Interest rates Chapter 6

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• Interest rates(Chapter 6)

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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

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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.
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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
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Premiums added to r for different types of debt
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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

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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.

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Hypothetical yield curve

• An upward sloping yield curve.
• Upward slope due to an increase in expected
  inflation and increasing maturity risk premium.

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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.

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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.

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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.
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An exampleObserved 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?
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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.
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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
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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
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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

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Other factors that influence interest rate levels

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

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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