equal an average of short term interests rates expected to occur over the life of the long term bond plus a liquidity premium that responds to the supply and demand of the bond interests rates on a long term bond will 1 bonds of different maturities are subsititutes a expected returns of one bond does influence the the expected return on a bond of a different maturity and allows investors to prefer one maturity over another 2 int it 1e a t 1 1e t n 1 n lnt lnt liquidity premium i always positive ii rises with the term of maturity ii Preferred Habitat Theory one maturity over another a particular bond maturity preferred habitat in which they prefer to invest investors have a preference for bonds of 1 investors prefer habitats of shorter investing periods over longer ones a expect higher returns in longer investing periods e Yield Curves i Downward sloping enter a recession ii Upward sloping increasing inflation Loose Monetary Policy iii Flat or downward sloping future decline in inflation Tight Monetary policy