CHAPTER 7: THE RISK AND TERM STRUCTURE OF
Core Principles 1 and 2, that time has value and that risk requires compensation,
are the keys to understanding the risk and term structures of interest rates. The risk
structure focuses on the yields on bonds of different risk, holding maturities fixed. The
term structure focuses on yields at different maturities, holding risk fixed.
The risk structure shows how interest rates on bonds with a fixed maturity (say,
10-year bonds) change as bond risk changes. So, compare the yield on 10-year Treasury
bonds with those on 10-year Aaa bonds and 10-year Baa bonds, as in Panel A of Figure
7.2 on text page 161. Treasury bonds are free of default risk, though they still have
inflation risk and interest rate risk. Bonds issued by all others have at least some default
risk, so Treasurys “anchor” the risk structure. Assuming other factors are given, the
interest rates on the Treasury bonds are less than rates on Aaa bonds, which in turn are
less than the rates on the Baa bonds; the riskier the bond (with lower bond ratings, as
measured by bond rating agencies) the higher the yield since risk-averse investors require
compensation for assuming additional risk (Core Principle 2). Furthermore, fluctuations
in systematic risk raise and lower the riskiness of other bonds relative to Treasury issues.
Finally, the risk of Treasurys changes due to factors like inflation risk. Changing risks to
Treasury issues raise and lower the entire risk structure.
The term structure compares the yields on bonds as the term to maturity changes,
holding risk fixed. For example, examining the interest rates on various Treasury
securities, from 3-month T-bills to 10-year Treasury notes and 30-year Treasury bonds,
you will usually find that the longer the term to maturity, the higher the yield. Risk is
“fixed” in that the U.S. Treasury will not default on its bonds. (Remember that Treasury
issues still have interest rate and inflation risk, so the risk premium on Treasurys is not
zero, and can vary with the term to maturity.) The usual patterns are for (i) the yields to
rise with the term to maturity, (ii) short term interest rates to be more volatile than long-
term rates, and (iii) all rates to move together.
DISCUSSION/EXTENSIONS OF THE BASICS
Liquidity Premium Theory: A look at the algebra and what it says
. A quick way to
organize your thoughts about the basic material is to consider equation (7) on text page
162, which expresses the liquidity premium theory, and is reproduced below: