Financial Institution

Zaheer Swati 1

Unit 6

THE STRUCTURE OF INTEREST RATE

Why interest rates vary among different financial claims?
The main factors which affect the yield (interest rate) of a security and explain differences in interest rate among
financial claims include:
1- Termto maturity
2- Default risk
3- Tax treatment

6.1 The Term to Maturity
The termto maturity of a financial claimis the length of time until the principal amount borrowed becomes payable
The termstructure of interest rate refers to the relationship between yield (interest rate) and termto maturity on
securities that differ only in length of time to maturity, other things (default risk, tax treatment, etc) remaining equal
If this relationship is graphed, then we have the yield curve
For example if when:
Maturity is 2 year, the yield is 2%
Maturity is 3 years, the yield is 3%
Maturity is 5 years, the yield is 5%, then the yield curve is :


In the above graph the yield curve slopes upwards. But what are the economic forces that determine the slope and
the shape of a yield curve? Or how can we explain changes in term structure?
Three theories are used in this respect:
1- The expectation theory
2- Liquidity preference theory
3- The market segmentation theory
Yield (%)
Yield Curve
5
3
5 3 2 1
2
Maturity (years)
Financial Institution


Zaheer Swati 2

Unit 6



6.1.1 The Expectations Theory
This theory state that the shape and slope of the yield curve are determined by investors expectation about future
short-term interest rate movements and that changes in these expectations about future interest rate will change the
shape of the yield curve
The Theory assumes that
Investors are profit maximizers, and that
Investors have no preference between holding long and short-termsecurities. That is they are indifferent
towards interest rate risk
To see how changing expectations of interest rate movements can alter the slope of the yield curve, suppose the
investors have only 1 year and 2 years securities that can be purchased, and each of the two securities currently
yields 3%. The yield curve then will be a flat, (one year security yields 3% and the two year security also yields 3%,
so joining the two points we obtain a flat curve)

Yield (%)

5
4
3 Yield curve
2
1
1 2 3 4 Maturity (years)

Now assume that investors expect interest rate to rise to 6% after one year. (6% is a future or forward rate, which
will occur after one year), then:
o If an investor buys the 2-year security, his yield is 3%.
o If instead he buys a 1-year security now (yield is 3%), and after a year buys another 1-year security (yield 6%),
his average yield fromthe two securities is:
3+6
--------- =4.5%
2
Financial Institution


Zaheer Swati 3

Unit 6

Clearly it is profitable to buy the two short-term securities rather than the one long-term security. So, investors will
start to sell the 2-years securities and buy the 1-year securities, and as a result:
Prices of 1-year securities will raise and their yield decreases, (The inverse relation between i and PB)
Prices of 2-years securities will decreases and their yield increases
This process continues until the difference between the average yield on the short-termand the yield on the long-
termsecurities is zero. That is, until an equilibriumis attained
In this example, the equilibriumoccurs when the yield of 1-year security decreases to 2%, and the yield on 2-years
security increases to 4%.
2-years security 4% =------- =4% (average of the 2-short termsecurities)
So the yield curve slopes upwards (changing frombeing flat)

So, if interest rate is expected to rise in the future, yield curve slopes upward and vice versa OR an upward sloping
yield curve indicates that future interest rates are expected to increase

Summary Table
Expected Interest Rate Movement Observed Yield Curve
If interest rates are expected to increase Upward-sloping
If interest rates are expected to decline Downward-sloping
If interest rates are expected to stay the same Flat


1 2
Yield Curve
2
4
Maturity (years)
Yield to maturity (%)
Financial Institution


Zaheer Swati 4

Unit 6

According to the expectations hypothesis, the yield on a long-termsecurity (say bond) is the average of expected
short-terminterest rates
Suppose one-year interest rate over the next five years are expected to be: 5%, 6%, 7%, 8% and 9%
Then, interest rate on the two-year bond:
(5% +6%)/2 =5. 5%
Interest rate on the five-year bond:
(5% +6% +7% +8% +9%)/5 =7%
Interest rates on one to five-year bonds:
5%, 5.5%, 6%, 6.5%, and 7%

