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Chapter 5: Behavior of Interest Rates
Determinants of Asset Demand
Wealth: the total resources owned by the individual, including all asset
 When we find that our wealth has increased, we have more resources available to purchase assets
=> the quantity of assets (clothes, houses for example) we demand increases.
 The effect of changes in wealth on the quantity demanded of an asset can be summarized as follows: Holding
everything else constant, an increase in wealth raises the quantity demanded of an asset.
Expected Return: the return expected over the next period on one asset relative to alternative assets
 The return on an asset (such as a bond) measures how much we gain from holding that asset.
 When we decide to buy an asset, we are influenced by what we expect the return on that asset to be.
 If a bond has a return of 15% half the time and 5% the other half, its expected return (which you can think of as the
average return) is:
o (10% = 0.5 x 15% + 0.5 x 5%)1
 If the expected return on bond rises relative to expected returns on alternative assets, then, holding everything
else constant, it becomes more desirable to purchase the Bell bond, and the quantity demanded increases.
 This can occur in either of two ways:
o (1) when the expected return on the Bell bond rises while the return on an alternative asset—say, stock in
Google—remains unchanged or
o (2) when the return on the alternative asset (the Google stock) falls while the return on the Bell bond
remains unchanged.
o To summarize, an increase in an asset’s expected return relative to that of an alternative asset, holding
everything else unchanged, raises the quantity demanded of the asset.
Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets
 Affects demand for the asset
o Consider two assets: stock in Fly-by-Night Airlines and stock in Feet-on-the-Ground Bus Company.
o Suppose that Fly-by-Night stock has a return of 15% half the time and 5% the other half, making its
expected return 10%, while Feet-on-the-Ground stock has a fixed return of 10%.
o Fly-by-Night stock has uncertainty associated with its returns and so has greater risk than Feet-on-theGround stock, whose return is a sure thing.
 A risk-averse person prefers stock in Feet-on-the-Ground (the sure thing) to Fly-byNight stock (the riskier asset),
even though the stocks have the same expected return: 10%.
 By contrast, a person who prefers risk is a risk preferred or risk lover. Most people are risk-averse, especially in
their financial decisions: Everything else being equal, they prefer to hold the less risky asset.
 Hence, holding everything else constant, if an asset’s risk rises relative to that of alternative assets, its quantity
demanded will fall.
Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets
 Another factor that affects the demand for an asset is how quickly it can be converted into cash at low costs—its
liquidity.
 An asset is liquid if the market in which it is traded has depth and breadth (if the market has many buyers and
sellers).
 A house is not a very liquid asset because it may be hard to find a buyer quickly; if a house must be sold to pay off
bills, it might have to be sold for a much lower price.
 And the transaction costs associated with selling a house (broker’s commissions, lawyer’s fees, and so on) are
substantial.
 A Canadian government Treasury bill, by contrast, is a highly liquid asset. It can be sold in a well-organized market
with many buyers, and so it can be sold quickly at low cost.
 The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it
is and the greater the quantity demanded will be.
Theory of Portfolio Choice
 Holding all other factors constant, the quantity demanded of an asset is:
1. positively related to wealth
2. positively related to its expected return relative to alternative assets
3. negatively related to the risk of its returns relative to alternative assets
4. positively related to its liquidity relative to alternative assets
III.
Demand and Supply in the Bond Market
 Bond Demand
o Holding all else constant, lower prices (or higher interest rates) increases the quantity demanded of
bonds
o Bond price and quantity demanded are inversely related
o Interest rates and quantity demanded are positive related
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Bond Supply
o
Holding all else constant, lower prices
(higher interest rates), decreases the quantity supplied of bonds
Bond price and quantity supplied are positive related
Interest rate and quantity supplied are inversely related
Market equilibrium
 Market equilibrium occurs when the amount demanded at a given bond price equals the amount supplied
 Bd = Bs defines the equilibrium (or market clearing) bond price and interest rate
 When Bd > Bs, there is excess demand, price will rise, and interest rate will fall
 When Bd < Bs, there is excess supply, price will fall and interest rate will rise
Shifts in the Demand for Bonds (…all else equal)
 Wealth: growing wealth shifts the demand curve for bonds to the right
 Expected returns: higher expected future interest rates shift the demand curve to the left
 Expected inflation: an increase in the expected rate of inflations shifts the demand curve to shift to the left
 Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left
 Liquidity: increased liquidity of bonds shifts the demand curve to the right
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Shift in supply of bond
Investment opportunities: Higher expected profitability of investment opportunities shifts the supply curve to the right
o When opportunities for profitable plant and equipment investments are plentiful, firms are more willing to
borrow to finance these investments.
