Interest Rates

1
Chapter 9

• Interest Rates

2
Goals

• To learn the important money market interest
  rates
• To explore the different interest rate quotations
• To revisit the term structure of interest rates
• To examine interest rate components

3
Money Market Rates

• Prime rate
• Rate on ST loans from largest commercial banks
  charge to their most creditworthy corporate
  customers
• Federal funds rate
• Rate banks charge each other for loans of 1
  million or more
• Discount rate
• Rate Fed offers to banks for overnight reserve
  loans

4
Money Market Rates

• Call money rate
• Rate brokerage firms pay to banks for margin
  loans
• LIBOR
• London Interbank Offered Rate rate
  international banks charge one another overnight
  loans

5
Money Market Rates

• Other rates
• Commercial paper
• Short term, unsecured debt issued by the largest
  corporations
• Certificates of deposit
• Large-denomination deposits of 100,000 or more
  at commercial banks for a specified term
• Not to be confused bank time deposits, these CDs
  are negotiable

6
Money Market Prices and Rates

• Pure discount securities
• Money market securities
• Basis point
• .01 or 1/100th of a percent

7
Money Market Prices and Rates

• Bank discount basis
• Current price FV x (1 Days to maturity x
  Discount yield)
• 360
• The difference between the face value and the
  current price is called the discount

8
Money Market Prices and Rates

• A 100,000 face value money market instrument is
  quoted on a discount basis at 6 percent. It will
  mature in 71 days. Calculate the price
• Current price FV x (1 Days to maturity x
  Discount yield)
• 360

9
Treasury Bill Quotes

• Prices can be calculated based on the bid or
  asked yields
• Bid price FV x (1 Days to maturity x bid
  yield)
• 360
• Ask price FV x (1 Days to maturity x asked
  yield)
• 360

10
Bond Equivalent Yields

• Assumes 365-day calendar year
• Only works for maturities lt 6 months
• BEY 365 x Discount yield
• 360 Days to maturity x Discount yield

11
Bond Equivalent Yields

• A T-bill has 45 days to maturity and an asked
  discount of 5 percent. What is the BEY?
• BEY 365 x Discount yield
• 360 Days to maturity x Discount yield

12
Effective Annual Yields

• The bond equivalent of EAR
• EAY (1 APR)m 1
• m

13
Effective Annual Yield (EAY)

• Your Discover Card quotes an APR of 18. Upon
  examining your statement, you find that interest
  is compounded monthly at 1.5. What is the EAY?

14
Discounts, APRs and EAYs

• A money market instrument with 60 days to
  maturity has a quoted ask price of 99.
• Find the
• Bankers discount yield
• Bond equivalent yield
• Effective annual yield

15
Bankers Discount Yield

• A money market instrument with 60 days to
  maturity has a quoted ask price of 99.

16
Bond Equivalent Yield

• A money market instrument with 60 days to
  maturity has a quoted ask price of 99.

17
Effective Annual Yield

• A money market instrument with 60 days to
  maturity has a quoted ask price of 99.

18
Yield Comparisons

• U.S. Treasuries
• U.S. Government Agencies
• Domestic corporations
• Yankee bonds
• Issued by foreign firms for sale in the US

19
Yield Comparisons

• Government agency mortgage rates
• FHLMC, FNMA, GNMA
• High yield corporate rates
• junk bonds
• Tax exempt rates
• Municipal rates

20
Yield Curve

• Try the Dynamic yield curve
• http//stockcharts.com/charts/YieldCurve.html

21
Nominal vs. Real Interest Rates

• Real rates nominal rates adjusted for price
  inflation
• Real rate Nominal rate inflation rate

22
Traditional Term Structure Theories

• Expectations theory
• Represents expectations regarding future interest
  rates
• Maturity preference theory
• Lenders prefer ST debt, Borrowers prefer LT debt.
  Borrowers have to pay higher rates to obtain LT
  lending
• Market segmentation theory
• Each maturity represents a separate market

23
Term Structure Revisited

• Graphically represents the relationship between
  interest rates and maturity

24
Modern Term Structure Theory

• NI RI IP RP
• NI nominal interest rate
• RI real interest rate
• IP inflation premium
• RP interest rate risk premium

25
Liquidity and Default Risk

• NI RI IP RP LP DP
• NI nominal interest rate
• RI real interest rate
• IP inflation premium
• RP interest rate risk premium
• LP liquidity premium (less liquidhigher yield)
• DP default premium

26
Quick Quiz

• What is the BEY?
• What is the real interest rate?
• What are some of the components of the term
  structure of interest rates?