The table and graph below provide data on a hypothetical US Treasury yield curve along with hypothetical corporate yield curves for AA- and B-rated bonds. a. Describe the shape of the Treasury yield curve using appropriate terminology. (Hint: see page 226-227 of the textbook for terms.) b. Describe your expectation regarding future inflation in the economy, based on the observed Treasury yield curve. c. Justify to what extent you think the other three MILD factors (maturity, liquidity, and default risk) are present in the Treasury yield curve. d. What is a likely reason that the corporate yield curves are upward sloping when the Treasury yield is not? e. What is your estimate of the default spread contribution for AA- and B-rated bonds?

b. Describe your expectation regarding future inflation in the economy, based on the observed Treasury yield curve. c. Justify to what extent you think the other three MILD factors (maturity, liquidity, and default risk) are present in the Treasury yield curve d. What is a likely reason that the corporate yield curves are upward sloping when the Treasury yield is not? e. What is your estimate of the default spread contribution for AA- and B-rated bonds Treasury rate 2.61 2.55 Time to maturity 1 month 2 months 3 months 6 months 2.39 2.25 2.18 2.31 2.41 2.52 2.78 3.02 AA Corporate rate 4.22 4.21 4.21 4.34 4.35 4.21 4.39 4.55 4.89 5.25 6.38 7.25 B Corporate rate 5.41 5.42 5.43 5.44 5.48 5.68 5.98 6.05 6.25 6.62 7.72 8.65 1 year 2 years 3 years 5 years 7 years 10 years 20 years Yield Curves 10 9 6 5 2 0 5 10 15 20 30 35 --Treasury tale --AA Corporate -- Corporaterale SELF-TEST Which bond usually will have a higher liquidity premium: one issued by a large company or one issued by a small company? 5-13 The Term Structure of Interest Rates The term structure of interest rates describes the relationship between long-term and short-term rates. The term structure is important both to corporate treasurers deciding whether to borrow by issuing long-term or short-term debt and to investors who are deciding whether to buy long-term or short-term bonds Interest rates for bonds with different maturities can be found in a variety of publications, including The Wall Street Journal and the Federal Reserve Bulletin, as well as on a number of Web sites, including Bloomberg, Yahoo!, CNN Financial, and the Federal Reserve Board. Using interest rate data from these sources, we can determine the term structure at any given point in time. For example, Figure 5-5 presents interest rates for different maturities on three different dates. The set of data for a given date, when plotted on a graph such as Figure 5-5, is called the yield curve for that date. 16 14 Yield Curve for March 1980 12 10 Yield Curve for February 2000 Yield Curve for March 2015 10 15 20 25 30 Years to Maturity As the figure shows, the yield curve changes both in position and in slope over time. In March 1980, all rates were quite high because high inflation was expected. However, the rate of inflation was expected to decline, so the inflation premium (IP) was larger for short-term bonds than for long-term bonds. This caused short-term yields to be higher than long-term yields, resulting in a downward-sloping yield curve. By February 2000, inflation had indeed declined and thus all rates were lower. The yield curve had become humped-medium-term rates were higher than either short- or long-term rates. In March 2015, all rates were below the 2000 levels. Because short-term rates had dropped below long-term rates, the yield curve was upward sloping Historically, long-term rates are generally higher than short-term rates owing to the maturity risk premium, so the yield curve usually slopes upward. For this reason, people often call an upward-sloping yield curve a normal yield curve and a yield curve that slopes downward an inverted yield curve or an abnormal yield curve. Thus, in Figure 5-5 the yield curve for March 1980 was inverted, whereas the yield curve in March 2015 was normal. As stated earlier, the February 2000 curve was humped. A few academics and practitioners contend that large bond traders who buy and sell securities of different maturities each day dominate the market. According to this view, a bond trader is just as willing to buy a 30-year bond to pick up a short-term profit as to buy a 3-month security. Strict proponents of this view argue that the shape of the yield curve is therefore determined only by market expectations about future interest