Structure of Interest Rates

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CHAPTER 3

• Structure of Interest Rates

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CHAPTER 3 OVERVIEW

• This chapter will
• A. Show how characteristics of debt securities
  cause their yields to vary
• B. Estimate forward rate
• C. Explain the theories behind the term structure
  of interest rates

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Characteristics of Debt Securities that Cause
Their Yields to Vary

• 1. Default Risk
• a. Rating Agencies
• 1.) Moodys Investor Service
• 2.) Standard and Poors Corporation
• b. Accuracy of Credit Ratings

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Exhibit 3.1 Rating Classification by Ratings
Agencies
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Exhibit 3.5 Yield Differentials of Corporate
Bonds
Note Chart shows yield to maturity on seasoned
corporate and Treasury Debt with 10 years to
maturity
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Characteristics of Debt Securities that Cause
Their Yields to Vary

• 2. Liquidity
• a. the ease of conversion to cash without loss
  of value.
• b. the lower a securities liquidity, the higher
  the yield preferred by investor.

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Characteristics of Debt Securities that Cause
Their Yields to Vary

• 3. Tax Status
• Investors are more concerned with after-tax
  income.
• Taxable securities must offer a higher
  before-tax yield

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Characteristics of Debt Securities that Cause
Their Yields to Vary

• To compute the equivalent Before-Tax Yield
• where tat After-tax yield
• tbt Before-tax yield
• T Investors marginal tax rate

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Characteristics of Debt Securities that Cause
Their Yields to Vary

• 4. Term to Maturity
• maturity dates will differ between debt
  securities
• The term structure of interest rates defines the
  relationship between term to maturity and the
  annualized yield
• Yield curve The graphical representation of the
  term structure.

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Term Structure of Interest Rates

• 1. Three prevailing theories
• a. Pure Expectations Theory
• emphasizes the impact of an expected change in
  interest rates
• b. Liquidity Premium Theory
• emphasizes estimation of the Forward Rate based
  on a Liquidity Premium
• c. Segmented Markets Theory

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Expectations Theory

• Depending on what investors expect the future
  short-term rate to be
• Higher than current short-term rate, or
• Lower than current short-term rate, or
• Same as current short-term rate
• We get different yield curves.

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Term Structure of Interest Rates

• Yield curve
• 1. upward slope
• 2. flat
• 3. downward slope

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Exhibit 3.10 Yield Curves at Various Points in
Time
Source FRBNY Quarterly Review, various issues.
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Exhibit 3.11 Yield Curves among Foreign Countries
(as of March 2007)
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Term Structure of Interest Rates

• 2. Uses of the Term Structure
• a) Forecast Interest Rates
• b) Investment Decisions
• c) Financing Decisions

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Term Structure of Interest Rates

• 1. Spot rate
• a rate quoted at current time
• 2. Forward rate
• a rate to be quoted at some point in the future
  (markets forecast of the future interest rate)

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How to find Forward rate?

• Two Strategies Method.

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Term Structure of Interest Rates

• Calculating forward rate
• One year forward rate at t1
• One year forward rate at t2

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Applying the forward rate formula

• Two-year maturity bonds offer yield-to-maturity
  of 6, and three-year bonds have yields of 7.
  What is the forward rate for the third year?
• Verify that the forward rate is 9.03

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Summary

• 1. Characteristics of debt securities cause their
  yields to vary
• 2. Use Spot rate to find forward rate
• 3. Homework Assignment 2 Problems 1, 2, 3, 4, 5