o When the economy is growing rapidly, as in a business cycle expansion, investment opportunities that are
expected to be profitable abound, and the quantity of bonds supplied at any given bond price increases
o Therefore, in a business cycle expansion, the supply of bonds increases and the supply curve shifts to the right.
o Likewise, in a recession, when far fewer profitable investment opportunities are expected, the supply of bonds
falls and the supply curve shifts to the left
Expected inflation: an increase in expected inflation shifts the supply curve to the right
o the real cost of borrowing is most accurately measured by the real interest rate, which equals the (nominal)
interest rate minus the expected inflation rate.
o For a given interest rate (and bond price), when expected inflation increases, the real cost of borrowing falls;
hence, the quantity of bonds supplied increases at any given bond price.
o An increase in expected inflation causes the supply of bonds to increase and the supply curve to shift to the
right (see Figure 5-3 ) and a decrease in expected inflation causes the supply of bonds to decrease and the
supply curve to shift to the left
Government budget: increased budget deficit shifts the supply curve to the right
o The activities of the government can influence the supply of bonds in several ways.
o The Canadian government issues bonds to finance government deficits, caused by gaps between the
government’s expenditures and its revenues.
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VIII.
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When these deficits are large, the government sells more bonds, and the quantity of bonds supplied at each
bond price increases.
Higher government deficits increase the supply of bonds and shift the supply curve to the right (see Figure 5-3
).
On the other hand, government surpluses, as have occurred in recent years, decrease the supply of bonds and
shift the supply curve to the left.
Provincial and municipal governments and other government agencies also issue bonds to finance their
expenditures, and this can affect the supply of bonds as well.
We will see in later chapters that the conduct of monetary policy involves the purchase and sale of bonds,
which in turn influences the supply of bonds.
We now can use our knowledge of how supply and demand curves shift to analyze how the equilibrium
interest rate can change.
The best way to do this is to pursue several applications that are particularly relevant to our understanding of
how monetary policy affects interest rates. In studying these applications, keep two things in mind:
 1. When we examine the effect of a variable change, we are assuming that all other variables are
unchanged; that is, we are making use of the ceteris paribus assumption.
 2. The interest rate is negatively related to the bond price, so when the equilibrium bond price rises,
the equilibrium interest rate falls.
 Conversely, if the equilibrium bond price moves downward, the equilibrium interest rate rises.
The Liquidity Preference (Alternative) Framework
Interest rates are determined by equilibrium in both money and bond markets
o Investors have two options to hold wealth: money and bonds
Total wealth in the economy equals the total amount of money and bonds
B s + M s = Bd + M d
s
d
d
Rearrange terms: B − B = M – Ms
Implication: If the bond market is in equilibrium, B s = Bd , then the money market must also be in equilibrium, M d = Ms
Demand for Money in the Liquidity Preference Framework
The demand curve for money shows the quantity of money demanded at each interest rate.
Its downward slope expresses the negative relationship between the quantity of money demanded and the interest
rate.
As the interest rate increases:
o the opportunity cost of holding money increases…
the relative expected return on money decrease and therefore the quantity demanded of money decreases
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Shifts in the Demand for Money
Income Effect
o a higher level of income 𝑦 causes the demand for money (𝑀𝐷) at each interest rate to increase and the
demand curve to shift to the right
o In Keynes’s view, there were two reasons why income would affect the demand for money.
