Chapter 5

Recapitulation of the Last Class
• Discussed the Evidence on Business Cycles

and Interest Rates relationship with reference to the
Indian Economy in the past.
• We observed that according the relationship, the
relationship is not clearly visible throughout the period
from 1999 to 2012.
• We have also discussed the special case of Japanese
case of negative interest rate in 1998.
• The case analyses how presence of deflation and
economic recession explained result of negative
interest rate in the market.
• We have also discussed one question how the
presence of inflation and negative economic growth
explains the increase in the interest rate in India
BITS Pilani, Pilani Campus
Part – II : Fundamentals of
Financial Market
Chapter 5: How do Risk and Term
BITS Pilani Structure affect interest rates?
Preview
• In our supply and demand analysis, we examined the
determination of just one interest rate.
• We have learned how various determinants do influence
the market interest rate and results systematic risk.
• However, in the economy there are enormous number of
bonds on which interest rates can and do differ.
• In this chapter, we analyze the relationship between all
the rates by explaining why they move together or differ
from each other.
• Understanding why they differ from bond to bond can
help business, banks, insurance companies and private
investors decide which bonds to purchase and which
ones to sell.
• First we look at the issue of bonds with same term to
maturity have different interest rates
• Second, bonds with different term to maturity have
different rates
Chapter Preview
• First we look at why bonds with same term to maturity
have different interest rates. The relationship among
these interest rates is called the Risk Structure of
Interest Rates. In this context, given the term to
maturity, risk, liquidity, income tax plays role in
explaining interest rate fluctuation and determine the
risk structure.
• Secondly, it is also a fact that a bond’s term to maturity
also affect its interest rate, and the relationship among
interest rates on bonds with different terms to maturity
is called Term Structure of Interest Rates.
• Given same risk of different maturity, This explains how
term to maturity affect interest rate.

Trends of Interest rates in India

Trends of Interest rates in India

Risk Structure of Interest
Rates
• To start this discussion, we first examine the yields for
several categories of long-term bonds over the last 85
years for US.
• You should note several aspects regarding these rates,
related to different bond categories and how this has
changed through time.

Risk Structure
of Long Bonds in the U.S.

Factors Affecting Risk Structure
of Interest Rates
1. Default Risk
2. Liquidity
3. Income Tax Considerations

Default Risk Factor
• One attribute of a bond that influences its interest rate is
its risk of default, which occurs when the issuer of the
bond is unable or unwilling to make interest payments
when promised.
• Treasury bonds have usually been considered to have no
default risk because the central government can always
increase taxes to pay off its obligations. Bonds like these
with no default risk are called default-free bonds.
• The spread between the interest rates on bonds with
default risk and default-free bonds, called the risk
premium, indicates how much additional interest people
must earn in order to be willing to hold that risky bond.
• A bond with default risk will always have a positive risk
premium, and an increase in its default risk will raise the
risk premium.
Increase in Default Risk
on Corporate Bonds
Figure 5.2 Response to an Increase in Default Risk on Corporate Bonds

Analysis of Figure 5.2: Increase in
Default on Corporate Bonds
• Corporate Bond Market
– Risk of corporate bonds , Dc , Dc shifts left
– Pc , ic 
• Treasury Bond Market
– Relative risk of Treasury bonds , DT , DT shifts right
– PT , iT 
• Outcome
– Risk premium, ic - iT, rises

Rating of Int. Corporations

CRISIL (Credit Rating
Information Services

CRISIL (Credit Rating
Information Services

Liquidity Factor
• Another attribute of a bond that influences its interest rate is
its liquidity; a liquid asset is one that can be quickly and
cheaply converted into cash if the need arises. The more
liquid an asset is, the more desirable it is (holding everything
else constant).
• Treasury bonds 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 them is low.
• A particular Corporate bond is not as liquid because fewer
bonds for any one corporation are traded; thus it can be
costly to sell these bonds in an emergency because it may
be hard to find
buyers quickly.
• The differences between interest rates on corporate bonds
and Treasury bonds (that is, the risk premiums) reflect not
only the corporate bond’s default risk but its liquidity too. This
is
why a risk premium is sometimes called a liquidity premium.

