Corporate Finance Theory and Practice, Third Edition

Chapter 20

THE TERM STRUCTURE OF INTEREST RATES

Here comes a curveball

Conventional financial theory, portfolio theory and the CAPM, which were presented in Chapter 19, are concerned with the notion of interest rates and reducing it to the level of a factor that is exogenous to their models, namely the risk-free rate. But the risk-free rate is by no means a given variable, and there is no financial instrument in existence which allows investors to completely escape risk.

Moreover, because it is a single-period model, the CAPM draws no distinction between short-term and long-term interest rates. As has been discussed, a money-market fund does not offer the same annual rate of return as a 10-year bond. An entire body of financial research is devoted to understanding movements in interest rates and, in particular, how different maturities are linked. This is the study of how the yield curve is formed.

Section 20.1

FIXED-INCOME SECURITIES AND RISK

Investing in debt securities is not risk free, although it is much less risky than options or even stocks. There are at least four risks involved in debt securities:

• inflation risk;
• the risk of a change in interest rates if the security's maturity is different from the investment horizon;
• liquidity risk; and
• counterparty (or default) risk.

Counterparty risk is ignored in yield curves, because generally they are based on government debt, and therefore the risk is considered to be negligible (although recent economic events have shown that ...