rates, a position that is called the pure expectations theory, or sometimes just the expectations theory. If this were true, then the maturity risk premium (MRP) would be zero and long- term interest rates would simply be a weighted average of current and expected future short-term interest rates. See Web Extension 5D for a more detailed discussion of the expectations theory b. Describe your expectation regarding future inflation in the economy, based on the observed Treasury yield curve. c. Justify to what extent you think the other three MILD factors (maturity, liquidity, and default risk) are present in the Treasury yield curve d. What is a likely reason that the corporate yield curves are upward sloping when the Treasury yield is not? e. What is your estimate of the default spread contribution for AA- and B-rated bonds Treasury rate 2.61 2.55 Time to maturity 1 month 2 months 3 months 6 months 2.39 2.25 2.18 2.31 2.41 2.52 2.78 3.02 AA Corporate rate 4.22 4.21 4.21 4.34 4.35 4.21 4.39 4.55 4.89 5.25 6.38 7.25 B Corporate rate 5.41 5.42 5.43 5.44 5.48 5.68 5.98 6.05 6.25 6.62 7.72 8.65 1 year 2 years 3 years 5 years 7 years 10 years 20 years Yield Curves 10 9 6 5 2 0 5 10 15 20 30 35 --Treasury tale --AA Corporate -- Corporaterale SELF-TEST Which bond usually will have a higher liquidity premium: one issued by a large company or one issued by a small company? 5-13 The Term Structure of Interest Rates The term structure of interest rates describes the relationship between long-term and short-term rates. The term structure is important both to corporate treasurers deciding whether to borrow by issuing long-term or short-term debt and to investors who are deciding whether to buy long-term or short-term bonds Interest rates for bonds with different maturities can be found in a variety of publications, including The Wall Street Journal and the Federal Reserve Bulletin, as well as on a number of Web sites, including Bloomberg, Yahoo!, CNN Financial, and the Federal Reserve Board. Using interest rate data from these sources, we can determine the term structure at any given point in time. For example, Figure 5-5 presents interest rates for different maturities on three different dates. The set of data for a given date, when plotted on a graph such as Figure 5-5, is called the yield curve for that date. 16 14 Yield Curve for March 1980 12 10 Yield Curve for February 2000 Yield Curve for March 2015 10 15 20 25 30 Years to Maturity As the figure shows, the yield curve changes both in position and in slope over time. In March 1980, all rates were quite high because high inflation was expected. However, the rate of inflation was expected to decline, so the inflation premium (IP) was larger for short-term bonds than for long-term bonds. This caused short-term yields to be higher than long-term yields, resulting in a downward-sloping yield curve. By February 2000, inflation had indeed declined and thus all rates were lower. The yield curve had become humped-medium-term rates were higher than either short- or long-term rates. In March 2015, all rates were below the 2000 levels. Because short-term rates had dropped below long-term rates, the yield curve was upward sloping Historically, long-term rates are generally higher than short-term rates owing to the maturity risk premium, so the yield curve usually slopes upward. For this reason, people often call an upward-sloping yield curve a normal yield curve and a yield curve that slopes downward an inverted yield curve or an abnormal yield curve. Thus, in Figure 5-5 the yield curve for March 1980 was inverted, whereas the yield curve in March 2015 was normal. As stated earlier, the February 2000 curve was humped. A few academics and practitioners contend that large bond traders who buy and sell securities of different maturities each day dominate the market. According to this view, a bond trader is just as willing to buy a 30-year bond to pick up a short-term profit as to buy a 3-month security. Strict proponents of this view argue that the shape of the yield curve is therefore determined only by market expectations about future interest rates, a position that is called the pure expectations theory, or sometimes just the expectations theory. If this were true, then the maturity risk premium (MRP) would be zero and long- term interest rates would simply be a weighted average of current and expected future short-term interest rates. See Web Extension 5D for a more detailed discussion of the expectations theory