 First, as an economy expands and income rises, wealth increases and people want to hold more
money as a store of value.
 Second, as the economy expands and income rises, people want to carry out more transactions using
money as a medium of exchange, and so they also want to hold more money.
Price-Level Effect
o a rise in the price level 𝑃 causes the demand for money (𝑀𝐷) at each interest rate to increase and the demand
curve to shift to the right
o Keynes took the view that people care about the amount of money they hold in real terms—that is, in terms
of the goods and services it can buy.
o When the price level rises, the same nominal quantity of money is no longer as valuable; it cannot be used to
purchase as many real goods or services.
o To restore their holdings of money in real terms to the former level, people will want to hold a greater
nominal quantity of money.
Shifts in the Supply of Money
Assume that the supply of money is controlled by the central bank
An increase in the money supply engineered by the Bank of Canada will shift the supply curve for money to the right
The money supply is therefore perfectly inelastic
XI.
Response to a Change in Income or the Price Level
 Changes in Income
o We have seen that when income is rising during a business cycle expansion, the demand for money
also rises, shown in Figure 5-9 by the rightward shift in the demand curve from M d 1 to Md 2.
o The new equilibrium is reached at point 2, at the intersection of the M d 2 curve with the money
supply curve Ms .
o As you can see, the equilibrium interest rate rises from i1 to i2.
o The liquidity preference framework thus generates the conclusion that when income is rising during a
business cycle expansion (holding other economic variables constant), interest rates will rise.
o This conclusion is unambiguous, unlike the conclusion we reached using the bond demand and supply
framework.
 Changes in the Price Level
o When the price level rises, the value of money in terms of its purchasing power is lower.
o To restore their money’s purchasing power in real terms to its former level, people will want to hold a
greater nominal quantity of money.
o A higher price level shifts the demand curve for money to the right from M d 1 to Md 2
o The equilibrium moves from point 1 to point 2, where the equilibrium interest rate has risen from i1
to i2, illustrating that when the price level increases, with the supply of money and other economic
variables held constant, interest rates will rise
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XII.
Changes in the Money Supply
o An increase in the money supply due to expansionary monetary policy by the Bank of Canada will
shift the supply curve for money to the right.
o As shown in Figure 5-10 by the movement of the supply curve from Ms 1 to Ms 2, the equilibrium rate
moves from point 1 down to point 2, where the Ms 2 supply curve intersects with the demand curve
Md and the equilibrium interest rate has fallen from i1 to i2.
o When the money supply increases (everything else remaining equal), interest rates will decline
Does a Higher Rate of Growth of the Money Supply Lower Interest Rates?
 Liquidity effect: Liquidity preference framework suggests that an increase in the money supply will lower
interest rates:
 Income effect finds interest rates rising because increasing the money supply is an expansionary influence on
the economy
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o Since the demand curve shifts to the right
Price-level effect predicts an increase in the money supply leads to a rise in interest rates in response to the
rise in the price level
Since the demand curve shifts to the right Expected-inflation effect shows an increase in interest rates
because an increase in the money supply may lead people to expect a higher price level in the future
Since the demand curve shifts to the right
the liquidity effect dominates the other effects so that the interest rate falls from i1 at time T to a final level of
i2.
The liquidity effect operates quickly to lower the interest rate, but as time goes by, the other effects start to
reverse some of the decline.
Because the liquidity effect is larger than the others, however, the interest rate never rises back to its initial
level.
the liquidity effect is smaller than the other effects, with the expected inflation effect operating slowly
because expectations of inflation are slow to adjust upward.
Initially, the liquidity effect drives down the interest rate. Then the income, price-level, and expected-inflation
effects begin to raise it.
Because these effects are dominant, the interest rate eventually rises above its initial level to i2.
In the short run, lower interest rates result from increased money growth, but eventually they end up climbing
above the initial level.
the expected-inflation effect dominates and operates rapidly because people quickly raise their expectations
of inflation when the rate of money growth increases.
