ECO 531 Chapter 14 Interest Rates PDF

ECO 531- CHAPTER ⑭ 4 STRUCTURE OF INTEREST RATES THE RISK AND TERM STRUCTURE OF INTEREST RATES • 2 CONCEPTS: • Risk structure of interest rates is the relationship among interest rates on bonds with (similar terms to maturity). • Term structure of interest rates is the relationship among int...

ECO 531- CHAPTER ⑭ 4 STRUCTURE OF INTEREST RATES THE RISK AND TERM STRUCTURE OF INTEREST RATES • 2 CONCEPTS: • Risk structure of interest rates is the relationship among interest rates on bonds with (similar terms to maturity). • Term structure of interest rates is the relationship among interest rates on bonds with (different terms to maturity). THE RISK STRUCTURE OF INTEREST RATES •Why bonds with the same term of maturity have different interest rates? •Given similar terms of maturity, different bonds earn different interest rates because of Loading… the difference in the following factors: •1. Default Risk •2. Liquidity •3. Administration/Information Costs •4. Taxation 1. DEFAULT RISK • Default risk occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or unable to pay off the face value when the bond matures. • A corporation suffer big losses might be more likely to suspend interest payments on its bonds. The default risk on its bond would therefore be quite high. • Treasury bonds: is no default risk because government can always increase taxes to pay off its obligations. Bonds like this are called default-free bonds. • Risk Premium: the spread between the interest rates on bonds with default risk and dengan bond young default-free bonds. difference between bond yang ada default risk default free . • Bond with default risk always has a positive risk premium: the higher the default risk is, the larger the risk premium will be. Y Difference DR & between D bond 1 S Loading… V DR DF From the graph: •Increase in default risk : the corporation suffer losses, the expected return on corporate bonds decrease. So that, the demand for corporate bonds decrease; D1c to D2c. •The equilibrium price of corporate bond falls from P1c to P2c and interest rate on corporate bonds increase from i1c to i2c. At the same time the demand for treasury bonds rises from D1t to D2t. •The equilibrium price increase from P1t to P2t and the interest rates for treasury bonds decrease from i1t to i2t. •The risk premium on corporate bond has risen from zero to i2c –i2t. So, we can conclude that a bond with default risk will always have a positive risk premium. 2. LIQUIDITY • • Liquidity is one of the bond attribute that influence interest rates. The more liquid an asset is, the more desirable it is. Treasury bonds (TB) are the most liquid of all long term bonds because they are so widely traded that they are the easiest to sell quickly and the cost of selling is low. Corporate bonds (CB) are not liquid because fewer bonds for any one corporation are traded, thus it can be costly to sell this bonds. • Using the same graph: • If CB become less liquid than TB, its demand will fall. The TB becomes relatively liquid in comparison with the CB. The demand curve for TB shift to the right. From the graph, it shows that the price of the less liquid asset falls and interest rates rise, while the price of the more liquid asset rises and the interest rates falls. • The result is the spread between the interest rates on the two bonds has risen. It is a Liquidity Premium. So Liquidity Premium = Risk Premium. 3. INFORMATION COST • The cost of acquiring information reduces the expected return on that financial asset (bond). • • Using the same graph: Let’s assume that the prices of the 2 bonds are initially equal. So the interest rates also equal. • When information costs rise for the CB, lenders are less willing to invest their funds in the market for that instrument at the going price and interest rate, shifting the DD curve to the left. And shifting to right for the relative asset (TB that has lower information cost). • As a result, the price rise and interest rate falls for TB. For the CB, the price falls, and interest rate rises. 4. TAXATION • Another reason for differences in interest rates across credit market instruments is taxation. From the graph: • If the Municipal Bond (MB) is given tax-free status, it raises their after tax expected return relative to TB and makes MB more desirable. Demand for MB increase. The result is equilibrium price increases and the interest rate falls. TB become less desirable. Its demand falls. The result is equilibrium price falls and the interest rate increased. • As a conclusion, if tax free is given, we are willing to hold the riskier and less liquid asset even though it has lower interest rates. Feb 2023: Identify 2 factors that determine the risk structure of interest rate. July 2023: Different interest rate eventhough same maturity (restructure question) Diagrams - explain why corporate bonds are likely to have higher interest rate compared to government bond. THE TERM STRUCTURE OF INTEREST RATE • Another factor that can influence interest rate on bonds is its term of maturity. • Yield Curve : is a plot of the yields on bonds with differing terms to maturity but the risk, liquidity, information cost and tax are considered the same. • When yield curve slop upward, the long term interest rates are above the short term interest rate. • When yield curves are flat, short term and long term interest rates are the same. • When yield curves are downward sloping, long term interest rates are below short term interest rates. Loading… THREE THEORIES TO EXPLAIN THE THREE FACTS 1. Pure Expectations Theory explains the first two facts but not the third (1 & 2) 2. Segmented Markets Theory explains fact three but not the first two (3) 3. Liquidity Premium theory combines the two theories to explain all three facts (1, 2 & 3) THE 3 FACTS ARE: Interest rates on bonds of different maturities move together over time. • 2. 