Understanding Interest Rates and

the Term Structure Theories

Different Theories Explaining the

Shape of the Yield Curve
By
Satty Nkhata
 OVERVIEW

• Importance of interest rates

• Understanding interest rates
• Determinants of Interest Rates
• Measuring Yield Spreads
• Theories of the Term Structure of Interest
Rates
 IMPORTANCE OF INTEREST RATES
• Interest rates are among the most closely watched
variables in all economies.

• Their movements are reported daily by television

stations and newspapers such as the Wall Street
Journal, Financial Times and many others.

• The level of interest rates affects the lives of

people, influences their decisions and determines
the extent of economic development.
 UNDERSTANDING INTEREST RATES

• When we are talking about interest rates, we

basically refer to what is known as the yield-
to-maturity or total return.
• It is also important to note that there are
several interest rates in any economy and each
relates to a specific bond sector (e.g.Treasury
Securities) or maturity sector such as short
term interest rates and so on and so forth.
• Often, when economists talk about
the level of interest rates, they refer to
the interest rates on risk-free
investments.

• There is a general agreement that he

level of interest rates in any economy
is influenced by the country’s central
bank and the state of the economy.
DETERMINANTS OF INTEREST RATES

• Interest rates are set in the market place by the forces of supply
and demand
• Investors are suppliers of funds and borrowers are demanders of
fund
• Taking the perspective of investors in analysing market
(determined interest rates), we can view an interest rate as being
composed of a real risk-free interest rate plus a set of four
premiums that are required returns or compensation for bearing
distinct types of risk.

R = Real risk free interest rate + inflation premium + default risk

premium + liquidity premium + maturity premium.
• Real risk-free interest rate is the single –
period interest rate for a completely risk free
security if no inflation were expected.

• In economic theory, the real risk free rate

reflects the time preferences of individuals for
current versus future real consumption.
• As it will be discussed, we should note that
the real risk free interest rate may itself
incorporate premiums for risk such as;
 Interest Rate Risk
 Call and Prepayment Risk
 Yield Curve Risk
 Reinvestment Risk
 Exchange Risk
 Volatility Risk, and
 Event Risk.
• Inflation Premium- compensates investors for
expected inflation and ‘reflects’ the average inflation
rate expected over the maturity of the debt.

• Defaults Risk Premium - compensates investors for

the possibility that the borrower will fail to make a
promised payment at the contracted time and in the
contracted amount.

• Liquidity Premium- compensates investors for the

risk of loss relative to an investment’s fair value of
the investment needs to be converted to cash quickly.
• Maturity Premium-
 compensates investors for the increased sensitivity
of the market value of debt to a change in market
interest rates as maturity is extended, in general
(holding all else equal).
 The difference between the interest rate on longer-
maturity, liquid treasury debt and that on short
term treasury debt reflects a positive maturity
premium for the longer term debt.
 MEASURING YIELD SPREADS

• A yield spread is simply the difference between

the yields on two bonds or types of bends. Three
different yield spread measures are as follows:
(i) Absolute Yield Spread
 The difference between yields on two bonds.
 Sometimes called the nominal spread.
 Absolute yield spreads are usually expressed in basis
points (100 th of 1%).
ii) RELATIVE YIELD SPREAD
 This is the absolute yield spread expressed as
a percentage of the lower-yield bond.


iii. YIELD RATIO

 This is the ratio of the yields on the two bonds.

 Note that the yield ratio is simply the relative yield

spread expressed as a decimal fraction plus 1
• The most commonly used yield spread is the
absolute yield spread, even though it is the
most simplistic.
• A short coming of the absolute yield spread is
that it may remain constant, even though
overall rates rise or fall.
• In this case, the effect of rising or falling rates
on spreads is captured by the relative yield
spread or the yield ratio.
EXAMPLE
Consider two bonds, X and Y with yields of
6.50% and 6.75% respectively. Using bond x as
the reference bond, compute
i. the absolute yield spread,
ii. the relative yield spread, and
iii. the yield ratio for these bonds.
SOLUTION
i. Absolute Spread
= 6.75 - 6.50= 0.25

