ch5 - The Risk and Term Structure of Interest Rates of...

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Unformatted text preview: The Risk and Term Structure of Interest Rates of Chapter 5 The Term Structure of Rates and the Yield Curve and Term Structure – Relationship among yields of different Relationship maturities of the same type of security. maturities Yield Curve Yield – Graphical relationship between yield and Graphical maturity. maturity. Empirical Facts Empirical Interest rates on bonds of different maturities Interest move together over time. move When short-term interest rates are low, yield When 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. be Yield curves almost always slope upward. Different Theories of the Shape of the Yield Curve of Supply and Demand – Determined by relative supply/demand of Determined different maturities different – Deals with each maturity by itself and ignores Deals the interrelationships between different interrelationships maturities of the same security maturities Expectations Hypothesis Expectations The shape of the yield curve is determined by the The investors’ expectations of future interest rate movements. movements. The interest rate on the long-term bond will equal an The average of short-term interest rates that people expect to occur over the life of the long-term bond. occur If the one-year interest rate over the next five years is If expected to be 5, 6, 7, 8, 9 percent, – then the interest rate on the two-year bond would be 5.5%. – While for the five-year bond it would be 7%. Investors are indifferent between short and long-term Investors securities. securities. Liquidity Premium Modification Liquidity Investors know from experience that short-term Investors securities provide greater marketability and have smaller price fluctuations than do long-term securities. The liquidity premium is that premium demanded for holding long-term securities. for Therefore, a two-year security would have to Therefore, yield more than the average of the two one-year securities as a reward for bearing more risk. securities The Preferred Habitat Approach The The interest rate on a long-term bond will equal an The average of short-term interest rates expected to occur over the life of the long-term bond plus a term (liquidity) premium that responds to supply and demand conditions for that bond. for If investors prefer the habitat of short-term bonds over If long-term bonds, they might be willing to hold short-term bonds even though they have a lower expected return. This means that investors would have to be paid a positive term premium to be willing to hold a long-term bond. bond. Real-World Observations Real-World When interest rates are high relative to When past rates, investors expect them to decline and the price of bonds to rise in the future resulting in big capital gains Investors would then favor long-term securities, which drives up price and lowers yield—downward sloping yield curve curve Real-World Observations Real-World If interest rates are low relative to past— results in an upward sloping curve Historically, over the business cycle shortHistorically, shortterm rates fluctuate more than longerterm rates term Yield curves tend to be upward sloping more often, suggesting the liquidity premium is the dominate theory premium Summary of Term Structure Theory Theory Expectations theory forms the foundation Expectations of the slope of the curve of Liquidity premium theory makes a longterm permanent modification that suggests term an upward sloping curve an Over short periods, relative supplies of Over securities have an impact on yields, altering the shape of the curve altering Government Bonds Government Reading the WSJ. Current coupon or on the run issue. Marketability Marketability Recently issued government bonds Recently (current coupon—“on the run”) are more (current ”) marketable than older issues (“off the marketable off run”) run – Because these newly issued bonds are highly Because marketable, they carry somewhat lower yields to maturity as compared to older issues Default Risk Default Other than US Federal government securities, Other bonds carry a risk of default default Risk on municipal bonds used to be Risk municipal considered very low considered – However, experience of New York City (1975), However, Cleveland (1978) and Orange Country, California (1995) suggest these bonds are becoming riskier (1995) Corporate bonds generally have a higher Corporate default risk than municipal bonds default Investors will expect higher return to Investors compensate for increased default risk Default Risk Default Standard and Poor’s and Moody’s Standard Investors Service rate the default risk on bonds which serve as a guide to investors bonds The introduction of risk in the yield curve The will cause the curve to shift since another variable other than “maturity” has changed The higher the perceived risk, the greater the upward shift of the curve for that particular security particular Risk and Tax Structure of Rates Risk Investors are concerned about the after Investors tax return on bonds tax Although municipal bonds are riskier than Although federal government bonds, tax exempt status of municipal bonds will generally status result in a lower yield (downward shift of the curve) the ...
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