 The expected-inflation effect begins immediately to overpower the liquidity effect, and the interest rate
immediately starts to climb.
 Over time, as the income and price-level effects start to take hold, the interest rate rises even higher, and the
eventual outcome is an interest rate that is substantially higher than the initial interest rate.
 The result shows clearly that increasing money supply growth is not the answer to reducing interest rates;
rather, money growth should be reduced to lower interest rates!
 An important issue for economic policymakers is deciding which of these three scenarios is closest to reality.
o If a decline in interest rates is desired, then an increase in money supply growth is called for when the liquidity
effect dominates the other effects, as in panel (a).
o A decrease in money growth is appropriate when the other effects dominate the liquidity effect and expectations
of inflation adjust rapidly, as in panel (c).
o If the other effects dominate the liquidity effect but expectations of inflation are slow to adjust, as in panel (b),
then the decision to increase or decrease money growth depends on whether policymakers are more concerned
about short-term or long-term issues.
 Which scenario is supported by the evidence?
o
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o
o
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The relationship between interest rates and money growth from 1968 to 2014 is plotted in Figure 5-12 . When the
rate of money supply growth began to climb in the late 1970s, interest rates rose, indicating that the liquidity
effect was dominated by the price-level, income, and expected-inflation effects.
By the early 1980s, interest rates reached levels unprecedented in the post–World War II period, as did the rate of
money supply growth.
The scenario depicted in panel (a) of Figure 5-11seems doubtful, and the case for lowering interest rates by raising
the rate of money growth is much weakened.
Looking back at Figure 5-5 , which shows the relationship between interest rates and expected inflation, you
should not find this too surprising.
The rise in the rate of money supply growth in the 1960s and 1970s is matched by a large rise in expected inflation,
which would lead us to predict that the expected-inflation effect would be dominant.
It is the most plausible explanation for why interest rates rose in the face of higher money growth.
However, Figure 5-12does not really tell us which one of the two scenarios depicted in panels (b) and (c) of Figure
5-11is more accurate.
It depends critically on how fast people’s expectations about inflation adjust.
Research done using more sophisticated methods than just looking at a graph like Figure 5-12 indicates that
increased money growth temporarily lowers short-term interest rates and thus conforms to the scenario in panel
(b).
 Short-Answer-type Question: Are interest rates are procyclical?
o Both the liquidity preference framework and the supply and demand for bonds framework can show that interest
rates are procyclical (i.e., rising when the economy is expanding and falling during recessions; Use incomes, y, and
investment opportunities as proxy for economic growth.
o You need to explain shifts in demand or supply curves for bonds or changes in money demand.
 Explain why you would be more or less willing to buy long-term Air Canada bonds under the following circumstances:
o Trading in these bonds increases, making them easier to sell.
 More, because the bonds have become more liquid.
o You expect a bear market in stocks (stock prices are expected to decline).
 More, because their expected return has risen relative to stocks.
o Brokerage commissions on stocks fall.
 Less, because they have become less liquid relative to stocks.
o You expect interest rates to rise.
 Less, because their expected return has fallen
o Brokerage commissions on bonds fall.
 More, because they have become more liquid
 Raphael observes that at the current level of interest rates there is an excess supply of bonds, and therefore he
anticipates an increase in the price of bonds. Is Raphael correct?
o Raphael is incorrect.
o
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If at the current level of interest rates there is an excess supply of bonds, the supply and demand analyses tells us
that interest rates will increase, creating a movement along both the demand curve (in the southeast direction)
and the supply curve (in the southwest direction) in order to reach the equilibrium interest rate (and price).
o The bond’s price will therefore fall, and the interest rate will rise to the equilibrium level.
Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial
market regulations. Can you describe the expected effect on interest rates?
o If many big corporations decide not to issue bonds because of new financial markets regulations, this will affect
the supply curve.
o The impact will translate into a shift to the left in the supply curve, increasing bonds’ prices (lowering interest
rates) and lowering the quantity of bonds bought and sold in the market.