3. When short-term interest rates are low, yield curve are more likely to have an upward slope, when short-term interest rates are high, yield curves are more likely to slope downward. Yield curve almost always slope upward. 1. 1. PURE EXPECTATION THEORY Key assumption: Perfect substitute good 2. A theory of the term structure of interest rates that views bonds with differing maturities as perfect substitutes, so their yields differ only because short-term interest rates are expected to rise or fall. 3. It explains how expectations about future yields can cause yields on instruments with different maturities to move together. 4. It states that the interest rates on a long term bond will equal an average of short term interest rates that people expect to occur over the life of the long term bond. • Buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. • If bonds with different maturities are perfect substitutes, the expected return must be equal. EXPECTATIONS THEORY - EXAMPLE • Let the current rate on one-year bond be 6%. • You expect the interest rate on a one-year bond to be 8% next year. • Then the expected return for buying two one-year bonds averages (6% + 8%)/2 = 7%. • The interest rate on a two-year bond must be 7% for you to be willing to purchase it. • Findings: • When the yield curve is upward sloping, the short-term interest rates are expected to rise in the future. • The long term rate is currently above the short term rate, the average of future short-term rates is expected to be higher than the current one. • When yield curve is slope downward, the average of future short-term interest rate is expected to below the current short term rate. 2. SEGMENTED MARKET THEORY • Key assumptions: not substitutes good • A theory of the term structure of interest rates that views bonds with differing maturities as non-substitutable, so their yields differ because they are determined in separate markets. Each market determines its own unique yield. • Bonds of different maturities are not substitutes at all, so the expected returns on holding bond of one maturity has no effect on the demand for a bond of another maturity. • It explains fact 3 that the yield curve always slope upward. • For instance, depository institutions such as commercial banks issue time deposits with relatively short terms to maturity of 1 to 3 years. They often wish to match these deposits with assets such as Treasury bonds with similar 1 to 3 year maturities, so they buy such Treasuries. Pension funds, in contrast, issue pension liabilities with much longer terms to maturity. • Suppose that initially the yields across Treasury Bonds with differing maturities are the same. If banks decide to hold more TB with 1 to 3 year maturities, the demand for such bonds will rise, causing an increase in their market price. As a result, the market yields on TB will fall. • So the demand for long term bond is relatively lower than for short-term bond, long term bonds will have lower prices and higher interest rates. • If all other factors are unchanged, the yields on TB with 1 to 3 year maturities will be lower than those on TB with 10 to 12 maturities. • That is market yields will differ across terms to maturity, and hence the yield curve will always slopes upward. • If investors have short desired holding periods and generally prefer bonds with shorter maturities that have less interest-rate risk, then this explains why yield curves usually slope upward (fact 3) 3. LIQUIDITY PREMIUM THEORY/ PREFERRED HABITAT THEORIES • Key assumptions: Substitutes good • A theory of the term structure of interest rates that views bonds as imperfectly substitutable, so yields on longer term bonds must be greater than those on shorter term bonds even if short term interest rates are not expected to rise or fall. • It states that the interest rates 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 liquidity premium. • Bonds of different maturities are substitutes, which means that the expected return on one bond does influence the expected return on a bond of a different maturity, but it allows investors to prefer one bond maturity over another. Investor tend to prefer short term bonds. • • This theory combines elements of the segmented and the expectations theory. According to the segmented, bonds which maturities differ are not at all substitutable. • The expectations theory, in contrast, assumes that bonds with different maturities are perfect substitutes. This is why savers will hold both one and two year bonds only if their expected returns are equal. • According to the Liquidity and pre-habitat theory, bonds with different maturities are substitutable, but only imperfectly. Under this theory, savers generally have a slight preference to hold bonds with shorter maturities. • Recall from Chapter 2, that money market trading is broader and more active than trading in capital markets. Consequently, money market instruments- bonds with shorter maturities are more liquid instruments. This greater liquidity of short term bonds can make them somewhat more attractive ton savers than longer term bonds. • Hence, savers can prefer the habitat of money markets just as animals prefer their own special habitat in the wild. PREFERRED HABITAT THEORY • Investors have a preference for bonds of one maturity over another • They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return • Investors are likely to prefer short-term bonds over longer-term bonds LIQUIDITY PREMIUM & PREFERRED HABITAT THEORIES, -EXPLANATION OF THE FACTS• Interest rates on different maturity bonds move together over time; explained by the first term in the equation • Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case • Yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens USES OF THE YIELD CURVE • 1. Forecasting Interest rate • 2. Determining Borrowing and Lending Maturities • 3. Selecting Individual Securities • 4. Pricing New Issues • TQ