Discussion 2
Ch. 6 – Interest Rates
1
The determinants of market interest rate
Nominal and real interest rates
Term structure of interest rates
Yield curve
Pure expectations theory
Macroeconomic factors that influence interest rate
Topics
2
What four factors affect the level of interest rates?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
“Nominal” vs. “Real” Rates
Nominal interest rate: r
the quoted or stated interest rate
the interest rate before taking inflation into account
Real interest rate: r*
It is the rate that would exist on a riskless security in a world where no inflation was expected.
4
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security, nominal rate
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
5
Default (Credit ) risk
Definition: The risk that a security’s issuer will default on that security by being late on or missing an interest or principal payment
Investors must consider the creditworthiness of the security issuer
Can use bond ratings of rating agencies
The higher the rating, the lower the perceived credit risk
Ratings can change over time as economic conditions change
6
Default (Credit ) risk
| Ratings Assigned by: | ||
| Description of Security | Moody’s | Standard and Poor’s |
| Highest quality | Aaa | AAA |
| High quality | Aa | AA |
| High-medium quality | A | A |
| Medium quality | Baa | BBB |
| Medium-low quality | Ba | BB |
| Low quality (speculative) | B | B |
| Poor quality | Caa | CCC |
| Very poor quality | Ca | CC |
| Lowest quality (in default) | C | DDD, D |
Speculative-grade
Investment-grade
7
Liquidity
Definition: the degree to which the securities can easily be converted to cash without a loss in value
If all other characteristics are equal, securities with less liquidity will have to offer a higher yield to be preferred.
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Term to maturity
Maturity dates will differ between debt securities
Maturity risk premium: to compensate investors for taking on the risk of holding bonds over a lengthy period of time.
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Premiums Added to r* for Different Types of Debt
| IP | MRP | DRP | LP | |
| S-T Treasury | | |||
| L-T Treasury | | | ||
| S-T Corporate | | | | |
| L-T Corporate | | | | |
10
Yield Curve and the Term Structure of Interest Rates
Term structure: relationship between interest rates (or yields) and maturities.
The yield curve is a graph of the term structure.
The March 2010 Treasury yield curve is shown at the right.
11
Years to Maturity
Interest Rate
Treasury Yield Curve and Yield Curves for Corporate Issues
Corporate yield curves are higher than that of Treasury securities, though not necessarily parallel to the Treasury curve.
The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases.
Since corporate yields include a default risk premium (DRP) and a liquidity premium (LP), the corporate bond yield spread can be calculated as:
12
Pure Expectations Theory
Pure expectations theory suggests that the shape of the yield curve is determined solely by expectations of future interest rates
The yield curve will become upward sloping if interest rates are expected to rise
The yield curve will become downward sloping if interest rates are expected to decline
The yield curve will become flat if interest rates are expected to remain the same
13
Macroeconomic Factors That Influence Interest Rate
Federal reserve policy
When the Fed reduces the money supply, it reduces the supply of loanable funds, putting upward pressure on interest rates.
Federal budget deficits or surpluses
A high deficit means a high demand for loanable funds by the government
Shifts the demand schedule outward (to the right)
Interest rates increase
International factors
Level of business activity
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LP
DRP
yield
bond
Treasury
yield
bond
Corporate
spread
yield
bond
Corporate
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