In the aftermath of the global economic crisis that started to take hold in 2008, Canadian government budget deficits
increased dramatically, yet interest rates on Canada bonds fell sharply and stayed low for quite some time. Does this
make sense? Why or why not?
o Given the answer to question above, the supply effect of large deficits should lead to higher interest rates.
o The effects of the economic crisis led to significantly lower wealth and income, which depressed Canada bond
demand but also decreased corporate bond supply by even more because investment opportunities collapsed.
o The larger leftward shift in the bond supply curve than the rightward shift in the bond demand curve would then
result in a rise in bond prices and a fall in interest rates.
o In addition, due to the severity of the global crisis, Canadian government debt became a safe haven investment,
reducing relative risk and increasing liquidity for Canadian government debt.
o This significantly raised Canada bond demand, leading to higher bond prices and significantly lower yields.
o In other words, the decrease in investment opportunities and risk factors significantly offset the wealth effect on
demand and the deficit effect on supply.
If the next governor of the Bank of Canada has a reputation for advocating an even slower rate of money growth than
the current governor, what will happen to interest rates? Discuss the possible resulting situations.
o Slower rate of money growth will lead to a liquidity effect, which raises interest rates, while the lower price level,
income, and inflation rates in the future will tend to lower interest rates.
o There are three possible scenarios for what will happen:
(a) if the liquidity effect is larger than the other effects, then interest rates will rise;
(b) if the liquidity effect is smaller than the other effects and expected inflation adjusts slowly, then interest rates
will rise at first but will eventually fall below their initial level; and
(c) if the liquidity effect is smaller than the expected-inflation effect and there is rapid adjustment of expected
inflation, then interest rates will immediately fall.
An important way in which the Bank of Canada decreases the money supply is by selling bonds to the public. Using a
supply and demand analysis for bonds, show what effect this action has on interest rates. Is your answer consistent with
what you would expect to find with the liquidity preference framework?
o When the Bank sells bonds to the public, it increases the supply of bonds, thus shifting the
supply curve Bs to the right.
o The result is that the intersection of the supply and demand curves Bs and Bd occurs at a
lower price and a higher equilibrium interest rate, and the interest rate rises.
o With the liquidity preference framework, the decrease in the money supply shifts the money
supply curve Msto the left, and the equilibrium interest rate rises. The answer from bond
supply and demand analysis is consistent with the answer from the liquidity preference
framework.
 Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates
are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?
o In the bond supply and demand analysis, the increased riskiness of bonds lowers the demand for
bonds. The demand curve Bd shifts to the left, and the equilibrium interest rate rises.
o The same answer is found in the liquidity preference framework.
o The increased riskiness of bonds relative to money increases the demand for money.
o The money demand curve Md shifts to the right, and the equilibrium interest rate rises.
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Chapter 6 - The Risk and Term Structure of Interest Rates
Risk Structure of Interest Rates
Bond yields differ (sometimes substantially) across bonds of similar maturity
Key factors:
o Risk of default (often referred to as credit risk)
 Default occurs when the issuer of the bond is unable or unwilling to make interest payments
when promised or to pay off the face value when the bond matures.
 Corporations suffering big losses might be more likely to suspend interest payments on their
bonds.
 The default risk on their bonds would therefore be quite high.
 By contrast, Canadian government bonds have usually been considered to have no default
risk because the federal government can always increase taxes or print money to pay off its
obligations.
 Bonds like these with no default risk are called default-free bonds.
 The spread between interest rates on bonds with default risk and interest rates on defaultfree bonds, both of the same maturity, is called the risk premium. The risk premium
indicates how much additional interest people must earn to be willing to hold the risky bond.
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If the possibility of a default increases because a corporation begins to suffer large losses,
the default risk on corporate bonds will increase, and the expected return on these bonds
will decrease. In addition, the corporate bond’s return will be more uncertain.
The theory of portfolio choice predicts that because the expected return on the corporate
bond falls relative to the expected return on the default-free Canada bond while its relative
riskiness rises, the corporate bond is less desirable (holding everything else equal), and
demand for it will fall.