6.1.2 Liquidity Premiums Theory
This theory is extension of the unbiased expectation theory
We have seen that the expectation theory assumes that investors are indifferent between purchasing long-termor
short-termsecurities
This usually is not true. Investors know from experience that short-term securities provide greater marketability
(more active secondary market) and have smaller price fluctuations (less price risk) than long-termsecurities
As a result, borrowers who seek long-termfunds to finance capital projects must pay lenders a liquidity premium(an
additional yield for accepting lower liquidity, also called premium)
That is, to compensate investors who purchase long-term securities, liquidity premiumis paid for them
This premiumincreases as maturity increases. This is because risk increases as maturity increases. Thus the yield
curve must have liquidity premiumadded to it
The liquidity premiumtherefore causes the observed market yield curve to be more upward-sloping than that
predicted by the expectation theory. The following graph illustrates this:



Maturity
Expectation theory Y.C
Observed Y.C
Liquidity Premium
Yield
Financial Institution


Zaheer Swati 5

Unit 6

The interest rate on a long-term bond will equal the average of short-term interest rates expected to occur over the
life of the long-termbond plus a liquidity premium
Suppose one-year interest rate over the next five years are 5%, 6%, 7%, 8%, 9%, liquidity premiums for one to five-
year are 0%, 0.25%, 0.5%, 0.75%, 1.0%
Then, interest rate on the two-year bond:
(5% +6%)/2 +0.25% =5.75%
Interest rate on the five-year bond:
(5% +6% +7% +8% +9%)/5 +1.0% =8%
Interest rates on one to five-year bonds:
5%, 5.75%, 6.5%, 7.25% and 8%

6.1.3 The Market Segmentation Theory
In accordance with the matching principle, financial institutions prefer to invest in assets with maturities that
match the institutions' liabilities
This means that there is not one market of interest rates, but at least three: short-term, intermediate-term, and
long-term. Interest rates are a function of supply and demand in each of the three market segments
This theory states that the market for different-maturity security is completely separate and segmented
The interest rate for a bond with a given maturity is determined by the supply and demand for bonds in that
segment with no effect fromthe returns on bonds in other segments

Yield
D
L
S
L

D
m
S
m
S =short-term
m
=
medium-term
D
s
S
s
L =long-term


Maturity



Financial Institution


Zaheer Swati 6

Unit 6

6.1.4 Which theory is right?
No one theory is totally correct. Studies have supported all theories, and the evidence is not conclusive yet

6.1.5 Economic Implications of the Yield Curve
o Yield curve is used to anticipate future behavior of the economy
o It is used in explaining business cycle and profits of financial institutions
o If the yield curve is upward-sloping, then:
1- Interest rates are expected to increase in the future
2- The economy is expected to have a period of economic expansion
3- Inflation is expected to rise (during expansion inflation is expected to rise)
4- The yield curve starts sloping upward at the beginning of economic expansion
5- Banks and financial institutions are expected to make better profits (since they borrow at short-termrates and
lend at long-termrates which are expected to increase when the yield curve is rising)
6- The more steeper the yield curve the higher is the expected profits of the banks and financial institutions.

6.2 Default Risk
Default risk refers to the possibility of not collecting the promised amount of interest or principal at the agreed time
Default risk is measured by default risk premium which to given by:

DRP =i i
rf

Where,
DRP is default risk premium
i is the promised yield to maturity on the security
i
rf
is the yield on a comparable default-free security

That is the DRP is the difference between the yield of (or rate paid on) a risky security and the rate paid on similar
default free securities (similar in terms of maturity and all other characteristics except default possibility)
Usually government securities (Treasury bills) are taken as default free securities

Example 6.1: Calculate the DRP on a 90-day commercial paper yielding 2.96%, if yield on 90-day government securities
is 2.5%.
Solution:

DRP =i i
rf

DRP = 2.96% - 2.5% =0.46

Note that the larger the DRP, the higher the probability of default, and the higher the security market yield (or the
rate paid on it), since such borrower will have to pay higher rates to be able to borrow




