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Social Science
Economics
Monetary Economics
Chapter 6: The Risk and Term Structure of Interest Rates
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Terms in this set (15)
Bonds with the same maturity have different interest rates due to (Risk Structure of Interest Rates):
Default Risk
Liquidity
Tax considerations
Default Risk
Probability that issuer of bond (borrower) is unable or unwilling to make interest payments or pay off the face value
US treasury bonds are considered default free (government can raise taxes and increase debt)
Risk Premium: the spread between the interest rate on bonds with default risk and the interest rate on (same maturity) Treasury bonds
Increase in default risk shifts the demand curve for corporate bonds left (i increase)...and shifts demand curve for treasury bonds right (i decrease)...thereby increasing the spread b/w the interest rates (increasing the risk premium)
Liquidity
Relative ease with which asset can be converted to cash
-From cost of selling bond (higher cost lowers liquidity)
-From number of buyers/sellers (higher number raises liquidity)
Higher liquidity means lower interest rate
Income tax considerations
Interest payments on municipal bonds are exempt from federal income tax, so have a lower interest rate and higher price than treasury bonds
Term Structure of Interest Rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Yield Curve
A plot of the yield on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations
Upward sloping: LT rates above ST rates
Downward sloping: LT rates below ST rates
Horizontal: LT and ST rates the same
Facts that the Theory of the Term Structure of Interest Rates must explain
(1) Interest rates on bonds of different maturities move together over time (don't see jagged curve)
(2) When short term interest rates are low, the yield curves are more likely to have an upward slope; when ST rates are high, yield curves more likely to have a downward slope
(3) Yield curves almost always slope upwards
Three theories to explain the three facts
(1) Expectations Theory: explains first two facts but not third
(2) Segmented Markets Theory: explains third fact but not first two
(3) Liquidity Premium (Preferred Habitat) Theory: combines first two theories to explain all three facts
Expectations Theory
The interest rate on a LT bond will equal an average of the current ST interest rate and the expected future ST rate
Assumption: buyers of bonds do not prefer bonds of one maturity over another; they consider bonds with different maturities to be perfect substitutes
i(n t)= [i(t) + iE(t+1) +...+ iE(t+n-1)]/n
i(n t)=yield on long term bond
n= years to maturity
i(t)= yield on 1 year (ST) bond
iE(t+1)= expected yield on 1 year (ST) bond, one year from now
Direction of Expected ST rates determines slope of yield curve:
-If ST rates expected to rise, upward sloping
-If ST rates expected to fall, downward sloping
-If ST rates expected to be constant, horizontal
Explains why the term structure of interest rates changes at different times (because expected future ST rates change)
Explains why interest rates on bonds with different maturities move together over time (fact 1): if iE(t+1) changes, it affects i2t but also i3t, i4t, i5t, etc.
Explains why yield curves tend to slope up when ST rates are low and slope down when ST rates are high (fact 2): If ST rates are really low now, you'd expect them to get higher in the future
CANNOT explain why yield curves usually slope upwards (fact 3)
Segmented Markets Theory
Bonds of different maturities are not substitutes at all- each maturity is a unique market
The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
If investors generally prefer bonds with shorter maturities that have less interest rate risk, then that explains why yield curves usually slope upwards (fact 3)
-A higher demand curve in the ST market compared to the LT market creates a lower interest rate in the ST market and higher interest rate in the LT market
Liquidity Premium Theory
The interest rate on a long term bond will equal an average of the short term interest rates expected to occur over the life of the LT bond PLUS a liquidity premium that responds to supply and demand conditions for that bond
Bonds of different maturities are partial (not perfect) substitutes
Liquidity premium is always positive, and rises with the term to maturity (need to be rewarded for taking a greater risk with a LT bond)
Essentially just ET+liquidity premium
Preferred Habitats Theory
Investors have a preference for bonds of one maturity over another
Investors likely to prefer ST bonds over LT bonds. To be enticed out of their habitual ST, need to be rewarded with higher expected yield. Thus, the liquidity premium rises as term to maturity rises
Relationship between LP(PH) Theory and ET Theory
If expected future ST interest rates remain steady, the ET curve will be horizontal. But the LP(PH) curve will rise, because liquidity premium rises as time to maturity rises
LP(PH) and the 3 Facts
Interest rates on different maturity bonds move together over time-- explained by the first term in the equation (the ET part)
Yield curves tend to slope upwards when ST interest rates are low-- explained by the liquidity premium
YIeld curves tend to slope downwards when ST interest rates are high-- explained because we expect high rates to level off, dragging down the average (the first term in the equation)
Yield curves typically slop upwards-- explained by a larger liquidity premium as the term to maturity lengthens
Using LP(PH) and ET to Interpret Expectations of ST Interest Rates on a Yield Curve
LT(PH):
A yield curve includes the liquidity premium. To properly gauge expectations of future ST rates, you need to remove the liquidity premium, causing the slope to pivot downwards
ET:
Easy to look at yield curve and see how market participants expect ST rates to change
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