Decrease in Liquidity
of Corporate Bonds
Figure 5.3 Response to a Decrease in the Liquidity of Corporate Bonds

Analysis of Figure 5.3: Corporate
Bond Becomes Less Liquid
• Corporate Bond Market
– Liquidity of corporate bonds , Dc , Dc shifts left
– Pc , ic 
– Relatively more liquid Treasury bonds, DT , DT shifts right
– PT , iT 
• Outcome
– Risk premium, ic - iT, rises
• Risk premium reflects not only corporate bonds' default
risk but also lower liquidity

Income Tax Factor
• Interest payments on municipal bonds / Infrastructure

Bonds are exempt from Central income taxes, a factor
that has the same effect on the demand for municipal
bonds/ infrastructure bonds as an increase in their
expected return
• Treasury bonds are exempt from state and local income
taxes, while interest payments from corporate bonds
are fully taxable

Tax Advantages of Municipal
Bonds/ Infrastructure Bonds
Figure 5.4 Interest Rates on Municipal / Infrastructure Bonds and Treasury Bonds

Analysis of Figure 5.4:
Tax Advantages of Municipal Bonds
• Municipal / Infrastructure Bond Market
1. Tax exemption raises relative Re on municipal /
Infrastructure bonds,
Dm , Dm shifts right
2. Pm , im 
1. Relative Re on Treasury bonds , DT , DT shifts left
2. PT , iT 
• Outcome
im < iT

Term Structure of the interest
rates
• A plot of yields on bonds with differing terms to maturity,
but the same risk, liquidity and tax consideration is called
Yield Curve.
• The yield curve may be upward sloping
• The yield curve may be Flat
• The yield curve may be downward sloping

Term Structure of the interest rates
• A yield curve is a line that plots the interest rates, at a

set point in time, of bonds having equal credit
quality but differing maturity dates.
• The yield curve may be upward sloping: Long term

interest rates are above short term interest rates
• The yield curve may be Flat: long term interest rates =
short term interest rates
• The yield curve may be downward sloping: short term
interest rates are above long term interest rates.

rates
• While analyzing the risk structure of interest rate we
assume that term to maturity of these bonds/assets are
same.
• Now we explain the interest rate variation due to terms to
maturity.
• In the literature, it is identified that a plot of yields on
bonds with differing terms to maturity, but the same
risk, liquidity and tax consideration as Yield Curve.
• Theoretically and empirically;

• The Yield curve can also have more complicated shape

which may first slope up and then down or the reverse.
• The shape of the yield curves are explained by good
theories.

Interest Rates on Different
Maturity Bonds Move Together

Movements of Interest rates of Govt.
Securities with different maturities.

Daily Government Securities Yield
Rates

Daily Treasury Rates 2020
Date 1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
09/01/20 0.09 0.11 0.12 0.13 0.12 0.13 0.14 0.26 0.46 0.68 1.20 1.43
09/02/20 0.10 0.10 0.12 0.12 0.13 0.14 0.16 0.26 0.45 0.66 1.16 1.38
09/03/20 0.10 0.11 0.11 0.12 0.12 0.13 0.15 0.24 0.43 0.63 1.13 1.34
09/04/20 0.09 0.10 0.11 0.12 0.13 0.14 0.18 0.30 0.50 0.72 1.25 1.46
09/08/20 0.10 0.10 0.13 0.14 0.15 0.14 0.17 0.28 0.47 0.69 1.22 1.43
09/09/20 0.10 0.11 0.12 0.14 0.14 0.14 0.17 0.28 0.48 0.71 1.25 1.45
09/10/20 0.10 0.11 0.12 0.12 0.15 0.14 0.17 0.26 0.46 0.68 1.22 1.43
09/11/20 0.10 0.11 0.11 0.12 0.13 0.13 0.16 0.26 0.45 0.67 1.21 1.42
09/14/20 0.10 0.11 0.11 0.13 0.14 0.14 0.16 0.27 0.46 0.68 1.21 1.42
09/15/20 0.09 0.10 0.11 0.12 0.13 0.14 0.16 0.27 0.46 0.68 1.21 1.43
09/16/20 0.08 0.11 0.12 0.12 0.12 0.14 0.16 0.28 0.47 0.69 1.23 1.45
09/17/20 0.09 0.09 0.09 0.11 0.12 0.13 0.16 0.28 0.47 0.69 1.22 1.43
09/18/20 0.09 0.10 0.10 0.12 0.13 0.14 0.16 0.29 0.48 0.70 1.24 1.45
09/21/20 0.09 0.10 0.10 0.11 0.12 0.14 0.16 0.27 0.46 0.68 1.22 1.43
09/22/20 0.08 0.09 0.10 0.11 0.12 0.13 0.15 0.27 0.46 0.68 1.21 1.42
09/23/20 0.08 0.09 0.11 0.11 0.13 0.14 0.15 0.28 0.46 0.68 1.21 1.42
09/24/20 0.08 0.09 0.10 0.11 0.12 0.14 0.16 0.27 0.46 0.67 1.19 1.40
09/25/20 0.08 0.09 0.10 0.11 0.12 0.12 0.15 0.26 0.45 0.66 1.19 1.40

Financial Market
• Started the discussing about chapter 5 which
addresses the question How do Risk and Term
Structure affect interest rates?
• As we have found from the trend of the interest rates in
most of the countries including India that there is a co
movement of different interest rates and also
differences among them across different assets in a
particular year.
• In this chapter, we analyze and explain why they move
together or differ from each other.

