The Term Structure and Debt Valuation

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The Term Structure and Debt Valuation

• Brealey and Myers Chapter 24

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Teaching notes Like the international finance
material, the ideas here the economic
determinants of the yield curve are among the
deeper concepts students have encountered. Perhap
s the most important determinant of this shape is
inflation and/or expectations of future
inflation. In class we visit websites that allow
one to access historical yield curves during
different inflationary periods. This exercise
allows immediate testing of the theories
developed in class.
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Review of interest rates

• The risk free rate satisfies
• Determinants of inflation
• Mainly govt monetary policy
• Maybe Competitive forces in industry? Market
  power?
• Determinants of real rate of interest
• Patience, investment opportunities, demographics
• Supply and demand for goods

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Debt Interest Rates
Supply
Real r ()
Demand
Quantity of bananas lent/borrowed
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Interest rates cont.

• Most economists believe that the real rate is
  relatively stable over time (especially
  short-run)
• Fishers theory
• So fluctuations in nominal rates must be driven
  by fluctuation in inflation
• Consistent with this idea, rates of return on
  inflation-protected securities have been
  relatively stable
• See Figure 24.1 in the text
• Why do you think this is the case?

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The yield curve

• But there isnt just one interest rate
• There is a different rate for borrowing at each
  maturity (the yield curve)
• There is a different rate for borrowing for each
  creditworthiness (the yield spread)
• http//www.spreadsheetmodeling.com/community.htm

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Forward Rates

• The current YTM on treasuries is about
• 3.2 for 1-yr
• 3.7 for 2-yr
• Lets say someone asks you to commit now to
  lending at T1, with repayment at time T2. What
  is the appropriate rate?
• This is a forward contract

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Spot/Forward rates

• Forward Rate Computations
• (1 rn)n (1 r1)(1f2)(1f3)....(1fn)

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Expectations Hypothesis

• Expectations hypothesis Forward rates equal the
  expected spot rates.
• Otherwise, long-term lenders would arbitrage
  the difference away
• Its not a real arbitrage b/c the future spot
  rates are risky

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Expectations Hypothesis

• is not the whole picture
• The yield curve has sloped upward (on average)
  through history
• Investors have consistently predicted that
  interest rates will rise?!
• Yet, it is a useful tool
• Changes in the yield curves shape signal the
  markets changing beliefs about the direction of
  spot rates

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Liquidity Preference Theory

• More people may want to lend short
• This additional demand pushes the interest rates
  on short-term debt lower than might be otherwise
  expected.

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Why?

• Sally Retiree needs money short-term
• Strategy 1 Lend short
• No risk
• Strategy 2 Lend long and sell as needed
• Interest rate risk

• Sally Jr. needs money long-term
• Strategy 1 Lend short, and roll over
• Interest rate risk
• Strategy 2 Lend long
• Inflation risk

gt On balance, this may favor lending short (all
else equal)
Uncertainty in end-of-period wealth due to
changes in mkt. interest rates between purchase
date and end date.
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Corporate Yield Spread

• http//bonds.yahoo.com/rates.html
• Note at the short end, there is virtually no
  difference between high-rated firms and
  treasuries
• Zero probability of default
• At the long end, some differences emerge
• Probability of default fluctuates over time, and
  so yield spread fluctuates over time