INTEREST RATES Chapter 6

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INTEREST RATES Chapter 6

• Interest Rate Determinants
• Term Structure

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INTEREST RATES

• Factors Influencing Interest rates.
• Federal Reserve Monetary Policy.
• Investor expectations about economy.
• Inflation expectations.
• Business Decisions.

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INTEREST RATES

• Interest Rates are the Cost of Borrowing
• Composition of Nominal Interest Rates.
• 1. Real rate of return.
• 2. Inflation premium.
• 3. Default premium.
• Liquidity premium.
• Maturity Risk premium

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Nominal Interest Rate

• 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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INTEREST RATES

• Term-Structure of Interest rates.
• 1. Relationship between short, intermediate,
  and long-term rates.
• 2. Yield Curve (See Fig. 6-4)
• Inverted (downward sloping to right)
• Flat
• Normal (upward sloping to right)

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Normal Yield Curve
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Treasury Yield vs. Corporate Yield Curves

• Corporate yield curves are higher than that of
  Treasury securities, though not necessarily
  parallel to the Treasury curve. (See Fig 6-6)
• The spread between corporate and Treasury yield
  curves widens as the corporate bond rating
  decreases.
• AAA to AA to A to BBB to BB to B to CCC, etc.
• D (default) bond issuer in arrears on interest
  and/or principal repayment.
• BB and below considered speculative or junk
  bonds
• BBB and above considered investment grade.

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Fixed Income Securities Risk

• Interest Rate Risk As interest rates go up, bond
  prices go down.
• Reinvestment Rate Risk the chance that your
  interest payments cannot be reinvested at the
  same coupon rate. Worst case rates have
  declined since you bought the bond.

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International Risk Factors

• Exchange rate risk If an investment is
  denominated in a currency other than U.S.
  dollars, the investments value will depend on
  what happens to exchange rates.
• Country risk Arises from investing or doing
  business in a particular country and depends on
  the countrys economic, political, and social
  environment.

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Country Risk Ratings

• Top 5 countries (least risk)
• Rank Country Score
• 1 Switzerland 95.2
• 2 Luxembourg 93.9
• 3 United States 93.7
• 4 Norway 93.7
• 5 United Kingdom 93.6

• Bottom 5 countries (most risk)
• Rank Country Score
• 169 Afghanistan 11.0
• 170 Liberia 9.4
• 171 Sierra Leone 9.3
• 172 North Korea 8.9
• 173 Somalia 8.2

Source Country Ratings by Region,
Institutional Investor, www.institutionalinvestor
.com, September 2004.
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Pure Expectations Hypothesis

• 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.

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THE FEDERAL RESERVE AND THE SUPPLY AND COST OF
CREDIT

• A. The Goals of Monetary Policy
• 1. Stable prices fighting inflation.
• a. Inflation drive values of financial assets
  down, real assets up.
• b. Deflation decrease in the real price of
  goods/services.
• 2. Full employment / Economic Growth
• supply of credit
• capital expansion.
• 3. Supervisory powers over member banks.

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THE FEDERAL RESERVE AND THE SUPPLY AND COST OF
CREDIT

• MONETARY POLICY TOOLS
• Reserve requirements for deposit liabilities
• Discount rate cost of borrowing from the Fed
• Open market operations by the FOMC
• Buying government securities adding liquidity.
• Selling government securities subtracting
  liquidity.
• Setting Margin Requirements for Security Markets

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Homework Assignment

• Self Test ST-1, b, c, d, e, g, i
• Questions 6-2, 6-3, 6-9
• Problems 6-1, 6-2