• First we look at the issue of bonds with same term to
maturity that have different interest rates
• Second we look at , bonds with different term to maturity
have different rates
• In this context, first we have started analyzing the Risk
Structure of the interest rate.
• The theory of risk structure is explained by default risk,
Liquidity and tax consideration.
• We have seen how the credit rating agency decides the
ranks of bonds based on the default risks.

rates
• While analyzing the risk structure of interest rate we
assume that term to maturity of these bonds/assets are
same.
• Now we explain the interest rate variation due to terms to
maturity.
• In the literature, it is identified that a plot of yields on
bonds with differing terms to maturity, but the same
risk, liquidity and tax consideration as Yield Curve.
• Theoretically and empirically;

• The Yield curve can also have more complicated shape

which may first slope up and then down or the reverse.
• The shape of the yield curves are explained by good
theories.

Interest Rates on Different
Maturity Bonds Move Together

Movements of Interest rates of Govt.
Securities with different maturities.

Daily Government Securities Yield
Rates

Daily Treasury Rates 2020
Date 1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
09/01/20 0.09 0.11 0.12 0.13 0.12 0.13 0.14 0.26 0.46 0.68 1.20 1.43
09/02/20 0.10 0.10 0.12 0.12 0.13 0.14 0.16 0.26 0.45 0.66 1.16 1.38
09/03/20 0.10 0.11 0.11 0.12 0.12 0.13 0.15 0.24 0.43 0.63 1.13 1.34
09/04/20 0.09 0.10 0.11 0.12 0.13 0.14 0.18 0.30 0.50 0.72 1.25 1.46
09/08/20 0.10 0.10 0.13 0.14 0.15 0.14 0.17 0.28 0.47 0.69 1.22 1.43
09/09/20 0.10 0.11 0.12 0.14 0.14 0.14 0.17 0.28 0.48 0.71 1.25 1.45
09/10/20 0.10 0.11 0.12 0.12 0.15 0.14 0.17 0.26 0.46 0.68 1.22 1.43
09/11/20 0.10 0.11 0.11 0.12 0.13 0.13 0.16 0.26 0.45 0.67 1.21 1.42
09/14/20 0.10 0.11 0.11 0.13 0.14 0.14 0.16 0.27 0.46 0.68 1.21 1.42
09/15/20 0.09 0.10 0.11 0.12 0.13 0.14 0.16 0.27 0.46 0.68 1.21 1.43
09/16/20 0.08 0.11 0.12 0.12 0.12 0.14 0.16 0.28 0.47 0.69 1.23 1.45
09/17/20 0.09 0.09 0.09 0.11 0.12 0.13 0.16 0.28 0.47 0.69 1.22 1.43
09/18/20 0.09 0.10 0.10 0.12 0.13 0.14 0.16 0.29 0.48 0.70 1.24 1.45
09/21/20 0.09 0.10 0.10 0.11 0.12 0.14 0.16 0.27 0.46 0.68 1.22 1.43
09/22/20 0.08 0.09 0.10 0.11 0.12 0.13 0.15 0.27 0.46 0.68 1.21 1.42
09/23/20 0.08 0.09 0.11 0.11 0.13 0.14 0.15 0.28 0.46 0.68 1.21 1.42
09/24/20 0.08 0.09 0.10 0.11 0.12 0.14 0.16 0.27 0.46 0.67 1.19 1.40
09/25/20 0.08 0.09 0.10 0.11 0.12 0.12 0.15 0.26 0.45 0.66 1.19 1.40

Treasury Yield curve 2014

Treasury Yield Curve 2020

Term Structure Facts to Be
Explained
Besides explaining why yield curves take on different
shape at different times, a good theory must explain
following three facts;
F1: Interest rates on bonds of different maturities move
together over time
F2: Yield curves tend to have steep upward slope when
short term rates are low and downward slope when
short term rates are high
F3: Yield curve almost always upward sloping.

Three Theories of Term
Structure of interest rates
A. Pure Expectations Theory
– Pure Expectations Theory explains F1 and F2,
but not F3
B. Market Segmentation Theory
– Market Segmentation Theory explains F3, but not
F1 and F2
C. Liquidity Premium Theory
– Solution: Combine features of both Pure
Expectations Theory and Market Segmentation
Theory to get Liquidity Premium Theory and
explain all facts (F1, F2, F3)

Yield Curve Analysis
• Several theories of term structures provide explanations

of how interest rates on bonds with different terms to
maturity are related.
• More precisely, the yield curves will tell us about the

future movements of short term interest rates in the
market as predicted by the investors.
• Hence, every investor use this tool for predicting the

short term interest rate of the corporation bonds.

