IFM - chapter 5 - How do risk and term structure affect interest rates?

What is default risk?

Default risk occurs when a bond issuer is unable or unwilling to:

• make interest payments as promised, or

• pay off the face value at maturity.

What are default-free bonds?

Bonds (e.g., U.S. Treasury bonds) considered free of default risk because the government can raise taxes or print money to meet obligations.

Are all government bonds default-free?

No. While generally low-risk, government bonds are not entirely free from default. Risk depends on creditworthiness, economic stability, and politics.

Which bonds have low default risk?

• U.S. Treasury Bonds: seen as “risk-free” due to strong credit and printing power.

• Highly Rated Countries: e.g., Germany, UK, Japan – low-risk but not completely default-free.

Which bonds have high default risk?

• Emerging Markets: e.g., Argentina, Venezuela

• Recent Defaulters: e.g., Greece during Eurozone crisis

→ Due to economic instability and weaker credit ratings.

What is the credit spread?

The difference in interest rates between bonds with default risk and default-free bonds.
→ Reflects the risk premium investors require.

How does credit spread relate to default risk?

• Bonds with default risk always have a positive risk premium.

• If default risk ↑ → risk premium ↑

Why do investors care about default probability?

It influences the size of the risk premium and helps assess risk. Investors use credit-rating agencies (e.g., Moody’s, S&P, Fitch) for estimates.

What are bond ratings and what do they mean?

Ratings like AAA (Moody’s, S&P, Fitch) indicate lowest risk. Ratings go down to C, indicating high or certain risk of default.

What are corporate bonds and their risk?

• Issued by corporations

• Subject to credit/default risk
  → Their cash flows are not certain.

How do corporate bond yields relate to credit risk?

Investors pay less for bonds with credit risk ⇒ Yield is higher than that of identical default-free bonds.

Why is the yield to maturity of a bond with certain default misleading?

Because it overstates the actual return; expected return is lower due to the certainty of not receiving full payments.

What does a higher yield to maturity imply if there is default risk?

It does not guarantee a higher expected return. A bond’s expected return is less than its yield if default is possible.

In the Avant Bond example, how do yield and return compare across different default risks?

What is a liquid asset?

An asset that can be quickly and cheaply converted to cash. More liquid = more desirable.

What is the risk premium in bond pricing?

The difference between corporate and Treasury bond interest rates:

• Reflects default risk and liquidity

• More accurately: risk and liquidity premium

Why do US municipal bonds have lower rates than Treasuries despite higher risk?

Because US municipal bonds are exempt from federal income tax, while:

• Treasury bonds are exempt from state & local income tax

• Corporate bonds are fully taxable
  But municipal bonds are NOT default-free and NOT as liquid as Treasuries.

How does maturity affect interest rates?

Bonds with different maturities have different required interest rates — longer maturities typically demand higher yields, all else equal

what three facts must a good theory of the term structure of interest rates explain?

1. Interest rates of different maturities move together

2. Yield curves:

   • Steep upward slope when short rates are low

   • Downward slope when short rates are high

3. Yield curve is typically upward sloping

What are the three theories of term structure and what do they each explain?

1. Expectations Theory: explains (1) and (2)

2. Market Segmentation Theory: explains (3)

3. Liquidity Premium Theory: explains all three by combining the above two

What is the key assumption and implication of the Expectations Theory?

Assumption: Bonds of different maturities are perfect substitutes
Implication: Expected returns on all maturities are equal

What does the Expectations Theory say about investment strategies over 2 years?

Strategy 1: Buy 1-year bond twice
Strategy 2: Buy 2-year bond once
→ If the theory is correct, both yield the same expected wealth
(But actual wealth may differ if rates change)

How does the Expectations Theory explain different yield curve shapes?

• Short rates ↑ in future → upward slope

• Short rates stay the same → flat curve

• Short rates ↓ in future → downward slope

How does Expectations Theory explain that short and long rates move together?

If short rate ↑ today, expected future short rates ↑ too
→ Average of future rates ↑ → long-term interest rates ↑

Why do yield curves steepen when short rates are low?

If short rates are low, they’re expected to rise
→ Future rates > current → steep upward-sloping curve

Why doesn’t Expectations Theory explain why yield curves are usually upward sloping?

Because short rates are equally likely to rise or fall
→ Future average rates won’t consistently be higher
→ So theory can’t explain the usual upward slope

What is the key assumption and implication of Market Segmentation Theory?

Assumption: Bonds of different maturities are not substitutes at all
Implication:

• Markets are completely segmented

• Interest rates at each maturity are determined independently

What does Market Segmentation Theory explain about the yield curve?

✔ Explains Fact 3: yield curve is usually upward sloping

• People prefer short holding periods → higher demand for short-term bonds

• Short-term bonds: higher price, lower interest rates
  ✘ Does not explain Facts 1 and 2 (rates determined independently)

What is the key assumption and implication of Liquidity Premium Theory?

Assumption: Bonds of different maturities are substitutes, but not perfect substitutes
Implication: Combines expectations theory with market segmentation theory → explains all 3 facts

Why do investors require a liquidity premium for long-term bonds?

Why does the Liquidity Premium Theory explain all three facts of the term structure?

• Explains Fact 3: yield curve is usually upward sloped because of the liquidity premium for long-term bonds

• Explains Fact 1 & 2: like the expectations theory, it uses the average of future short rates to determine long-term rates

How is the term structure of interest rates useful as a forecasting tool?

• The yield curve provides information about future interest rates

• It helps forecast inflation and real output

  • Rising rates → economic booms

  • Falling rates → recessions

• Rates include both real and expected inflation components

Why are interest-rate forecasts important for financial institutions?

• Future changes in interest rates affect profitability

• Managers must set loan interest rates in advance for future periods
  → Accurate forecasts are crucial for planning and pricing

What does the slope of the yield curve tell us about future interest rates?

• A steeply upward-sloping yield curve → future rates expected to rise

• A downward-sloping yield curve → future rates expected to fall
  → Reflects the market's prediction of interest rate direction

What is the difference between forward and spot rates?

What is a forward interest rate, and how is it used?

• A forward rate is guaranteed today for a future loan or investment

• Example: Forward rate for year 5 is the rate for a 1-year investment starting 4 years from now