ii. Relative Spread

= (0.25/6.5) x 100 = 3.85%

iii. Yield Ratio

= 6.75/6.50
=1.0385
CROSS-SECTION OF YIELD SPREADS
Figure 1 illustrates a set of par yield curves for
various credits as of December 1998.
• For reference, the spreads are listed in Table 1
below.
• The curves are sorted by credit rating, from
AAA to B, using S&P’s ratings.
• They increase with maturity and with lower
credit quality.
• The lowest curve is the Treasuries curve,
which represents risk-free bonds.
• Spreads for AAA credits are low, starting at
46bp at short maturities and increasing to
60bp at longer maturities.
• Spreads for B credits are much wider; they
also increase faster, from 275 to 450.
• Finally, note how close together the AAA
Figure 1-Yield Spreads( Adapted from Fillipe Jorion- Handbook of
Financial Risk Managers 10th edition
Table 1: Yield/credit spreads. Adapted from Fillepe Jorion, Handbook
of Financial Risk Managers, 10th edition
 CREDIT SPREADS

• Credit spreads reflect potential losses caused by default risk,

and perhaps a risk premium.
• Some of this default risk is specific to the issuer and requires
a detailed analysis of its prospective financial condition.
• Part of this risk, however, can be attributed to common credit
risk factors.
• These common factors are particularly important, as they
cannot be diversified away in a large portfolio of credit-
sensitive bonds.
• First among these factors are general economic conditions.
Economic growth is negatively correlated with credit spreads.
• A credit (quality) spread is the difference in yields
between two issues that are similar in all respects
except for credit rating and that there are no
embedded options.
• An example of a credit spread is the difference
between the yields of an AAA rated bond and the
AA rated bond.
• These spreads show the effect of credit quality on
yields and reveal the risk return trade-off the
investor can expect (i.e. how much added return
an investor can earn by investing in issues with
higher perceived credit risks.
• Credit spreads are related to the state of the economy.
• During an expanding economy, credit spreads decline
as corporations are expected to have stronger cash
flows.
• On the other hand, during economic contractions, cash
flows are pressured, leading to a greater probability of
default and higher yields on lower-quality issues when
investors anticipate an economic downturn, they often
sell lower-quality issues and buy higher quality issues
including Treasuries.
• This “flight to quality” puts downward pressure on the
prices of low quality issues, thereby raising their
yields.
• When the economy slows down, more companies are
likely to have cash-flow problems and to default on
their bonds.
• Figure 2 compares the speculative-grade default rate
from Moody’s and the Baa-Treasury credit spread.
• Shaded areas indicate periods of recession.
• The graph shows that both default rates and credit
spreads tend to increase around recessions.
• Because spreads are forward-looking, however, they
tend to lead default rates, which peak after recessions.
Figure 2: Default Rates and High Yield Spreads
• Also, the effect of the 2007–2008 credit crisis
is apparent from the unprecedented widening
of credit spreads.

• These reflect a combination of higher risk

aversion and anticipation of very high default
rates.

• Volatility is also a factor. In a more volatile

environment, investors may require larger risk
premiums, thus increasing credit spreads.
• When this happens, liquidity may also dry up.
• Investors may then require a greater credit spread in
order to hold increasingly illiquid securities.
• Finally, volatility has another effect through an option
channel.
• Corporate bond indices include many callable bonds,
unlike Treasury indices.
• The buyer of a callable bond requires a higher yield
in exchange for granting the call option.
• Higher volatility should increase the value of this
option and therefore this yield, all else equal.
• Thus, credit spreads directly increase with volatility.
 THEORIES OF THE TERM STRUCTURE OF
INTEREST RATES

• Term structure of interest rates: is the

relationship between a security’s interest rate
and its remaining term to maturity.