Expectations Theory
• The expectation theory of term structure states that

interest rates on a long term bond will equal on an
average the short term interest rates that people expect
to occur over the life of the long term bonds.
• If people expect that on an average, the short term
bonds will yield 10% for coming 5 years, Theory predicts
that interest rate on bond with 5 years maturity will be
10%.
• If short term interest rate is expected to increase to 11%
over 20 years, interest rate on 20 year bonds would be
11% and would be higher than that of 5 years bond.
• The hypothesis of the theory are based on few
assumptions.

Expectation Theory
Key Assumption:
Bonds of different maturities are perfect substitutes
Implication:
Re on bonds of different maturities are equal
Hypothesis:
The interest rate on long term bond will equal on an
average on short term interest rates that people expect
to occur over the life of the long term bonds.

Investment Strategy of the Theory.
Investment strategies for two-period horizon;

Strategy I:
Buy ₹1 of one-year bond and when matures buy
another ₹1 one-year bond
Strategy II:
Buy ₹1 of two-year bond and hold it till maturity.
• Current interest rate is 9% and it is expected to increase

to 11% next year.
• So, you will hold the two year bond if the interest rate is
10% = (9% + 11%) / 2.

Pure Expectations Theory
• Expected return from strategy 1
(1 + it )(1 + i ) − 1 = 1 + it + i
e
t +1
e
t +1
+ it (i ) − 1
e
t +1
Since it(iet+1) is also extremely small,

expected return is approximately
it + iet+1
5-51
• Expected return from strategy 2
(1+ i2t )(1+ i2t ) − 1 = 1 + 2(i2t ) + (i2t )2 − 1
Since (i2t)2 is extremely small, expected return is

approximately 2(i2t)
5-52
• From implication above expected returns of two
strategies are equal
• Therefore
2(i2t ) = it + i
e
t +1
Solving for i2t
it + i e
i2t = t +1 (1)
2
5-53
Pure Expectation Theory
• Expected return of different bonds:
– One year bonds for two years
– Two year bond for two years are same;
2(i2t ) = it + i
e
t +1
Solving for i2t
it + i e
i2t = t +1
2
Expectations Theory
• To help see this, here’s a picture that
describes the same information:
Example 5.2: Expectations Theory
• This is an example, with actual #’s:
More generally for
n-period bond…
• Don’t let this seem complicated. Equation 2

simply states that the interest rate on a long-
term bond equals the average of short rates
expected to occur over life of the long-term
bond.
More generally for n-period bond…
• Numerical example
– One-year interest rate over the next five years
is expected to be 5%, 6%, 7%, 8%, and 9%
• Interest rate on two-year bond:
(5% + 6%)/2 = 5.5%
• Interest rate for five-year bond:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
• Interest rate for one- to five-year bonds:
5%, 5.5%, 6%, 6.5% and 7%
5-58
and Term Structure Facts
• Explains why yield curve has different slopes
1. When short rates are expected to rise in
future, average of future short rates = int is
above today's short rate; therefore yield curve
is upward sloping.
2. When short rates expected to stay same in
future, average of future short rates same as
today's, and yield curve is flat.
3. Only when short rates expected to fall will
yield curve be downward sloping.
• Pure expectations theory explains fact 1—that

short and long rates move together
1. Short rate rises are persistent
2. If it  today, iet+1, iet+2 etc.  
average of future rates   int 
3. Therefore: it   int 
(i.e., short and long rates move together)
Explains Fact 2—that yield curves tend to have
steep slope when short rates are low and
downward slope when short rates are high
1. When short rates are low, they are expected to
rise to normal level, and long rate = average of
future short rates will be well above today's short
rate; yield curve will have steep upward slope.
2. When short rates are high, they will be expected to
fall in future, and long rate will be below current
short rate; yield curve will have downward slope.


Financial Market
• While discussing the Term structure of interest rate, we

addressed the concept of Yield Curve in Financial
Economics.
• What is a Yield Curve?
• Yield curve a plot of yields on bonds with differing
terms to maturity, but the same risk, liquidity and
tax consideration
• The Yield curve can be upward, downward sloping or
flat.
• The shapes of the yield curve helps the investors to
predict the future short term interest rate of the Bonds.

• There are 3 theories of term structure which explain the

term structure of interest rate;
• Pure expectation Theory,
• Market Segment Theory and
• Liquidity premium Theory.
• In the last class, we have explained the pure expectation
theory which is based on the assumption that Bonds of
different maturities are perfect substitutes.
• The hypothesis that the theory derives that interest rate
on long term bond will equal on an average of the short-
term interest rates that people expect to occur over the
life of the long-term bonds.

