Risk, Return and Interest Rates Assoc. Prof. Hülya Hazar

1.

BUS 362 Financial Institutions and
Markets
Week 4: Risk, Return and Interest Rates
Assoc. Prof. Hülya Hazar
Faculty of Economics and Administrative Sciences, Department of
Business Administration
[email protected]
1

2.

Financial Institutions and Markets
1. Risk Structure of Interest Rates
2. Term Structure of Interest Rates
ue.aydin.edu.tr
2

3.

Financial Institutions and Markets
Risk Structure of Interest Rates
• Risk factors
• Default Risk
• Liquidity
• Income Tax Considerations
ue.aydin.edu.tr
3

4.

Financial Institutions and Markets
Default risk: The debtor is unable or unwilling to make interest
payments when promised.
Default-free bonds: Bonds with no default risk are called
default-free bonds.
Risk premium:
• The spread between the interest rates on bonds with default
risk and default-free bonds, called the risk premium.
• It indicates how much additional interest people must earn in
order to be willing to hold that risky bond.
• Default risk is an important component of the size of the risk
premium.
• Because of this, bond investors would like to know as much
as possible about the default probability of a bond.
ue.aydin.edu.tr
4

5.

Financial Institutions and Markets
Bond Ratings by Moody’s and Standard and Poor’s
ue.aydin.edu.tr
5

6.

Financial Institutions and Markets
Liquidity
• 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.
• The differences between interest rates reflect its liquidity too.
ue.aydin.edu.tr
6

7.

Financial Institutions and Markets
Income Tax Considerations
• Interest payments on government bonds are exempt from
income taxes, a factor that increases in their expected
return.
• Interest payments from corporate bonds are fully taxable.
ue.aydin.edu.tr
7

8.

Financial Institutions and Markets
Term Structure of Interest Rates
• Maturity : The number of years (term) until the expiration date.
• Different maturities have different interest rates
• Yield curve: rates at different maturities
ue.aydin.edu.tr
8

9.

Financial Institutions and Markets
Three Theories of Term Structure:
1.
2.
3.
Expectations Theory
Market Segmentation Theory
Liquidity Premium Theory
ue.aydin.edu.tr
9

10.

Financial Institutions and Markets
Expectations Theory:
• The long-term interest rate is the average of the current and
expected future short-term rates.
• For example, the yield to maturity on a five-year bond is the
average of the current and expected future short-term rate
for the next five years.
• The expected wealth is the same at the start. The actual
wealth may differ, if rates change unexpectedly after a year.
• The theory also believes that because people make
decisions based on the available information at hand
combined with their past experiences, most of the time their
decisions will be correct.
ue.aydin.edu.tr
10

11.

Financial Institutions and Markets
Market Segmentation Theory:
• Long and short-term interest rates are not related to each
other.
• Interest rates for short, intermediate, and long-term bonds
should be viewed separately like items in different markets
for debt securities.
• People typically prefer short holding periods and thus have
higher demand for short-term bonds, which have higher
prices and lower interest rates than long-term bonds.
• Market segmentation seeks to identify targeted groups of
consumers to tailor products and branding in a way that is
attractive to the group. Markets can be segmented in several
ways such as geographically, demographically, or
behaviorally.
ue.aydin.edu.tr
11

12.

Financial Institutions and Markets
Liquidity Premium Theory:
• People do prefer liquid assets more often due to fewer risks
in short-term assets.
• It means lesser risks like default risk.
• Investors prefer short-term rather than long-term bonds. This
implies that investors must be paid positive liquidity premium
to hold long term bonds.
ue.aydin.edu.tr
12

13.

Subjects Covered
1. Risk Structure of Interest Rates
2. Term Structure of Interest Rates
ue.aydin.edu.tr
13

14.

References
Readings:
Chapter 5
Reference Book:
Mishkin, Frederic S. Financial Markets and Institutions. Eighth Edition.
UK: Pearson, 2016.
ue.aydin.edu.tr
14

15.

Financial Institutions and Markets
See you next week…
ue.aydin.edu.tr
15