• Yield curve: the yield curve is a curve that

results from relationship between interest rates
and the term to maturity.
 Types of Yield Curves

• Normal (upward sloping) Yield Curve

• Inverted Yield Curve

• Flat Yield Curve

• Humped Yield Curve

 UPWARD SLOPING YIELD
CURVE
Interest Rate(%)
18
16
14
12
10 Interest Rate(%)
8
6
4
2
0
0 1 2 3 4 5 6
 DOWN WARD SLOPING YIELD
CURVE
Interest Rate(%)
20
18
16
14
12
Interest Rate(%)
10
8
6
4
2
0
0 1 2 3 4 5 6
 FLAT YIELD CURVE

Interest Rate(%)
9
8
7
6
5 Interest Rate(%)
4
3
2
1
0
0 2 4 6 8 10 12
 HUMPED YIELD CURVE
Interest Rate(%)
14

12

10

8 Interest Rate(%)
6

0
0 1 2 3 4 5 6
 Theories of the Term Structure of
Interest Rates
• Unbiased Expectations Theory
• Liquidity Preference Theory
• Market Segmentation Theory
• Preferred Habitat Theory
 Unbiased Expectations Theory

• At a given point, the yield curve reflects the

market expectations of the future short term
rates.
• The observed yield for a particular maturity is
an average of the short term rates that are
expected in the future.
 Unbiased Expectations Theory

• At a given point, the yield curve reflects the average

market expectations of the future short term rates.
• Intuitively , investing in a four year bond to yield
the current spot(S4) each year is the same as
investing in four successive one year bonds [of
which only the current one yield (S1 = 1f0 ) while the
others are 1f1 , 1f2 and 1f 3 are expected].
• Thus:
• S4 =[(1 + 1f0 )( 1 + 1f1 ) ( 1 + 1f2 ) ( 1 + 1f3 )]1/4 – 1
 Unbiased Expectations Theory

• The implications of the shapes:

Shape of Term Structure Implications

Upward Sloping Rates expected to

(normal) rise
Downward Sloping Rates expected to
(Inverted) decline
Flat Rates not expected
to change
 Liquidity Preference Theory

• According to the liquidity preference theory, the term structure of interest rates
is determined by:

(1) expectations about future interest rates and

(2) a yield premium for interest rate (liquidity) risk.

• This is based on the following:

(1) risk is greater for longer maturity bonds.
(2) The longer the maturity, the greater the price volatility when interest
rates change and investors want to be compensated for this risk.
 Liquidity Preference Theory
• As liquidity risk increases with maturity, the
liquidity premium increases with maturity.
• This implies that an upward-sloping yield curve
may reflect expectations that future interest
rates either :
(a) will rise or
(b) will be unchanged or even fall, but with a yield
premium increasing with maturity fast enough
to produce an upward sloping yield curve.
 Liquidity Preference Theory
• Thus , this theory has no explanation for an
upward sloping yield curve.
• However, for flat or downward sloping yield
curves, the theory is consistent with a forecast
of declining future short-term interest rates
given the theory’s prediction that the yield
(liquidity) premium for interest rate risk
increase with maturity.
 Liquidity Preference Theory
• thus:
S4 =[(1 + 1f0 )( 1 + 1f1 ) ( 1 + 1f2 ) ( 1 + 1f3) + L4 ]1/4 – 1
where:
Lt = liquidity premium for period t
LN …… ˃ L4 ˃ L3 ˃ L2 ˃ L1
 Market Segmentation Theory

• Individuals and institutional investors have

specific maturity preferences dictated by the
maturity of their liabilities .
• that within the different maturity sectors of the
yield curve, the supply and demand for funds
determines the interest rate for that sector.
• That is, each sector is an independent segmented
of the market for purposes of determining the
interest rate in that maturity sector.
 Market Segmentation Theory

• Thus the yield curve can take any shape, that

is, upward sloping, inverted , flat and humped
yield curves are all possible.

• In fact, the market segmentation theory can be

used to explain any shape that one might
observe for the yield curve.
 Preferred Habitat Theory

• A variant of the market segmentation theory.

• This theory argues that investors prefer to invest in a
particular maturity sector as dictated by the nature of their
liabilities.
• However, if there are given an inducement in the form of
a yield premium, they are willing to move from their
preferred maturity ranges to other maturity ranges.
• Unlike under the liquidity preference , this premium does
not increase with maturity.
• This theory implies that the yield curve can take any
shape.