Chapter - 3

Structure of Interest
Rates
Chapter Objectives

 Learnwhy individual interest rates differ or

why security prices vary or change

 Analyze theories explaining why rates vary by

term or maturity, called the term structure of
interest rates
 Factors Affecting Security Yields

 Risk-averse investors demand higher yields

for added riskiness
 Risk is associated with variability of returns
 Increased riskiness generates lower security
prices or higher required rates of return
Factors Affecting Yields on Securities

 Yields and prices on Securities are affected by

levels and changes in:
1. Credit (default) risk
2. Liquidity
3. Tax status
4. Term to maturity
Factors Affecting Security Yields

1. Credit (default) risk:

 Most securities are subject to the risk of default, investors must
consider the creditworthiness of the security issuer. Although
investors always have the option of purchasing risk-free Treasury
securities, they may prefer other securities if the yield
compensates them for the risk. Thus, if all other characteristics
besides credit (default) risk are equal, securities with a higher
degree of default risk must offer higher yields before investors
will purchase them.
 Rating agencies set default risk ratings
 Anticipated or actual ratings changes impact security prices and
yields
Factors Affecting Security Yields

2. Liquidity:
The Liquidity of a security affects the
yield/price of the security
A liquid investment is easily converted to cash
at minimum transactions cost
Investors pay more (lower yield) for liquid
investment
Factors Affecting Security Yields

3. Tax status
Tax status of income or gain on security
impacts the security yield
Investor concerned with after-tax return or
yield
Investors require higher yields for higher taxed
securities
Factors Affecting Security Yields

Yat = Ybt(1 – T)

Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Factors Affecting Security Yields

 Example: a taxable security that offers a

before-tax yield of 14 percent. The investor’s
tax rate is 20 percent. Calculate the after-tax
yield.
Yat = 14%(1 – 0.2)
= 11.2%
 The fully taxable pre-tax equivalent corporate
bond for a 11.2% municipal bond is:
Ybt = 11.2%/(1 – .2) = 14%
Factors Affecting Security Yields

4. Term to Maturity
 Interest rates typically vary by maturity.
 The term structure of interest rates defines the
relationship between maturity and yield.
 The Yield Curve is the plot of current interest yields
versus time to maturity.
 Exhibit: 3.3
Exhibit 3.3
Example of Relationship between Maturity and Yield of Treasury
Securities (as of March 2014).
 Yield Curve
The slope of the yield curve can predict future interest rate
changes and economic activity.

Yield
%

Time to Maturity

An upward-sloping (normal) yield curve indicates that

Treasury Securities with longer maturities offer higher annual
Yields.
 Yield Curve Shapes

Normal Level or Flat Inverted

An inverted-sloping yield curve indicates that when

short-term rates are greater than long-term rates.
A flat yield curve results when yields for short- and long-term
maturities are roughly equal.
Factors Affecting Security Yields

 Special Provisions
 Call Feature: enables borrower to buy back the
bonds before maturity at a specified price
 Call features are exercised when interest rates have
declined
 Investors demand higher yield on callable bonds,
especially when rates are expected to fall in the future

Firms must pay slightly higher rates of interest on bonds that

are callable, other things being equal.
Factors Affecting Security Yields

 Special provisions
 Convertible bonds
 Convertibility feature allows investors to convert the
bond into a specified number of common stock shares
 Investors will accept a lower yield for convertible bonds
because investor returns include expected return on
equity participation
Estimating the Appropriate Yield

 The appropriate yield to be offered on a debt

security is based on the risk-free rate for the
corresponding maturity plus adjustments to
capture various security characteristics

Yn = Rf,n + DP + LP + TA + CALLP + COND

Estimating the Appropriate Yield
Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury
(risk-free) security
DP = default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount
The Term Structure of Interest Rates

Theories Explaining Shape of Yield Curve

Pure Expectations Theory

Liquidity Premium Theory
Segmented Markets Theory
The Term Structure of Interest Rates

 Pure Expectations Theory

According to pure expectations theory, the term structure of
interest rates is determined solely by expectations of interest
rates.
 Long-term rates are average of current short-term
and expected future short-term rates
 Yield curve slope reflects market expectations of
future interest rates
 Investors select maturity based on expectations
The Term Structure of Interest Rates

 Pure Expectations Theory

 Assumes investor has no maturity preferences and
transaction costs are low
 Long-term rates are averages of current short term
rates and expected short term rates
 Forward rate: market’s forecast of the future interest
rate
The Term Structure of Interest Rates

Downward-
Upward-
Sloping
Sloping
Yield Curve
Yield Curve

 Expected higher interest  Expected lower interest

rate levels rate levels
 Expansive monetary  Tight monetary policy
policy  Recession soon?
 Expanding economy
The Term Structure of Interest Rates

 Liquidity Premium Theory

 Investors prefer short-term, more liquid, securities
 Long-term securities and associated risks are
desirable only with increased yields
 Explains upward-sloping yield curve
 When combined with the expectations theory,
yield curves could still be used to interpret interest
rate expectations
The Term Structure of Interest Rates

 Segmented Markets Theory

According to the segmented markets theory, investors and
borrowers choose securities with maturities that satisfy their
forecasted cash needs.
Pension funds and life insurance companies may generally prefer
long-term investments that coincide with their long-term
liabilities.
 Theory explaining segmented, broken yield curves
 Assumes investors have maturity preference boundaries,
e.g., short-term vs. long-term maturities
The Term Structure of Interest Rates
 Uses of the term structure
The term structure of interest rates is used to forecast interest rates, to
forecast recessions, and to make investment and financing
decisions.
 Forecast interest rates
• The market provides a consensus forecast of expected future
interest rates
 Forecast recessions
• Flat or inverted yield curves have been a good predictor of
recessions. See Exhibit 3.14.
 Investment and financing decisions
• Lenders/borrowers attempt to time investment/financing based on
expectations shown by the yield curve
 Exhibit 3.14 Yield Curve as a Signal for
Recessions
Interest Rate Differential (10-Year Rate

7
Minus Three-Month Rate)

6
5
4
3
2
1
0
–1
–2
–3
–4
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2001
Year
*The general shape of the yield curve is measured as the differential between annualized 10-year and three-month inte
Recessionary periods are shaded.
International Structure of Interest Rates

 Yield differences between countries are

related to:
 Expected changes in forex rates
 Varied expected real rates of return
 Varied expected inflation rates
 Varied country and business risk
 Varied central bank monetary policy