• This theory also Explains why the yield curve has
different slopes
1. When short rates are expected to rise in future,
average of future short rates = int is above today's
short rate; therefore, yield curve is upward
sloping.
2. When short rates expected to stay same in future,
average of future short rates same as todays, and
yield curve is flat.
3. Only when short rates expected to fall will yield
curve be downward sloping.
Term Structure Facts to Be
Explained
▪ Besides explaining why yield curves take on
different shape at different times, a good theory
must explain following three facts;
F1: Interest rates on bonds of different maturities
move together over time
F2: Yield curves tend to have steep upward slope
when short term rates are low and downward
slope when short term rates are high
F3: Yield curve almost always upward sloping.

Market Segmentation Theory
• Different maturity bonds are completely separate

and segmented.
• The interest rate for each bonds with different
maturity are determined by the supply and demand
for bonds.
• There is no cross effects from one category of
bonds to the other.
• Hence the Key Assumption of the Market
Segmentation Theory is; Bonds of different
maturities are not substitutes at all

• Implication: Markets are completely segmented; interest rate

at each maturity determined separately.
• In typical situation, the demand for long term bonds relatively
lower than short term bonds. Leads to lower prices and higher
interest rate and hence the yield curve is an upward sloping.
Explanation of the Theory:

• Investors are of strong preferences to one maturity against
another.
• They have holding period in their mind.
• Long term bonds are less preferred because its is attached
with high interest rate risk and hence the bond price is less,
and interest rate is more.
• Explains fact 3—that yield curve is usually

upward sloping
– People typically prefer short holding periods and thus
have higher demand for short-term bonds, which
have higher prices and lower interest rates than long
bonds
• Does not explain fact 1 or fact 2 because it
assumes long-term and short-term rates are
determined independently. They are not
substitutes.

Liquidity Premium Theory or
Preferred Habitat Theory
• Interest rate on long term bond = average (E
(interest on short term bonds)) + liquidity
premium.
• The liquidity premium or the term premium responds
to the supply and demand conditions of that bond.
• Bonds of different maturities are substitutes, which
means that the expected yield of one maturity does
affect the yield of different maturity, but it allows the
investors to prefer one bond maturity over another.
• Investor prefer short term bonds because these
bonds bear less interest rate risk than long term
bonds.
• So, investor must be offered a positive liquidity
premium to induce them to hold long term bonds.
Liquidity Premium Theory
• Key Assumption: Bonds of different maturities are

substitutes, but are not perfect substitutes
• Implication: Modifies Pure Expectations Theory with
features of Market Segmentation Theory.
• Bond yield of one maturity does affect the yield of
different maturity but it allows investors to prefer one
bond maturity over another.
• Investors prefer short term bonds because those bonds
bear less interest rate risk than long term bonds.
• So, investors must be offered a positive liquidity
premium to induce them to hold long term bonds.

• Investors prefer short rather than long bonds 
must be paid positive liquidity premium, int, to hold
long term bonds
• Results in following modification of Pure
Expectations Theory
it + i + i + ... + i
e
t +1
e
t+2
e
t + ( n−1)
int = + nt
n (3)
Figure 5.6 Relationship Between the Liquidity Premium and Pure Expectations Theory
5-74
• The liquidity premium is always positive and
grows as the term to maturity increases.
• Hence, the yield curve implied by the liquidity
premium theory always above the yield curve
implied by the pure expectation theory and
generally have a steeper slope.
Numerical Example
1. One-year interest rate over the next five years

are expected to be : 5%, 6%, 7%, 8%, and 9%
2. Investors' preferences for holding short-term
bonds so liquidity premium for one- to five-
year bonds: 0%, 0.25%, 0.5%, 0.75%, and 1.0%.
• Interest rate on the two-year bond:

0.25% + (5% + 6%)/2 = 5.75%
• Interest rate on the five-year bond:
1.0% + (5% + 6% + 7% + 8% + 9%)/5 = 8%

Numerical Example
• Interest rates on one to five-year bonds (based on

Liquidity Premium Theory):
5%, 5.75%, 6.5%, 7.25%, and 8%
• Interest rate for one- to five-year bonds (based on

pure Expectation Theory):
5%, 5.5%, 6%, 6.5% and 7%

Liquidity Premium Theory:
Term Structure Facts
• Explains All 3 Facts;
• Supporting F1: interest rates of different maturity bonds
move together over time.
• A rise in the short term interest rates indicates that short
term interest rate on an average will be higher in future
– long term interest rate increases.
• Supports F2: when interest rates are below normal it is
expected to rise + liquidity premium and hence yield
curve is upward sloping.
• when interest rates are above normal it is expected to
fall and despite liquidity premium yield curve will fall.
• Explains F3 that usual upward sloped yield curve by
liquidity premium for long-term bonds

Market
Predictions
of Future
Short Rates
Figure 5.7 Yield Curves and
the Market’s Expectations of
Future Short-Term Interest
Rates
Yield curve as the forecasting Tool
for Inflation and Business Cycles
• We have learned in chapter 4 that rising interest rates
are associated with Boom and falling are with
recessions.
➢ When interest rate are flat or downward, the economy
is likely to experience recessions.
➢ In chapter 3 we have also learned that nominal
interest is composed of real interest and expected
inflation.
• This means the yield curve contains both prediction
about future path of real interest and expected
inflation.

