CHAPTER 6: Interest Rates - Po-Hsuan (Paul) Hsu

1
CHAPTER 6 Interest Rates- Po-Hsuan (Paul) Hsu

• Whatre interest rates?
• Determinants of interest rates
• The term structure and yield curves

2
Whatre interest rates (r)?

• Interest is a charge for borrowed capital.
• Interest rates vary across different types of
  money borrowed (debt securities) why?
• 3 major money borrowers
• 1. Banks (checking, saving, CD)
• 2. Governments (Fed, State, City)
• 3. Firms/corporates

3

• The duration of the money borrowed
• 1. Short-term (1m, 3m, 6m, 9m)
• 2. Long-term (1y, 2y, 3y, 5y, 10y, 30y, etc.)
• We mainly discuss the following 4 types of debt
  securities
• 1. Government Long-term (T-bonds), short-term
  (T-bills). T denotes treasury
• 2. Corporate Long-term bond, short-term (notes)

4
Nominal vs. real interest rates

• r represents any nominal rate
• r represents the real risk-free rate of
  interest.
• ? Whats the most secured debt?

5
Determinants of interest rates

• r r IP DRP LP MRP
• r required/expected return on a debt security
• r real risk-free rate of interest existing?
• IP inflation premium
• DRP default risk premium
• LP liquidity premium Corporate only
• MRP maturity risk premium Corporate only

6
Premiums added to r for different types of debt
IP MRP DRP LP
Short-term Treasury ?
Long-term Treasury ? ?
Short-term Corporate ? ? ?
Long-term Corporate ? ? ? ?
7
Treasury bills and bondsHypothetical T-bond
yield curve

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

8
Calculating inflation premium (IP)

• IP for future t years Find the average expected
  inflation rate (INFL) over years 1 to t

9

• Assume inflation is expected to be 5 next year,
  6 the following year, and 8 thereafter.
• IP1 5 / 1 5.00
• IP10 5 6 8(8) / 10 7.50
• IP20 5 6 8(18) / 20 7.75
• - Any nominal r must earn these IPs to break even
  vs. inflation

10
Computing maturity risk premium (MRP)

• Find the appropriate maturity risk premium (MRP).
  The following equation will be used to find a
  bonds MRP at t

11

• Using the given equation
• MRP1 0.1 x (1-1) 0.0
• MRP10 0.1 x (10-1) 0.9
• MRP20 0.1 x (20-1) 1.9
• Notice that the MRP is increasing in t (as the
  time to maturity increases), as it should be.

12
Add the IPs and MRPs to r to construct the
T-bond yield curve

• By adding IP and MRP to r
• rt r IPt MRPt
• Assume r 3,
• r1 3 5.0 0.0 8.0
• r10 3 7.5 0.9 11.4
• r20 3 7.75 1.9 12.65

13
Pure Expectations Hypothesis (PEH)

• The yield curve reflects the markets expectation
  of future interest rates
• We can break down a long-term interest rate into
  an average of current short-term rates and future
  short-term rates

14
An exampleObserved Treasury rates and the PEH

• Maturity Yield
• 1 year 6.0
• 2 years 6.2
• 3 years 6.4
• 4 years 6.5
• 5 years 6.5
• If PEH holds, what does the market expect will be
  the interest rate on one-year securities, one
  year from now? Three-year securities, two years
  from now?

15
One-year forward rate (i.e. future one-year
interest rate)
6.0
x
0 1
2
6.2

• (1.062)2 (1.060) (1x)
• 1.12784/1.060 (1x)
• 6.4004 x
• PEH says that one-year securities will yield
  6.4004, one year from now.

16
Three-year security, two years from now
6.2
x
0 1 2
3 4 5
6.5

• (1.065)5 (1.062)2 (1x)3
• 1.37009/1.12784 (1x)3
• 6.7005 x
• PEH says that three-year securities will yield
  6.7005, two years from now.
• Note You may want to learn how to use Yx in your
  financial calculator!!

17
How about corporate bond yields? Corporate and
Treasury yield curves
Interest Rate ()
15
10
Treasury Yield Curve
6.0
5.9
5
5.2
Years to Maturity
0
0
1
5
10
15
20
18
Compare T-bill to short-term corporate bond
Interest rate (yield) LP DRP
1-year T-bill 4.65 - -
1-year AAA ? 0.10 0.40
1-year BBB ? 0.20 0.80
Hint Page 5 of this handout!
19
End
20
Other factors that influence interest rate levels

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

21
Risks associated with investing overseas

• 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.

22
Country risk rankings
Top 5 countries (least risk) Top 5 countries (least risk) 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) Bottom 5 countries (most risk) 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.