Finance Exam 25 questions and one hour limit !!!
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fin201chapter6_spring2016.pptxChapter 6
Interest Rates
4.1
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
6-2
2
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 | | | | |
6-3
3
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 February 2013 Treasury yield curve is shown at the right.
6-4
Yield Curve for February 2013
4
Years to Maturity
Interest Rate (%)
Hypothetical Yield Curve
An upward-sloping yield curve.
Upward slope due to an increase in expected inflation and increasing maturity risk premium.
6-5
Years to
Maturity
Real risk-free rate
0
5
10
15
1
Interest
Rate (%)
Maturity risk premium
Inflation premium
10
20
5
Relationship Between 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:
6-6
6
Representative Interest Rates on 5-Year Bonds in February 2013
7-7
| Rate | Corporate Bond Yield Spread = DRP + LP | |
| U. S. Treasury | 0.83% | |
| AAA Corporate | 0.93 | 0.10% |
| AA Corporate | 1.29 | 0.46 |
| A Corporate | 1.67 | 0.84 |
Illustrating the Relationship Between Corporate and Treasury Yield Curves
6-8
8
Pure Expectations Theory
The pure expectations theory contends that the shape of the yield curve depends on investors’ expectations about future interest rates.
If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. Thus, the yield curve can slope up, down, or even bow.
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9
Assumptions of Pure Expectations
Assumes that the maturity risk premium for Treasury securities is zero.
Long-term rates are an average of current and future short-term rates.
If the pure expectations theory is correct, you can use the yield curve to “back out” expected future interest rates.
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10
An Example: Observed Treasury Rates and Pure Expectations
If the pure expectations theory holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?
6-11
| Maturity | Yield |
| 1 year | 6.0% |
| 2 years | 6.2 |
| 3 years | 6.4 |
| 4 years | 6.5 |
| 5 years | 6.5 |
11
LP
DRP
yield
bond
Treasury
yield
bond
Corporate
spread
yield
bond
Corporate
+
=
-
=
