Chapter 10 - Risk and Term Structure of Interest Rates

THE RISK AND TERM
STRUCTURE OF
INTEREST RATES
Presented by: Group 10
Learning Objectives
Identify and explain three factors explaining the

01
risk structure of interest rates.
02 List and explain the three theories of why

interest rates vary across maturities.
Risk Structure
of Interest
Rates
Risk Structure of
Interest Rates
The risk structure of interest to the relationship between the

interest rates of different securities with varying degrees of
risk.
It explained by three factors: default risk, liquidity and the
income tax consideration of a bond’s interest payments.
Default Risk
It is the probability that a borrower will not pay in full the
promised interest, principal, or both.
Generally, the larger the default risk, the larger the risk
premium, the higher the interest rate.

Default Risk
Bonds having no default risk, like government bonds,

are called default-free bonds.
Risk premium: the spread between the interest rates
on bonds with default risk and the interest rates on
(same maturity).
Default Risk
Let's assume that the interest rate on a 10-year

government bond is 2%, while the interest rate on a 10-
year corporate bond issued by a company with a higher
risk of default is 4%. In this case, the risk premium for
the corporate bond is 2%.
Liquidity
 It is the relative ease with which an asset can be converted into

cash.
The lower liquidity of corporate bonds relative to treasury bonds
increases the spread between the interest rates on these two
bonds
Liquidity
 One of the main factors that can influence the relationship
between liquidity and interest rates is the supply and demand
dynamics.
Income Tax Consideration
 refers to the impact that income taxes have on an individual or entity's
financial decisions, particularly with respect to investment decisions.
 It involves evaluating the tax implications of different investment

options and considering the after-tax returns of various investments.
 Generally, instruments that are tax exempt, can offer lower interest
rates.
Income Tax Consideration
 There are two common tax treatments for interest income earned from
investments: taxable interest income and tax-exempt interest
income.
1. Taxable Interest Income – is interest income earned from investments

that are subject to income tax.
2. Tax-Exempt Interest Income - is interest income earned from

investments that are exempt from income tax.
Term Structure
of Interest
Rates
Term Structure of
Interest Rates
It refers to the relationship between time to maturity and

yields for a particular category of bonds at a particular point
in time.
It is commonly known as the yield curve, depicts the interest
rates of similar quality bonds at different maturities.
Yield Curve
is a graphical representation of the relationship between
the yields on debt securities of different maturities, usually
for a given issuer or market.
A plot of the yields on bonds with different maturities but
same risk, liquidity and tax considerations.
The yield curve is normally upward sloping, meaning that
interest rates rise with maturity.
Yield Curve
There are three main types of yield curves: upward-sloping, flat, and
inverted.
1. An upward-sloping yield curve
 occurs when long-term interest rates are

higher than short-term interest rates.
Yield Curve
inverted.
2. Flat yield curve:
 occurs when short-term and long-term interest

rates are roughly equal.
Yield Curve
inverted.
3. Inverted yield curve:
 occurs when long-term interest rates are lower

than short-term interest rates.
Yield Curve
Theory of Term
Structure Interest
The theory of the term structure of interest rates must explain the
following facts:
1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to
have an upward slope; when short-term rates are high, yield curves are
more likely to slope downward and be inverted.
3. Yield curves almost always slope upward.
Three theories to explain the three
facts:
 Expectations Theory
 Segmented Markets Theory
 Liquidity Premium
Expectation
Theory
 The interest rate on a long-term bond will equal an average

of the short-term interest rates that people expect to occur
over the life of the long-term bond.
 Bond holders consider bonds with different maturities to be

perfect substitutes
 Buyers of bonds do not prefer bonds of one maturity over
another; they will not hold any quantity of a bond if its
expected return is less than that of another bond with a
different maturity.
Segmented
Markets Theory
 Market segmentation theory is a theory that long and short-

term interest rates are not related to each other. It also
states that the prevailing interest rates for short,
intermediate, and long-term bonds should be viewed
separately like items in different markets for debt securities.
Bonds of different maturities are not substitutes at
all.
The interest rate for each bond with a different

maturity is determined by the demand for and
supply of that bond.
Liquidity Premium
 The liquidity premium theory asserts that long-term interest

rates not only reflect investors' assumptions about future
interest rates, but also include a premium for holding long-
term bonds (investors prefer short term bonds to long term
bonds), called the term premium or the liquidity premium.
This premium compensates investors for the added
risk of having their money tied up for a longer
period, including the greater price uncertainty.
Because of the term premium, long-term bond
yields tend to be higher than short-term yields, and
the yield curve slopes upward.
Reporters
BELESTA, JEAN PAGCALIWANGAN,

LOUESE C. JUSTINE
Thank You for
Listening!
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THE RISK AND TERM

Identify and explain three factors explaining the

02 List and explain the three theories of why

The risk structure of interest to the relationship between the

promised interest, principal, or both.

premium, the higher the interest rate.

Bonds having no default risk, like government bonds,

Let's assume that the interest rate on a 10-year

 It is the relative ease with which an asset can be converted into

 One of the main factors that can influence the relationship

between liquidity and interest rates is the supply and demand

 It involves evaluating the tax implications of different investment

1. Taxable Interest Income – is interest income earned from investments

2. Tax-Exempt Interest Income - is interest income earned from

It refers to the relationship between time to maturity and

1. An upward-sloping yield curve

 occurs when long-term interest rates are

2. Flat yield curve:

 occurs when short-term and long-term interest

3. Inverted yield curve:

 occurs when long-term interest rates are lower

 The interest rate on a long-term bond will equal an average

 Bond holders consider bonds with different maturities to be

 Market segmentation theory is a theory that long and short-

The interest rate for each bond with a different

 The liquidity premium theory asserts that long-term interest

BELESTA, JEAN PAGCALIWANGAN,

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