Term Structure of Interest rates

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Term Structure of Interest rates
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Not all interest rates are equal

• We have seen since beginning of class that
  different interest rates move differently
• example Fed raises short term rates and
  long-term rates fall
• This pattern of interest rates over time is named
  the term structure of interest rates

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Determinants of interest rates

• Many things go into the investors required
  returns
• example liquidity, time preferences, taxes,
  economy
• how these things influence interest rates can be
  examined by holding other things constant

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Interest rates

• /-
• i f(default risk, expected inflation, taxes,
  maturity)
• obviously as default risk increases interest
  rates increase

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Bonds and Taxes

• Interest is taxed as ordinary income
• municipals
• investors concerned with after-tax rate
• rate of interest rate on munis is tehrefore lower
• Muni rate corporate rate(1-tax rate)

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Default risk

• Risk that either interest or principla will not
  be paid
• bond rating agencies Moodys,SP,
• Moodys Aaa, Aa, A, Baa, BA, B, Caa, Ca, C, D
• SP AAA, AA, A, BBB, BB, B, CCC, CC, C, D

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Bond ratings

• Rating agencies use ratio analysis, industry
  analysis, company trends, and other factors in
  rating firms debt.

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Term Structure

• To examine how the interest rates move over time
  we examine government securities with varying
  maturities
• also called yield curve
• exhibit 8.2
• show Flat, steep, inverted curves

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Theories used to explain term structure

• Expectations Hypothesis
• simplest
• forward rate is expected future spot rate
• geometric average
• example
• problem does not fit the data

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Liquidity Preference theory

• Investor prefer short term investments, so must
  be coerced into buying longer term rates with
  higher interest rates
• here the forward rate exceeds the future spot rate

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Market Segmentation Hypothesis

• Distinct markets for short term, intermediate,and
  long term bonds
• thus different interest rates merely reflect the
  preferences of players in those separate markets

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Preferred habitat

• Investors may prefer short term rates, but will
  switch for the right price

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• When do we see steep curves?
• When we expect future growth either inflation, or
  demand.
• Practically when we expect times to improve

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• When do we see downward sloping curves?
• Usually when we expect interest rates to fall.
  Hence at a business cycle top

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• Flat curves exist when we expect relatively
  constant conditions

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Interactions

• In actuality other things are not equal.
• Example time, credit risk, and taxes are all
  changing at once
• spreads between hi risk and low risk change over
  time as economy changes. Ex. Simultaneously the
  underlying government bond rate is changing.

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Preferred Habitat Theory