• Hence, a steep upward sloping yield curve predicts a
future increase in inflation and downward sloping yield
curve indicates a decline in inflation.
• This also implies that;
• A Steep upward Yield curve infers a Stance of Loose
Monetary Policy.
• Flat or downward Yield curve infers a Stance of tight
Monetary Policy.

Some Applications of Yield Curve
Yield to
Yield to
Maturity
Maturity
Term to Maturity
Term to Maturity
Q. If a yield curve shaped looks like the above, what is

the market predicting about the movement of future
short-term interest rates that based on liquidity
premium theory? What might the yield curve prediction
about (i) future inflation rate and (ii) business cycle in
India?

Answers. (Left Graph)
• The flat yield curve at shorter maturities suggests that

short-term interest rates are expected to fall moderately
in the near future.
• The steep upward slope of the yield curve at longer
maturities indicates that interest rates further into the
future are expected to rise.
• Because interest rates and expected inflation move
together, the yield curve suggests that the market
expects inflation to fall moderately in the near future but
to rise later on and hence expects a loose monetary
policy in future also predicts economic expansion

Answers. (Right Graph)
• The steep upward-sloping yield curve at shorter maturities
suggests that short-term interest rates are expected to rise
moderately in the near future because the initial, steep
upward slope indicates that the average of expected short-
term interest rates in the near future is above the current
short-term interest rate.
• The downward slope for longer maturities indicates that
short-term interest rates are eventually expected to fall
sharply. With a positive risk premium on long-term bonds,
as in the liquidity premium theory, a downward slope of the
yield curve occurs only if the average of expected short-
term interest rates is declining sharply.
• This occurs only if short-term interest rates far into the

future are falling sharply and the prediction of declining
inflation and business cycle contraction.
• Since interest rates and expected inflation move
expects inflation to rise moderately in the near future but
fall later on
• This trend also predicts about the business cycle that we
expects economic recessions in future.

Yield Curves and Economic
Forecasting
• A normal or upward sloping yield curve indicates yields
on longer-term bonds may continue to rise, responding to
periods of economic expansion.
• When investors expect longer-maturity bond yields to
become even higher in the future, many would
temporarily park their funds in shorter-term securities in
hopes of purchasing longer-term bonds later for higher
yields.
• In a rising interest rate environment, it is risky to have
investments tied up in longer-term bonds when their
value has yet to decline as a result of higher yields over
time.
• The increasing temporary demand for shorter-term
securities pushes their bond price high and yields even
lower, setting in motion a steeper up-sloped normal yield
curve.
Forecasting
• An inverted or down-sloped yield curve suggests yields on
longer-term bonds may continue to fall, corresponding to
periods of economic recession.
become even lower in the future, many would purchase
longer-maturity bonds to lock in yields before they
decrease further.
• The increasing onset of demand for longer-maturity bonds
and the lack of demand for shorter-term securities lead to
higher prices but lower yields on longer-maturity bonds,
and lower prices but higher yields on shorter-term
securities, further inverting a down-sloped yield curve.

Forecasting
• A flat yield curve may arise from normal or inverted yield
curve, depending on changing economic conditions.
When the economy is transitioning from expansion to
slower development and even recession, yields on
longer-maturity bonds tend to fall and yields on shorter-
term securities likely rise, inverting a normal yield curve
into a flat yield curve.
• When the economy is transitioning from recession to
recovery and potentially expansion, yields on longer-
maturity bonds are set to rise and yields on shorter-
maturity securities are sure to fall, tilting an inverted yield
curve toward a flat yield curve.

Financial Market
• While discussing the Term structure of interest rate, we

addressed the concept of Yield Curve and various
theories addressed slopes of the curve.
• We have discussed the Pure expectation theory which
explains Fact 1, 2 and Market segmentation theory
which support fact 3.
• Both of these theories are based on different
assumptions and hence derived different hypothesis.
• However, Liquidity Premium theory explain all three
facts and hence accepted by business to explain the
slopes of the yield curve.

Market
Predictions
of Future
Short Rates
Figure 5.7 Yield Curves and
the Market’s Expectations of
Future Short-Term Interest
Rates
Yield curve as the forecasting Tool
for Inflation and Business Cycles
• We have learned in chapter 4 that rising interest rates
are associated with Boom and falling are with
recessions.
➢ When interest rate are flat or downward, the economy
is likely to experience recessions.
➢ In chapter 3 we have also learned that nominal
interest is composed of real interest and expected
inflation.
• This means the yield curve contains both prediction
about future path of real interest and expected
inflation.

