Chapter 3

Structure of Interest Rates

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Chapter Outline
 Characteristics of debt securities that
cause their yields to vary
 Explaining actual yield differentials
 Estimating the appropriate yield
 A closer look at the term structure
 Interest Ratestructure in Bangladesh:
Some thought

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Characteristics of Debt Securities
 Credit (default) risk
 Securities with a higher degree of risk have to offer
higher yields to be chosen
 Credit risk is especially relevant for longer-term
securities
 Investors must consider the creditworthiness of the
security issuer
 Can use bond ratings of rating agencies
 The higher the rating, the lower the perceived credit risk
 Ratings can change over time as economic conditions
change
 Ratings for different bond issues by the same issuer can vary

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Characteristics of Debt Securities
(cont’d)
 Credit (default) risk (cont’d)
 Rating agencies
 Moody’s Investor Service and Standard and Poor’s
Corporation are the most popular
 Agencies use different methods to assess the
creditworthiness of firms and state governments
 A particular bond issue could have different ratings from each
agency, but differences are usually small
 Financial institutions may be required to invest only in
investment-grade bonds rated Baa or better by Moody’s
and BBB or better by Standard and Poor’s

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Characteristics of Debt Securities
(cont’d)
Ratings Assigned by:
Description of Security Moody’s Standard and Poor’s
Highest quality Aaa AAA
High quality Aa AA
High-medium quality A A
Medium quality Baa BBB
Medium-low quality Ba BB
Low quality (speculative) B B
Poor quality Caa CCC
Very poor quality Ca CC
Lowest quality (in default) C DDD, D
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Characteristics of Debt Securities
(cont’d)
 Credit (default) risk (cont’d)
 Shifts in credit risk premiums
 The risk premium corresponding to a particular
bond rating can chance over time
 Accuracy of credit ratings
 In general, credit ratings have served as
reasonable indicators of the likelihood of default
 Credit rating agencies do not always detect
financial problems of firms

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Characteristics of Debt Securities
(cont’d)
 Liquidity
 Liquid securities can be easily converted to
cash without a loss in value
 Short-maturity securities with an active secondary
market are liquid
 Securities with lower liquidity have to offer a
higher yield to be preferred

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Characteristics of Debt Securities
(cont’d)
 Tax status
 Investorsare more concerned with after-tax income
than before-tax income
 Taxable securities have to offer a higher before-tax yield
to be preferred
 The after-tax yield is equal to:

Yat  Ybt (1  T )

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Characteristics of Debt Securities
(cont’d)
 Tax status
 Computing the equivalent before-tax yield
 The before-tax yield necessary to match the after-tax yield
on a tax-exempt security is:

Yat
Ybt 
(1  T )
 State taxes should be considered along with federal taxes

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Computing the Equivalent
Before-Tax Yield
Assume a firm in the 30 percent tax bracket is
aware of a tax-exempt security that pays a
yield of 9 percent. To match this after-tax yield,
taxable securities (with similar maturity and
risk) must offer a before-tax yield of:

Yat 9%
Ybt    12.86%
(1  T ) (1  .3)

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Characteristics of Debt Securities
(cont’d)
 Term to maturity
 The term structure of interest rates defines the relationship
between maturity and annualized yield
 Special provisions
 A call feature allows the issuer of bonds to buy the bonds
back before maturity
 The yield on callable bonds should be higher than on noncallable
bonds
 A convertibility clause allows investors to convert the bond
into a specified number of common stock shares
 The yield on convertible bonds is lower than on nonconvertible
bonds

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Explaining Actual Yield Differentials
 Yield differentials are often measured in basis
points
 100 basis points equal 1 percent
 Yield differentials of money market securities
 Commercial paper rates are higher than T-bill rates
 Eurodollar deposit rates are higher than yields on
other money market securities
 Market forces cause the yields of all securities to
move in the same direction

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Explaining Actual Yield Differentials
(cont’d)
 Yield differentials of capital market securities
 Municipal bonds have the lowest before-tax yield
 After-tax yield is higher than that of Treasury bonds
 Treasury bonds have the lowest yield
 No default risk
 Very liquid
 Investorsprefer municipal or corporate bonds over
Treasury bonds only if the after-tax yield
compensates for default risk and lower liquidity

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Estimating the Appropriate Yield
 The yield on a debt security is based on the
risk-free rate with adjustments to capture
various characteristics:
Yn  Rf ,n  DP  LP  TA  CALLP  COND

 Maturity is controlled for by matching the

maturity of the risk-free security to that of the
security of concern

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Computing the Appropriate Yield
A company wants to issue 180-day commercial paper. Six-
month T-bills currently have a yield of 7 percent.
Assume that a default risk premium of 0.8 percent, a
liquidity premium of 0.1 percent, and a 0.2 percent tax
adjustment are necessary to sell the commercial paper
to investors. What is the appropriate yield the company
should offer on its commercial paper?

