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PPT – Interest rates Chapter 6 PowerPoint presentation | free to download - id: 2bb20-NDA4Z

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- Interest rates (Chapter 6)

The cost of money

- The price, or cost, of debt capital is the

interest rate. - The price, or cost, of equity capital is the

required return. The required return investors

expect is composed of compensation in the form of

dividends and capital gains.

What four factors affect the cost of money?

- Production opportunities
- Time preferences for consumption
- Risk
- Expected inflation

Nominal vs. Real rates

k represents any nominal rate k represents

the real risk-free rate of interest. Like a

T-bill rate, if there was no inflation.

Typically ranges from 1 to 4 per year. kRF

represents the rate of interest on Treasury

securities.

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

Premiums added to r for different types of debt

Exam type question

- Given the following data, find the expected rate

of inflation during the next year. - r real risk-free rate 3.
- Maturity risk premium on a 1-year corporate bond

0.5. - Default risk premium on a 1-year corporate bond

1.5. - Liquidity premium on a 1-year corporate bond

0.5. - Going interest rate on 1-year corporate bond

7.5. - a. 3.5
- b. 4.5
- c. 2.0
- d. 5

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 November 2005 Treasury yield curve is shown

at the right.

Hypothetical yield curve

- An upward sloping yield curve.
- Upward slope due to an increase in expected

inflation and increasing maturity risk premium.

What is the relationship between the Treasury

yield curve and the 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.

What determines the yield curve? Pure

Expectations Hypothesis (PEH)

- The PEH 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. - Assumes that the maturity risk premium for

Treasury securities is zero. - Long-term rates are an average of current and

future short-term rates. - Most evidence supports the general view that

lenders prefer S-T securities, and view L-T

securities as riskier.

Exam type question

The real risk-free rate, k, is expected to

remain constant at 3 percent per year. Inflation

is expected to be 2 percent per year forever.

Assume that the expectations theory holds that

is, there is no maturity risk premium. Which of

the following statements is most correct? a.The

yield curve for corporate bonds must be flat, but

corporate bonds will yield more than 5

percent. b.The Treasury yield curve is upward

sloping for the first 10 years, and then downward

sloping. c.The Treasury yield curve is flat and

all Treasury securities yield 5 percent.

d.Statements a and c are correct.

An example Observed Treasury rates and the PEH

Maturity Yield 1 year 6.0 2

years 6.2 If PEH holds, what does the

market expect will be the interest rate on

one-year securities, one year from now?

One-year forward rate

The expected one-year rate (forward rate) 6.2

(6.0 x) / 2 x 6.4 PEH says that

one-year securities will yield 6.4, one year

from now.

Another example of future expected interest rates

Bank of America has the following CD rates 2.8

for a 2-year (24 months) CD, and 2.4 for a

1-year (12 months) CD. What is the expected

1-year rate (yield), one year from now You know

Two-year rate ( 2.8) and One-year rate now (

2.4) Expected 1-year rate (yield), one year from

now is found from 2-year yield(2.8)

(1-year(2.4) x) / 2 2.8 x 2 2.4

x 5.6 - 2.4 x 3.2 x PEH says that

one-year CD rate, one year from now, will yield

3.2

Another example of expected One-year yield

(interest rate), one year from now

Washington Mutual Bank has the following CD

rates 3 for a 2-year (24 months) CD, and 2.7

for a 1-year (12 months) CD. What is the expected

1-year rate (yield), one year from now You know

Two-year rate ( 3) and One-year rate now (

2.7) Expected 1-year rate (yield), one year from

now is found from 2-year yield(3)

(1-year(2.7) x) / 2 3 x 2 2.7 x 6

- 2.7 x 3.3 x PEH says that one-year CD

rate, one year from now, will yield 3.3

Exam type question

- One-year government bonds yield 4 percent and

2-year government bonds yield 4.5 percent. Assume

that the expectations theory holds. What does

the market believe the rate on 1-year government

bonds will be one year from today? - a. 5.50
- b. 5.0
- c. 5.75
- d. 5.25

Other factors that influence interest rate levels

- Federal reserve policy
- Federal budget surplus or deficit
- Level of business activity
- International factors

Learning objectives

- Discuss the four fundamental factors that affect

the cost of money - Discuss the determinants of market interest rates
- Distinguish between real and nominal interest

rates - What is the yield curve, and what type of shapes

might have? - Know how to calculate the 1-year expected

rate/yield (forward rate) one year from now given

the spot rates - Discuss the pure expectations theory and other

factors that influence interest rate levels (i.e.

FED policy, deficits, international markets,

economic activity) - Interest rates and business decisions (see text

section 6.9) - Problems ST-1,ST-3a, 6-2 to 6-6,
- No need to prepare for the exam text sections

6.6, 6.8