Interest rate

Interest Rate Risks

Interest rate risk refers to the change in the price of a bond for a given change in yield to maturity. Bonds have interest rate risk, because the yield to maturity at a given point in time changes with market interest rates.

Investors risk the default of the bond, the value of the payments relative to inflation, the value of the payments' reinvestment rates, and the payments over the time to maturity.

Examples of different types of interest rate risks are:

• Default risk: The bond issuer will not be able to repay the interest, the principle, or both.

• Inflation risk: The value of payments and the principle decline because of unanticipated inflation.

• Reinvestment risk: The value of the payment might earn a lower return than the original bond.

• Maturity risk: Over time, more risks can occur to the payment stream of a bond.

• Liquidity risk: This is the preference of investors to risk short-term versus long-term.

Investor perception on the risk of bonds will raise their desired return, the interest rate, resulting in falling bond prices. The consequent shift in investor holdings based on risk from stocks to bonds or vice versa is called “flight to quality.”

Bonds are rated with respect to default risk. Third-party companies that are independent of the bond issuer rate the bonds' default risk. Each of these companies uses letters to rank the company. The conventions on the financial markets use the company ratings to grade the debt.

• Investment grade: The debt has a high rating.

• Speculative (junk) grade: The debt has a low rating.

The higher the rating, the lower the default risk, and thus, the lower the interest rate. From a management point of view, this reduces cost of financing. The lower risk is preferred by some investors.

Yield Curve

The structure of interest rates is the term referring to the relationship between interest rates and maturity of securities. In its graphical representation, it is called the yield curve. The term structure refers to the relationship among various maturities of the same type of security. The term yield curve represents the graphical relationship between yield and maturity. Yield is measured on the vertical axis, and term to maturity is measured on the horizontal axis.

Does the yield curve slope upward, downward, or is it horizontal? In reality, the yields on all maturities tend to move together, but there are distinct, divergent patterns in short-term and long-term movements.

The term structure of interest rates, also called the yield curve, is the relationship between interest rates or yields and the time to maturity for debt securities of similar risks. The structure is constructed by graphing the yield to maturities and the respective maturity dates of a set of benchmark fixed-income securities.

The yield curve is a measure of the market's expectations of future interest rates based on current market conditions. Treasuries, which are issued by the federal government, are considered risk free, and their yields are often used as the benchmarks for fixed-income securities with the same maturities.

The term structure of interest rates is graphed as though each coupon payment of a non-callable fixed-income security were a zero-coupon bond that matures on the coupon payment date. The exact shape of the curve can differ at various points in time. When the normal yield curve changes shape, it indicates that investors may need to reconsider their investment decisions.

The Pure Expectations Theory

The pure expectations theory is one of the theories describing the term structure of interest rates. Under this theory, the rates on long-term securities can be derived as a function of short-term securities. As a result, short-term and long-term securities are good substitutes for each other in investment portfolios.

There are no separate markets for short-term and long-term securities. Investors are interested in the return over a period and not the maturity date of the final payment. This implies that the expectation of future short-term rates is a determining factor in long-term rates.

Buying and selling activities exert pressure on the long-term rate, which is an average of the current short-term rate and the expected future short-term rates. If expected future short-term rates are more than the current short-term rates, the yield curve will slope upward. Lower expected short-term rates will cause the curve to slope downward. The yield curve is the plot of the yield versus the maturity of interest bearing securities.

One-year and two-year rates are called spot rates because they are the prevailing rates today. The one-year rate one year from today is called the forward rate.

• Interest rate risk: A bondholder wants a return on the risk of holding a bond. The management wants to minimize the cost of funds. The higher the risk, the more the investor wants to be compensated for taking the risk and thus offers a lower price.

• Term structure of interest rates: This reveals the relationship between an interest bearing security and its maturity.

• Yield curve: This is the plot of the yield versus the maturity of interest bearing securities.

• Pure expectations theory: This theory suggests that the shape of the yield curve is based on the expectations of long interest rates being equal to those of a series of short-term interest rates.

• Historical or average return: This is the mathematical average of historical returns.

• Expected return: The expected return is the weighted average of the expected returns and their respective probabilities.