Another way of thinking about this is that if you were an investor, you would want to hold
(demand) a smaller amount of corporate bonds. The demand curve for corporate bonds in
panel (a) of Figure 6- 2then shifts to the left, from Dc 1 to Dc 2.
At the same time, the expected return on default-free Canada bonds increases relative to
the expected return on corporate bonds, while their relative riskiness declines.
The Canada bonds thus become more desirable, and demand rises, as shown in panel (b) by
the rightward shift in the demand curve for these bonds from D T 1 to DT2.
As we can see in Figure 6- 2 , the equilibrium price for corporate bonds falls from
Pc 1 to Pc 2, and since the bond price is negatively related to the interest rate, the equilibrium
interest rate on corporate bonds rises to i c 2.
At the same time, however, the equilibrium price for the Canada bonds rises from
o
o
PT 1 to PT 2 and the equilibrium interest rate falls to i T 2.
 The spread between the interest rates on corporate and default-free bonds—that is, the risk
premium on corporate bonds—has risen from zero to ic2 - i T 2.
 We can now conclude that a bond with default risk will always have a positive risk premium,
and an increase in its default risk will raise the risk premium.
 Because default risk is so important to the size of the risk premium, purchasers of bonds
need to know whether a corporation is likely to default on its bonds.
Liquidity: the ease with which an asset can be converted into cash
 cost of selling a bond
 number of buyers/sellers in a bond market
 a liquid asset is one that can be quickly and cheaply converted into cash if the need arises.
 The more liquid an asset is, the more desirable it is (holding everything else constant).
 Canada bonds are the most liquid of all long-term bonds because they are so widely traded
that they are the easiest to sell quickly and the cost of selling them is low.
 Corporate bonds are not as liquid because fewer bonds for any one corporation are traded;
thus it can be costly to sell these bonds in an emergency because it may be hard to find
buyers quickly.
 How does the reduced liquidity of corporate bonds affect their interest rates relative to the
interest rate on Canada bonds?
 We can use supply and demand analysis with the same figure that was used to analyze the
effect of default risk, Figure 6- 2 , to show that the lower liquidity of corporate bonds relative
to Canada bonds increases the spread between the interest rates on these two bonds.
 Let us start the analysis by assuming that initially corporate and Canada bonds are equally
liquid and all their other attributes are the same.
 As shown in Figure 6- 2 , their equilibrium prices and interest rates will initially be equal: Pc 1
= PT 1 and i c 1 = i T 1.
 If the corporate bond becomes less liquid than the Canada bond because it is less widely
traded, then (as the theory of portfolio choice indicates) demand for it will fall, shifting its
demand curve from Dc 1 to Dc 2, as in panel (a).
 The Canada bond now becomes relatively more liquid in comparison with the corporate
bond, so its demand curve shifts rightward from D T 1 to DT 2 , as in panel (b).
 The shifts in the curves in Figure 6- 2show that the price of the less liquid corporate bond
falls and its interest rate rises, while the price of the more liquid Canada bond rises and its
interest rate falls.
 The result is that the spread between the interest rates on the two bond types has risen.
 Therefore, the differences between interest rates on corporate bonds and Canada bonds
(that is, the risk premiums) reflect not only the corporate bond’s default risk but its liquidity
too.
 This is why a risk premium is more accurately a “risk and liquidity premium,” but convention
dictates that it be called a risk premium
Tax considerations: interest payments on U.S. municipal bonds are exempt from federal income taxes
 Default Risk: probability
that the issuer of the bond
is unable or unwilling to
make interest payments or
pay off the face value
o
Government of
Canada bonds are
considered default-free bonds (since the government can always raise taxes to pay interest and the
face value of bond)
 (Credit) Risk Premium: the spread between the interest rates on bonds with default risk and the interest rates
on (same maturity) Canada bonds
 Credit-rating agencies assess and grade risk
 Bond Ratings by DBRS, Moody’s, S&P and Fitch Question: Which should have the higher risk premium on its interest
rates, a corporate bond with a DBRS AA rating or a corporate bond with a BBB rating?