Financial Institution


Zaheer Swati 7

Unit 6

6.3 Tax Treatment
What is important to investors is after tax return of security.
After tax yield is measured by:

i
at
=i
bt
(1 - t)

Where,
i
at
=after tax yield;
i
bt

=
beforetax

yield
;
and
t =marginal tax rate of the investors (tax bracket)

Example 6.2: Calculate after tax return on a Rs. 1,000 treasury bill with 8% coupon rate held by investors in the 30% tax
bracket.
Solution:
i
bt
=8% ; and t =30% =0.3; Then:
i
at
= 8% (1-0.3) = 8% (0.7) =5.6%

Note that if t is low the difference between before and after tax yield is small. This is why investors in high tax
brackets (high t) prefer government securities (tax free, lower market yield), since its after tax yield is higher to
them than taxable securities. Investors in lower tax brackets (low t) receive high after tax fromtaxable securities,
since they pay less tax

6.4 The Term Structure Formula
The expectation theory implies that a relationship between long and short-term rates exists. So, given a short-term
yield and expected future rates, we can calculate long-termyield
The yield of a security maturity n years fromnow is given by the formula:

(1+
t
R
n
) =[(1+
t
R
1
) +(1+
t+1
f
1
)+(1+
t+2
f
1
) +-------+(1+
t+n-1
f
1
)]
1/n
(1)

Where
R =the observed (actual) market interest rate
f
1
=the forward or future interest rate
t =time period for which the rate is applicable
n =maturity of the bond

Note that, since n is the number of years in which security matures, and t is the time period in which the security
originates, then:
(1+
t
R
1
) is the actual market rate of interest on 1-year security today or at the present time (t). So:
(1+
t
R
5
) is the current market rate on a 5-year security at time t; and
(1+
t
R
10
) is the current market rate on a 10-year security at time t.

Financial Institution


Zaheer Swati 8

Unit 6

Similarly:
(1+
t+1
f
1
) is the 1-year interest rate, one year in the future (t+1), and,
(1+
t+2
f
1
) is the one year rate, 2-year fromnow (t+2), and,
(1+
t+n-1
f
1
) is the one-year rate, n-1 year in the future.

Using TermStructure Formula to Calculate the Implied Forward Rates
The termstructure formula can be used to calculate the implied forward rate (f
1
), given any two adjacent spot rate
(
t
R
n
) and (
t
R
n-1
). The formula used to calculate (f
1
) is:

t+n-1
f
1
=[[(1+
t
R
n
)
n
/ (1+
t
R
n-1
)
n-1
] 1]*100

Example 6.3: Suppose we know that:
One-year spot rate (
t
R
1
) is 3%
Two-year spot rate (
t
R
2
) is 4%
Three-year spot rate (
t
R
3
) is 5%

Then, the implied forward rate on one year bond originating one year fromnow (
t+1
f
1
) is:


t+1
f
1
=[[(1+
t
R
2
)
2
/ (1+
t
R
1
)
1
] 1]*100 =[[(1+0.04)
2
/ (1+0.03)
1
] 1]*100
=[[1.0815 / 1.03] 1]*100 =[1.05 1]*100
=0.05*100 =5%




The implied forward rate on a one-year bond originating two-year in the future (
t+2
f
1
) is:

t+2
f
1
=[[(1+
t
R
3
)
3
/ (1+
t
R
2
)
2
] 1]*100

=[[(1+0.05)
3
/ (1+0.04)
2
] 1]*100


=[[1.158 / 1.082] 1]*100 =0.07*100 =7%


Example 6.4: Calculate the one-year forward rate three-year from now if three and four year spot rates are 5.50% and
5.80% respectively.


t+3
f
1
=[[(1+
t
R
4
)
4
/ (1+
t
R
3
)
3
] 1]*100
=[[(1+0.058)
4
/ (1+0.055)
3
] 1]*100
=[[1.253 / 1.174] 1]*100 =0.067*100 =6.7%