• Hence, a steep upward sloping yield curve predicts a
future increase in inflation and downward sloping yield
curve indicates a decline in inflation.
• This also implies that;
• A Steep upward Yield curve infers a Stance of Loose
Monetary Policy.
• Flat or downward Yield curve infers a Stance of tight
Monetary Policy.

Some Applications of Yield Curve
Yield to
Yield to
Maturity
Maturity
Term to Maturity
Term to Maturity
Q. If a yield curve shaped looks like the above, what is

the market predicting about the movement of future
short-term interest rates that based on liquidity
premium theory? What might the yield curve prediction
about (i) future inflation rate and (ii) business cycle in
India?

Answers. (Left Graph)
• The flat yield curve at shorter maturities suggests that

short-term interest rates are expected to fall moderately
in the near future.
• The steep upward slope of the yield curve at longer
maturities indicates that interest rates further into the
future are expected to rise.
• Because interest rates and expected inflation move
expects inflation to fall moderately in the near future but
to rise later on and hence expects a loose monetary
policy in future also predicts economic expansion

• The steep upward-sloping yield curve at shorter maturities
suggests that short-term interest rates are expected to rise
moderately in the near future because the initial, steep
upward slope indicates that the average of expected short-
term interest rates in the near future is above the current
short-term interest rate.
• The downward slope for longer maturities indicates that
short-term interest rates are eventually expected to fall
sharply. With a positive risk premium on long-term bonds,
as in the liquidity premium theory, a downward slope of the
yield curve occurs only if the average of expected short-
term interest rates is declining sharply.
• This occurs only if short-term interest rates far into the

future are falling sharply and the prediction of declining
inflation and business cycle contraction.
• Since interest rates and expected inflation move
expects inflation to rise moderately in the near future but
fall later on
• This trend also predicts about the business cycle that we
expects economic recessions in future.

Forecasting
• A normal or upward sloping yield curve indicates yields
on longer-term bonds may continue to rise, responding to
periods of economic expansion.
become even higher in the future, many would
temporarily park their funds in shorter-term securities in
hopes of purchasing longer-term bonds later for higher
yields.
• In a rising interest rate environment, it is risky to have
investments tied up in longer-term bonds when their
value has yet to decline as a result of higher yields over
time.
• The increasing temporary demand for shorter-term
securities pushes their bond price high and yields even
lower, setting in motion a steeper up-sloped normal yield
curve.
Forecasting
• An inverted or down-sloped yield curve suggests yields on
longer-term bonds may continue to fall, corresponding to
periods of economic recession.
become even lower in the future, many would purchase
longer-maturity bonds to lock in yields before they
decrease further.
• The increasing onset of demand for longer-maturity bonds
and the lack of demand for shorter-term securities lead to
higher prices but lower yields on longer-maturity bonds,
and lower prices but higher yields on shorter-term
securities, further inverting a down-sloped yield curve.

Forecasting
• A flat yield curve may arise from normal or inverted yield
curve, depending on changing economic conditions.
When the economy is transitioning from expansion to
slower development and even recession, yields on
longer-maturity bonds tend to fall and yields on shorter-
term securities likely rise, inverting a normal yield curve
into a flat yield curve.
• When the economy is transitioning from recession to
recovery and potentially expansion, yields on longer-
maturity bonds are set to rise and yields on shorter-
maturity securities are sure to fall, tilting an inverted yield
curve toward a flat yield curve.

Forecasting Interest Rates
with the Term Structure
• Forecasting interest rates are extremely
important to the managers of financial
institutions as the changes in the interest rates
have significant impact on the profitability of
their institutions.
• Further, forecast is necessary as the manager
must set on the interest rates of loans that are
promised to the customers in the future.
5-102
• Our discussion of the yield curves and their
slopes provide general information regarding
market prediction of future path of the interest
rates.
• For example, a steeply upward sloping yield
curve indicates that short term interest rates
are predicted to rise in future and a
downward sloping yield curves indicates that
the future short term interest rates are
expected to fall in future.
• However, financial managers need specific
information about the forecasted interest rate.
• Pure Expectations Theory: Invest in 1-period bonds
or in two-period bond, the returns are equal 
(1 + it )(1 + ite+1 )− 1 = (1+ i2t )(1 + i2t ) − 1
Solve for forward rate, iet+1