 If junk bonds are “junk,” then why do investors buy them?
Junk bonds are referred to as “junk” in that they are very risky investments but provide high yields to investors who buy
them at very low prices and are therefore compensated with a high-risk premium
 S&P’s probabilities of default, by rating and term to maturity
 Increase in Default Risk…
 Practice question: In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of
defaulting due to the severity of the global financial crisis.
▪ As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake.
▪ How would this affect, if at all, the yield and risk premium on AIG corporate debt?
▪ The risk of default would significantly decrease demand for AIG corporate debt, resulting in a much higher yield.
▪ But, after the announcement that the government would provide extraordinary assistance to support AIG and
keep it from failing, demand for its corporate debt would rise and yields would fall.
II.
Term Structure of Interest Rates
 Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to
maturity is different
 Yield Curve: a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerations
 Upward-sloping: long-term rates are above short-term rates
 Flat: short- and long-term rates are the same
 Inverted: long-term rates are below short-term rates
 Movements over Time of Interest Rates on Government of Canada Bonds with Different Maturities
 Practice Question: Risk premiums on corporate bonds are usually anticyclical (or “counter-cyclical” vs. “pro-cyclical”)
▪ They decrease during business-cycle expansions and increase during recessions. Why is this so?
▪ During business-cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds,
which lowers their risk premium.
▪ Conversely, during recessions, default risk on corporate bonds increases and their risk premium increases.
▪ The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.
III.
The Theory of the Term Structure of Interest Rates Must Explain:
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
IV.
Three Theories to Explain the Three Facts
1. Expectations theory
▪ Explains the first two facts but not the third
▪ 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
▪ According to the theory, 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
▪ Bond holders consider bonds with different maturities to be perfect substitutes
 Example:
▪ Let the current rate on one-year bond be 9%
▪ You expect the interest rate on a one-year bond issued next year to be 11%
▪ Then the expected return for buying two one-year bonds averages (9% + 11%)/2 = 10%
▪ The current interest rate on a two-year bond must be 10% for you to be willing to purchase it
2.
3.
▪ Explains why the term-structure of interest rates changes at different times
▪ Explains why interest rates on bonds with different maturities move together over time
▪ Explains why yield curves tend to slope up when short-term rates are low and slope down when short-term rates are high
▪ Cannot explain why yield curves usually slope upward
Segmented markets theory
▪ Explains fact number three but not the first two facts
▪ Bonds of different maturities are not substituting at all
▪ The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond
▪ Investors have preferences for bonds of one maturity over another
▪ If investors generally prefer bonds with shorter maturities that have less interest rate risk, then this explains why yield
curves usually slope upward
Liquidity premium theory
▪ Combines the two theories to explain all three facts
▪ The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over
the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that
bond
▪ Liquidity premium also referred to as a term premium
▪ Bonds of different maturities are partial (not perfect) substitutes
V.
“Preferred Habitat” Theory
▪ Closely related to the liquidity premium theory
▪ Investors have a preference for bonds of one maturity over another
▪ They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return
▪ Investors are likely to prefer short-term bonds over longer-term bonds
VI.
Liquidity Premium and Preferred Habitat Theories
▪ Interest rates on different bonds move together
▪ Explained by first term in the equation
▪ Yield curves slope upward when short-term rates are low and downward when short-term rates are high
▪ Explained by the liquidity premium term, 𝑙𝑛𝑡, in the first case and by a low expected average interest rates in the second
case
▪ Yield curves typically slope upward
▪ Explained by a larger liquidity premium as the term to maturity lengthens
 Yield Curves and the Market’s Expectations of Future Short-Term Interest Rates According to the Liquidity Premium
(Preferred Habitat) Theory
(a) indicates that short-term interest rates are
expected to rise in the future. A moderately
steep yield curve
(b) indicates that short-term interest rates are
not expected to rise or fall much in the future. A
flat yield curve,
(c) indicates that short-term rates are expected
to fall moderately in the future. Finally, an
inverted yield curve,
(d) indicates that short-term interest rates are
expected to fall sharply in the future.
