The Use of Treasury Securities Yield as Benchmark Interest Rates

1
The Use of Treasury Securities Yield as
Benchmark Interest Rates

• Rosita P. Chang, Ph.D., CFA
• Professor of Finance
• College of Business Administration
• University of Hawaii
• Conference on Development of
• Indonesian Government Bond Market
• July 25-26, 2000

2
Importance of an Efficient Government Bond Market

• to finance fiscal deficits and public
  expenditures
• to provide instruments and markets for monetary
  policy implementation
• to precede development of broad based financial
  markets to create benchmark interest rates for
  pricing of other financial assets and liabilities

3
Risk Return Tradeoff (1950-1999)

Return
Small Company Stock
Large Company Stock
.
Long-Term Corporate Bond
T-bills KRF
Long-Term Govt Bond
Intermediate Govt Bond
Risk
4
Determinants of Interest Rate

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

5
Basic Bond Equationk k IP DRP LP MRP

• where
• k Nominal interest rate on a debt
  security
• k Real risk-free rate
• IP Inflation premium
• DRP Default risk premium
• LP Liquidity premium
• MRP Maturity risk premium

6
Real versus Risk-Free Rates
7
Historical Rates of Returns (1950-1999)

• Inflation 4.25
• Treasury Bills 4.38
• Medium Term Govt 5.28
• Long Term Govt 5.34
• Long Term Corporate 5.52
• Large Company Stock 13.00
• Small Company Stock 15.92

8
Premiums Added for Different Types of Debt
Securities

• Inflation 4.25
• Treasury bills, kRF real interest rate
  inflation risk premium 4.38 vs 4.25
• Long Term Treasury maturity risk premium 5.28
  vs 4.38
• Long Term Corporate default risk premium 5.52
  vs 5.34

9
Usefulness of Government Bond Yields

• Treasury securities yields are often used to
  describe term structure of interest rates and to
  chart yield curves
• Term structure the relationship between
  interest rates (or yields) and maturities
• A graph of the term structure is called the yield
  curve

10
T-Bond Yield Curve
Interest Rate ()
1 yr 6.11 2 yr 6.43 5 yr
6.29 10 yr 6.15 30 yr 5.19

10
Yield Curve (June 2000)
5
Years to Maturity
0
10
20
30
11
Yield Curves on Different Types of Debt
Instruments
Interest Rate ()
15
BB-Rated
10
AAA-Rated
Treasury yield curve
6.4
6.1
5.5
5
Years to maturity
0
0
1
5
10
15
20
12
Usefulness of the Yield Curve

• To forecast interest rates
• To select mis-priced securities in active bond
  portfolio management

13
Use of KRF inStock Valuation Models

• The risk-free interest rate, kRF is also used as
  a basis for stock valuation models such as
• Capital Asset Pricing Model (CAPM)
  
• Arbitrage Pricing Model
• Option Pricing Model

14
Use of KRF inCapital Asset Pricing Model (CAPM)

• The Security Market Line (SML) is part of the
  CAPM which describes the relations between risk
  return for individual stocks
  
• ki risk-free rate risk premium
  kRF (kM - kRF)bi

15
Use of KRF in Black-Scholes Option Pricing Model

• V PN(d1) - Xe -kRFtN(d2)
• d1
• s t
• d2 d1 - s t

ln(P/X) kRF (s2/2)t
16
Government Securities as Effective Benchmarks

• The government borrowing program should follow a
  regular and well publicized timetable
• The government debt instruments should comprise
  of differing maturity
• gt will ensure a complete range of benchmark
  yield curve that facilitates pricing of other
  financial instruments

17
Government Securities as Effective Benchmarks

• There should be an active secondary government
  bond market
• There should be a complete range of financial
  derivatives to complement spot trading of
  government bonds
• gt will supply a critical mass of high quality
  security to the bond market enhancing investors
  awareness and confidence to debt securities