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Term Structure of Interest Rates Explained

The document discusses the term structure of interest rates, which refers to how interest rates change over different bond maturity periods. It presents several theories for why the term structure takes on different shapes such as upward sloping, downward sloping, and flat curves. The preferred habitat theory suggests that investors prefer short-term rates but can be enticed into longer-term bonds for higher rates. Upward sloping curves typically occur when growth is expected, while downward sloping curves usually appear at economic peaks when interest rate declines are anticipated.

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Theagarajan Thanikachalam
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20 views17 pages

Term Structure of Interest Rates Explained

The document discusses the term structure of interest rates, which refers to how interest rates change over different bond maturity periods. It presents several theories for why the term structure takes on different shapes such as upward sloping, downward sloping, and flat curves. The preferred habitat theory suggests that investors prefer short-term rates but can be enticed into longer-term bonds for higher rates. Upward sloping curves typically occur when growth is expected, while downward sloping curves usually appear at economic peaks when interest rate declines are anticipated.

Uploaded by

Theagarajan Thanikachalam
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd

Term Structure of Interest rates

Not all interest rates are equal


• We have seen since beginning of class that
different interest rates move differently
• example: Fed raises short term rates and
long-term rates fall

• This pattern of interest rates over time is


named the term structure of interest rates
Determinants of interest rates
• Many things go into the investors’ required
returns
• example: liquidity, time preferences, taxes,
economy

• how these things influence interest rates can


be examined by holding other things constant
Interest rates
+ + +/-
• i = f(default risk, expected inflation, taxes,
maturity)

• obviously as default risk increases interest


rates increase
Bonds and Taxes
• Interest is taxed as ordinary income

• municipals
• investors concerned with after-tax rate
• rate of interest rate on munis is tehrefore
lower
• Muni rate = corporate rate(1-tax rate)
Default risk
• Risk that either interest or principla will not
be paid
• bond rating agencies: Moody’s,S&P,
• Moodys: Aaa, Aa, A, Baa, BA, B, Caa, Ca,
C, D
• S&P: AAA, AA, A, BBB, BB, B, CCC,
CC, C, D
Bond ratings
• Rating agencies use ratio analysis, industry
analysis, company trends, and other factors
in rating firms’ debt.
Term Structure
• To examine how the interest rates move
over time we examine government
securities with varying maturities
• also called yield curve
• exhibit 8.2
– show Flat, steep, inverted curves
Theories used to explain term
structure
• Expectations Hypothesis
– simplest
– forward rate is expected future spot rate
– geometric average
– example:
– problem: does not fit the data
Liquidity Preference theory
• Investor prefer short term investments, so
must be coerced into buying longer term
rates with higher interest rates

• here the forward rate exceeds the future


spot rate
Market Segmentation Hypothesis
• Distinct markets for short term,
intermediate,and long term bonds
• thus different interest rates merely reflect
the preferences of players in those separate
markets
Preferred habitat
• Investors may prefer short term rates, but
will switch for the right price
• When do we see steep curves?
– When we expect future growth either inflation,
or demand.
– Practically when we expect times to improve
• When do we see downward sloping curves?
– Usually when we expect interest rates to fall.
Hence at a business cycle “top”
• Flat curves exist when we expect relatively
constant conditions
Interactions
• In actuality other things are not equal.
• Example time, credit risk, and taxes are all
changing at once
• spreads between hi risk and low risk change
over time as economy changes. Ex.
Simultaneously the underlying government
bond rate is changing.
Preferred Habitat Theory

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