FIN320 Midterm Study Guide （need to complete within 5 hours）

Risk and Term Structure of Interest Rates

Professor Lamont Black FIN320 Week 4

The Universe of Interest Rates •  How is the universe of interest rates related to the risk- free rate?

•  The “risk premium” –  Spreads at same maturity

•  The “term premium” –  A “long” rate minus a “short” rate –  What explains the term premium? –  Why has it been so small since the crisis? –  Can it be negaOve?

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Risk Premium

•  The “risk structure of interest rates” describes the relaOonship among the interest rates on bonds that have different characteris-cs but the same maturity – i.e., “comparables” – no difference in interest rate risk

•  If same maturity, than difference in risk and spread is difference in default risk…

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Default Risk •  Bonds differ in default risk (i.e., credit risk) which is the risk that the issuer will fail to make a payment (interest or principal)

•  “Default risk premium” (i.e., credit risk premium) is difference between interest rate on bond and the interest rate on a comparable Treasury (same maturity) – Spread relaOve to comparable risk-free rate

•  Premium depends on current price of risk 4

Measuring Default Risk •  There are many tools for measuring default risk

–  “credit risk modeling”

•  StaOsOcal model to predict default based on borrower data –  E.g., regression analysis on historical outcomes

•  Consumer credit example: FICO score is “credit score” –  High FICO: low probability of default –  Low FICO: high probability of default

•  Every lender has its own internal staOsOcal methodology for measuring credit risk

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Credit RaOngs Agencies •  Credit ra-ngs agencies provide informaOon about the creditworthiness of corporaOons or governments that issue bonds –  Moody’s, S&P, Fitch

•  Private, for-profit enOOes that are recognized by SEC –  “NaOonally recognized staOsOcal raOng organizaOons” (NRSRO)

–  h_ps://www.sec.gov/ocr/ocr-current-nrsros.html

•  Moody’s, S&P, and Fitch are “sell side” raOngs agencies •  Egan-Jones is a “buy side” raOngs agency

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Credit RaOngs

•  A bond’s credit ra-ng is a single staOsOc that summarizes a raOng agency’s opinion of issuer’s likely ability to make payments

•  RaOngs on publicly-traded debt

•  A “summary staOsOc” of default risk

•  Sell side raOngs are assigned prior to issuance

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Credit RaOngs

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Blank Moody’s Investors Service

Standard & Poor’s (S&P) Fitch Ra-ngs Meaning of the ra-ngs

Investment grade bonds

Aaa AAA AAA Highest credit quality

Blank Aa AA AA Very high credit quality

Blank A A A High credit quality

Blank Baa BBB BBB Good credit quality

Noninvestment grade bonds Ba BB BB SpeculaOve

Blank B B B Highly speculaOve

Blank Caa CCC CCC SubstanOal default risk

Blank Ca CC CC Very high levels of default risk

Blank C C C ExcepOonally high levels of default risk (for Moody’s: “typically in default”)

Blank — D D Default

Segments of the Bond Market •  Investment Grade bond market

•  Other names for the lower segment of the bond market –  Non-Investment Grade bonds –  High yield bonds –  Junk bonds

•  “CCC is junkiest of the junk” –  Leveraged market (risky because of the leverage)

•  Bonds and leveraged loans

•  Risks of non-IG –  “Yield tourists” (don’t really understand risks) –  A different kind of interest rate risk

•  Rising rates lead to defaults

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Default Risk and Risk Premium

•  Think about this across countries as well 10

Risk Premium and Recessions

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Two Versions of Risk Premium

•  Risk premium can be calculated as Aaa corporate bond yield minus 10-year treasury yield

OR

•  Baa corporate bond yield minus Aaa corporate bond yield

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Risk Premium

Risk Premium: Baa - Aaa

Other Factors in Same-Maturity Yields

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An increase in a bond’s … causes its yield to … because …

default risk rise investors must be compensated for bearing addiOonal risk.

liquidity fall investors incur lower costs in selling the bond.

informaOon costs rise investors must spend more resources to evaluate the bond.

tax liability rise investors care about amer-tax returns and must be compensated for paying higher taxes.

Conflicts of Interest

•  Do credit raOngs agencies have conflicts of interest?

•  What is the role of compeOOon?

•  How can this be addressed?

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Term Premium (Yield Curve)

•  The “term structure of interest rates” describes the relaOonship among the interest rates on bonds that are otherwise similar but have different maturi-es

•  Treasury “yield curve” – Treasury bills, notes, bonds – From weeks to 30 years – Starts at “overnight”

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Two Examples from the U.S.

•  “expectaOons of future short-term interest rates” •  Usually upward sloping

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Sovereign Bond Market •  Every country that issues sovereign bonds has its own yield curve

•  Central bank policy sets the overnight rate

•  Central bank policy influences the short-end of the yield curve

•  Investor behavior influences the long-end of the yield curve

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Long and Short Rate over the Years

•  Some inversions •  Post-crisis fla_ening

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ExpectaOons Theory

•  ExpectaOons theory of the term structure: the long-term rate is an average of expecta-ons for the short-term rate over the same amount of Ome

•  AssumpOon: investors seek highest return

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ExpectaOons Theory Example You invest $1,000 for two years and are considering one of two strategies: 1.  The buy-and-hold strategy. You buy a two-year bond and hold it unOl maturity.

Amer two years, the $1,000 investment will have grown to

$1,000(1 + i2t)(1 + i2t)

2.  The rollover strategy. You buy a one-year bond today and roll it over

Amer two years, you will expect your $1,000 investment to have grown to

$1,000(1 + i1t) (1 + ie1,t+1) With the rollover strategy, you must form an expectaOon of what the interest rate on the one-year bond will be.

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ExpectaOons Theory Example The expectaOons theory assumes that the returns from the two strategies must be the same (Arbitrage)

This means: For an n-year bond, the interest rate is:

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2 2 1 1 1$1,000(1 )(1 ) $1,000(1 )(1 ). e

t t t ti i i i ++ + = + +

i2t = i1t + i1,t+1

e

2 .

int = i1t + i1t+1

e + i1t+2 e + i1t+3

e ..+ i1t+(n−1 e

n .

ExpectaOons and Yield Curve

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Other ExplanaOons of Yield Curve

•  Segmented markets: short-market and long-market are separate (different investors)

•  Liquidity premium theory –  Investors prefer bonds with short maturiOes (more liquid) –  Longer-term bonds have a term premium –  Upward sloping yield curve

.

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1 1 1 2 2 ,2

e TPt t

t t i i

i i+ +

= +

Yield Curve and the Business Cycle

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Current Yield Curve

•  What is the shape of the current yield curve?

•  How is it changing?

•  What might explain this?

•  What is the role of investors?

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Term Premium

Term Premium: 10 Year – 2 Year

Fla_ening Yield Curve

•  Fed is raising short-term interest rates •  But long-term rates are not rising as much •  This produces a fla_ening yield curve

•  Should we be worried?

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