 Practice Question
▪ If a yield curve looks like the one shown in the figure
to the right, what is the market predicting about the
movement of future short-term interest rates?
▪ What might the yield curve indicate about the
market’s predictions for the inflation rate in the future?
▪ According to the Expectations Theory: The flat yield
curve at shorter maturities suggests that short-term
interest rates are expected to stay relatively flat in the near future, while the steep upward slope of the yield curve at
longer maturities indicates that interest rates further into the future are expected to rise.
▪ But, what if there exists a liquidity premium?
1. If junk bonds are “junk,” then why do investors buy them?
Junk bonds are referred to as “junk” in that they are very risky investments but provide high yields to investors
who buy them at very low prices and are therefore compensated with a high-risk premium.
2. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting
due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG
with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk
premium on AIG corporate debt?
The risk of default would significantly decrease demand for AIG corporate debt, resulting in a much higher yield.
After the announcement that the government would provide extraordinary assistance to support AIG and keep
it from failing, demand for its corporate debt would rise and yields would fall.
3. Just before the collapse of the U.S. subprime mortgage market in 2007, the most important credit-rating agencies
rated mortgage-backed securities with Aaa and AAA ratings. Explain how it was possible that a few months into 2008,
the same securities had the lowest possible ratings. Should we always trust credit-rating agencies?
Historically, mortgage -backed securities were considered low-risk assets, since homeowners had the highest incentives to
pay their mortgages (otherwise they might lose their home).
However, after standards on lending practices decreased during the first years of the new century, many individuals were
able to buy a house but not to make their mortgage payments.
This resulted in poor quality mortgage-backed securities that should never have had such good ratings.
Both Standard and Poor’s and Moody’s were investigated for assigning such good ratings and therefore misleading
investors in buying these instruments. Sometimes credit-rating agencies also make mistakes in assigning risks.
4. During 2008, the difference in yield (the yield spread) between three-month AA-rated financial commercial paper and
three-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to
over a full percentage point at its peak in October 2008. What explains this sudden increase?
The global financial crisis hit financial companies very suddenly and very hard, creating much uncertainty about the
soundness of the financial system and doubt about the soundness of even the most healthy banks and financial companies.
As a result, there was a sharp decrease in demand for financial commercial paper relative to the seemingly safer
nonfinancial commercial paper.
This resulted in a spike in the yield spread between the two, reflecting the greater risk of financial company investments.
5. If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of
future short -term interest rates? What might the yield curve indicate about the market’s predictions for the inflation
rate in the future?
The flat yield curve at shorter maturities suggests that short- term interest rates are expected to fall moderately in the near
future, while the steep upward slope of the yield curve at longer maturities indicates that interest rates further into the
future are expected to rise.
Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to
fall moderately in the near future but to rise later on.
6. If expectations of future short-term interest rates suddenly fell, what would happen to the slope of the yield curve?
The slope of the yield curve would fall because the drop in expected future short rates means that the average of expected
future short rates falls so that the long rate falls.
7. Suppose that the Bank of Canada made an announcement that it would purchase up to $300 billion of longer-term
Canada securities over the following six months. What effect might this policy have on the yield curve?
If the Bank of Canada purchases a significant amount of longer-term government debt, this will reduce the effective supply
of bonds of those particular maturities, resulting in a higher price and lower yield.
This should have the effect of lowering the “long end” of the curve, decreasing medium and longer-term yields. In other
words, the yield curve will shift down, but mostly on medium- and long-term maturities.
8. In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond
market graphs, compare the effects on the risk premium between U.S. Treasury debt and comparable-maturity Greek
debt.As the risk of default by the Greek government increased, this reduced the demand for Greek bonds relative to U.S.
Treasuries. The result was lower prices and higher yields of Greek debt relative to U.S. debt, similar to the graphs in
Figure 6-2 shown in the text.