Yn  Rf ,n  DP  LP  TA  CALLP  COND
 7%  .8%  .1%  .2%
 8.1%
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A Closer Look at the Term
Structure
 Pure expectations theory
 Pure expectations theory suggests that the
shape of the yield curve is determined solely
by expectations of future interest rates
 Assuming an initially flat yield curve:
 The yield curve will become upward sloping if
interest rates are expected to rise
 The yield curve will become downward sloping if
interest rates are expected to decline

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Sudden Expectation of Higher
Interest Rates
Market for short-term risk-free debt Market for long-term risk-free debt

S1 S2 S2 S1

i1 i2

D1 D2
i2 i1
D2 D1

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Sudden Expectation of Higher
Interest Rates (cont’d)
Yield Curve

YC2

YC1

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Sudden Expectation of Lower
Interest Rates
Market for long-term risk-free debt Market for short-term risk-free debt

S1 S2 S2 S1

i1 i2

D1 D2
i2 i1
D2 D1

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Sudden Expectation of Lower
Interest Rates (cont’d)
Yield Curve

YC1

YC2

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A Closer Look at the Term
Structure (cont’d)
 Pure expectations theory (cont’d)
 Algebraic presentation
 The relationship between interest rates on two-year and
one-year securities is:

(1 t i 2 )2  (1 t i1 )(1 t 1r1 )

 The one-year interest rate in one year (the forward rate)
can then be estimated:

(1 t i 2 )2
t 1 r1  1
(1 t i1 )

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Computing the Forward Rate
Assume that the annualized two-year interest rate today is
8 percent. Furthermore, one-year securities currently
offer an interest rate of 5 percent. What is an estimate
of the forward rate?

(1 t i 2 )2
t 1 r1  1
(1 t i1 )
1.08 2
 1
1.05
 11.09%

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A Closer Look at the Term
Structure (cont’d)
 Pure expectations theory (cont’d)
 Algebraic presentation (cont’d)
 The one-year interest rate in two years (the forward
rate) can also be estimated:

(1 t i 3 )
3

t  2 r1  1
(1 t i1 )(1 t 1r1 )

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Computing the One-Year Interest
Rate Two Years from Now
Continuing with the previous example, assume that three-
year securities currently offer an interest rate of 10
percent. What is an estimate of the one-year interest
rate that will prevail two years from now?

(1 t i 3 )3
t  2 r1  1
(1 t i1 )(1 t 1r1 )
1.10 3
 1
(1.05 )(1.1109 )
 14.11%

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A Closer Look at the Term
Structure (cont’d)
 Pure expectations theory (cont’d)
 Algebraic presentation (cont’d)
 Future annualized interest rates for periods other than
one year can also be computed using the yield curve
 A one-year investment followed by a two-year
investment should offer the same yield as a three-year
security:

(1 t i 3 )3
1 t 1r2 
2

(1 t i1 )

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Computing the Two-Year Interest
Rate One Year from Now
Continuing with the previous example, what is an
estimate of the two-year interest rate that will prevail
in one year?

(1.10)3
1 t 1r2 2

(1.05)
 1.27
t 1 r2  1.27  1
 12.59%

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A Closer Look at the Term
Structure (cont’d)
 Pure expectations theory (cont’d)
 The theory assumes that forward rates are
unbiased estimators of future interest rates
 If forward rates are biased, investors should
attempt to capitalize on the discrepancy

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A Closer Look at the Term
Structure (cont’d)
 Liquidity premium theory
 According to the liquidity premium theory, the
yield curve changes as the liquidity premium
changes over time due to investor preferences
 Investors who prefer short-term securities will hold long-
term securities only if compensated with a premium
 Short-term securities are typically more liquid than long-
term securities
 Thepreference for short-term securities places
upward pressure on the slope of the yield curve

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A Closer Look at the Term
Structure (cont’d)
 Liquidity premium theory (cont’d)
 Estimation of the forward rate based on a liquidity
premium
 The yield on a security will not necessarily be equal to
the yield from consecutive investments in shorter-term
securities:

(1 t i 2 )2  (1 t i1 )(1 t 1r1 )  LP2

 The relationship between the liquidity premium and the

term to maturity is:

0  LP1  LP2  LP3  ...  LP20

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A Closer Look at the Term
Structure (cont’d)
 Liquidity premium theory (cont’d)
 Estimation of the forward rate based on a liquidity premium
(cont’d)
 The one-year forward rate can be derived as:
(1 t i 2 )2
t 1 r1   1  LP2 /(1 t i1 )
(1 t i1 )
 A positive liquidity premium means that the forward rate
overestimates the market’s expectations of the future interest
rate
 A flat yield curve means the market is expecting a slight
decrease in interest rates
 A slight upward slope means no expected change in interest
rates

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Computing the Forward Rate
With A Liquidity Premium
Assume that one-year interest rates are currently 10
percent. Further assume that two year interest rates
are equal to 8 percent. The liquidity premium on a two-
year security is 0.7 percent. What is an estimate of the
one-year forward rate?
(1 t i 2 )2
t 1 r1   1  LP2 /(1 t i1 )
(1 t i1 )
1.08 2
  1  .007 / 1.10
1.10
 5.4%
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A Closer Look at the Term
Structure (cont’d)
 Segmented market theory
 According to segmented markets theory,
investors and borrowers choose securities with
maturities that satisfy their forecasted cash needs
 Pension funds and life insurance companies prefer long-
term investments
 Commercial banks prefer short-term investments
 Shiftingby investors or borrowers between
maturity markets only occurs if the timing of their
cash needs change

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 Impact of Different Scenarios –
Segmented Markets Theory
Investors Have Mostly Investors Have Mostly
Short-Term Funds Long-Term Funds
Available; Borrowers Available; Borrowers
Want Long-Term Funds Want Short-Term Funds
Supply of short-term funds Upward pressure Downward pressure
provided by investors
Demand for short-term funds by Downward pressure Upward pressure
borrowers
Yield on new short-term Downward pressure Upward pressure
securities
Supply of long-term funds Downward pressure Upward pressure
provided by investors
Demand for long-term funds Upward pressure Downward pressure
issued by borrowers
Yield on long-term securities Upward pressure Downward pressure

Shape of yield curve Upward slope Downward slope33

A Closer Look at the Term
Structure (cont’d)
 Segmented market theory (cont’d)
 Limitations of the theory
 Some borrowers and savers have the flexibility to choose
among various maturity markets
 e.g., Corporations may initially obtain short term funds if
they expect long-term interest rates to decline
 If markets were segmented, an adjustment in the interest
rate in one market would have no impact on other markets,
but evidence shows this is not true

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A Closer Look at the Term
Structure (cont’d)
 Segmented market theory (cont’d)
 Implications
 The preference for particular maturities can affect the
prices and yields of securities with different maturities
and therefore the shape of the yield curve
 The preferred habitat theory is a more flexible
perspective
 Investors and borrowers may wander from their markets
given certain events

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A Closer Look at the Term
Structure (cont’d)
 Research on term structure theories
 Interest rate expectations have a strong influence on the
term structure
 The forward rate from the yield curve does not accurately
predict future interest rates
 Variation in the yield-maturity relationship cannot be
explained by interest rate expectations or liquidity
 General research implications
 Some evidence for pure expectations, liquidity premium, and
segmented markets theory

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A Closer Look at the Term
Structure (cont’d)
 Uses of the term structure
 Forecast interest rates
 Pure expectations and liquidity premium theories can be
used
 Forecast recessions
 A flat or inverted yield curve may indicate a recession in
the near future since lower interest rates are expected

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A Closer Look at the Term
Structure (cont’d)
 Uses of the term structure (cont’d)
 Investment decisions
 Riding the yield curve involves investment in higher-
yielding long-term securities with short-term funds
 Financial institutions whose liability maturities are
different from their asset maturities monitor the yield
curve
 Financing decisions
 Assessing prevailing rates on securities for various
maturities allows firms to estimate the rates to be paid on
bonds with different maturities

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A Closer Look at the Term
Structure (cont’d)
 Impact of debt management on term structure
 If the Treasury uses a relatively large proportion of long-term
debt, this places upward pressure on long-term yields
 If the Treasury uses short-term debt, long-term interest rates
may be relatively low
 Historical review of the term structure
 Early 1980s: downward sloping yield curve
 1982 to 2001: an upward sloping yield curve generally
persisted
 September 11, 2001: investors shifted funds into short-term
securities and the Fed provided funds to the banking system,
causing the yield curve to become steeper

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International Structure of Interest
Rates
 Yield curves vary among countries
 Interest rate movements across countries
tend to be positively correlated
 Interest rates may vary across countries at
any particular point in time
 Supply and demand conditions across
countries cause differences

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