(1 + i2t )
2
e
i
t +1 = −1
1 + it (4)
Numerical example: i1t = 5%, i2t = 5.5%
e (1 + 0.055)2
it +1 = − 1 = 0.06 = 6%
1 + 0.05
• Let us name the measure of expected
interest rate in the next year is called Forward
Rate. And the current interest rate is called
Spot rate.
• We can also compare holding of three-year
bond against holding a sequence of one –
year bonds which reveals the following
relationships;
• Compare 3-year bond versus 3 one-year bonds
(1 + it )(1 + ite+1 )(1 + ite+2 )− 1 = (1 + i3t )(1+ i3t )(1 + i3t ) − 1
Using iet+1 derived in (4), solve for iet+2
(1 + i3t )
3
e
i = 2 −1
(1+ i2t )
t +2
• Generalize to:
(1+ in+1t )
n +1
e
i = −1
(1 + int )
t +n n (5)
Liquidity Premium Theory: int - = same as pure

expectations theory; replace int by int - in (5)
to get adjusted forward-rate forecast
(1+ in+1t − n +1t )

n+1
e
i = −1 (6)
(1+ int − nt )
t +n n
• Our discussion indicated that pure expectation

theory is not entirely satisfactory because
investors must be compensated with liquidity
premium to induce them to hold long term
bonds.
• Hence, we need to modify our analysis by
adjusting for liquidity premium to the pure
expectation theory calculations of future
interest rate.
(1+ in+1t − n +1t )

n+1
e
i = −1 (6)
(1+ int − nt )
t +n n

• Recall our discussion that investors want to hold

short term bonds rather than long term bonds,
the n-period interest rate differs from the interest
rate indicated by pure expectations theory by a
liquidity premium lnt. So, to allow for liquidity
premium, we need to subtract lnt from int .
• So that this forecasted interest rate is adjusted
forward rate forecasted interest rate.
Numerical Example
1. One-year interest rate over the next five years: 5%,
6%, 7%, 8%, and 9%
2. Investors' preferences for holding short-term
bonds so liquidity premium for one- to five-year
bonds: 0%, 0.25%, 0.5%, 0.75%, and 1.0%
• Hence, Interest rate on the two-year bond:
0.25% + (5% + 6%)/2 = 5.75%
• Numerical Example
2t = 0.25%, 1t=0, i1t=5%, i2t = 5.75%
e (1 + 0.0575 − 0.0025)2
it +1 = − 1 = 0.06 = 6%
(1 + 0.05)
with the Term Structure and Yield curve
(1+ in+1t )
n +1
e
i = −1
(1 + int )
t +n n (5)

(1+ in+1t − n +1t )

n+1
e
i = −1 (6)
(1+ int − nt )
t +n n
Question
• A customer asks a bank if it would be willing to
commit to make the customer a one –year loan at
an interest rate of 8% one year from now. To
compensate for the cost of making the loan, the
bank needs to charge one percentage point more
than the expected interest rate on a treasury
bond with same maturity if it is to make a profit. If
the bank manager estimates the liquidity
premium to be 0.4%, the one year treasury bond
rate is 6% and the two year bond rate is 7%,
should the manager be willing to make the
commitment?
Example: 1-year loan next year

T-bond + 1%, 2t = 0.4%, i1t = 6%, i2t = 7%
e (1 + 0.07 − 0.004)2
it +1 = − 1 = 0.072 = 7.2%
(1 + 0.06)
Loan rate must be > 8.2% as 1% necessary to make profit
in one year loan. Hence, loan is expected to be at least
8.2%. Hence, the Bank Manager is unwilling to make loan
at 8%.

Chapter 5

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Chapter 5

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Recapitulation of the Last Class

• Discussed the Evidence on Business Cycles

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BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

3. Income Tax Considerations

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Figure 5.2 Response to an Increase in Default Risk on Corporate Bonds

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BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

Figure 5.3 Response to a Decrease in the Liquidity of Corporate Bonds

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BITS Pilani, Pilani Campus

• Interest payments on municipal bonds / Infrastructure

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

• A yield curve is a line that plots the interest rates, at a

• The yield curve may be upward sloping: Long term

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• The yield curve may be upward sloping: Long term

• The Yield curve can also have more complicated shape

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

• The yield curve may be upward sloping: Long term

• The Yield curve can also have more complicated shape

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

BITS Pilani, Pilani Campus

• Several theories of term structures provide explanations

• More precisely, the yield curves will tell us about the

• Hence, every investor use this tool for predicting the

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• The expectation theory of term structure states that

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BITS Pilani, Pilani Campus

Investment strategies for two-period horizon;

• Current interest rate is 9% and it is expected to increase

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Since it(iet+1) is also extremely small,

• Expected return from strategy 2

(1+ i2t )(1+ i2t ) − 1 = 1 + 2(i2t ) + (i2t )2 − 1

Since (i2t)2 is extremely small, expected return is

Solving for i2t

Solving for i2t