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Interest Rate Determination Nominal Rate = Real Rate +Expected Inflation.

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Presentation on theme: "Interest Rate Determination Nominal Rate = Real Rate +Expected Inflation."— Presentation transcript:

1 Interest Rate Determination Nominal Rate = Real Rate +Expected Inflation

2 The Risk and Term Structures of Interest Rates Risk structure: Bonds with the same maturity (n) have different interest rates because of – default risk premium ( ) – illiquidity risk premium ( ) – income tax risk discount ( ) Term structure: For bonds with identical characteristics, the interest rate (i) increases as maturity (n) increases – maturity premium (i nt – i t ) – liquidity premium (l nt ) – The yield curve is the relationship between i and n.

3 Risk Structure Default risk premium Default risk is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value – U.S. Treasury bonds are considered default free – Default risk premium ( ) is the spread between the interest rates on bonds with default risk and the interest rates on Treasury bonds, holding,, n, l nt, and i nt – i t equal

4 TABLE 1 Risk Structure Default risk premium

5 Corporate Bond Market U.S. Treasury Bond Market PPii 9505 DcDc DtDt QQ Risk Structure Default risk premium ScSc StSt 9505

6 Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc QQ Risk Structure Default risk premium 9505 5 6925 DtDt

7 Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ Risk Structure Default risk premium 9505 5 6 4 975 925

8 Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ Risk Structure Default risk premium 6 4 975 925 2

9 Pre-bailout N = 1 I% = A PV = -1068 PMT = 100 FV = 1000 Post-bailout N = 1 I% = A PV = -1023 PMT = 100 FV = 1000 You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout. Risk Structure Default risk premium

10 Pre-bailout N = 1 I% = 2.996 PV = -1068 PMT = 100 FV = 1000 Post-bailout N = 1 I% = 7.527 PV = -1023 PMT = 100 FV = 1000 You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout. Risk Structure Default risk premium

11 Liquidity is the relative ease with which an asset can be converted into cash – Cost of selling a bond – Number of buyers/sellers in a bond market – Illiquidity risk premium ( ) is the spread between the interest rate on a bond that is illiquid and the interest rate on Treasury bonds, holding,, n, l nt, and i nt – i t equal. – E.g., assume an investor is looking at buying two corporate bonds that have the same coupon rates and maturities, but only one is traded on a public exchange. The investor is not be willing to pay as much for the non-public bond. The difference in yields the investor is willing to pay for each bond is the liquidity premium. Risk Structure Illiquidity risk premium

12 Corporate Bond Market U.S. Treasury Bond Market PPii 9505 DcDc DtDt QQ ScSc StSt 5 Risk Structure Illiquidity risk premium

13 Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc QQ 9505 5 6925 DtDt Risk Structure Illiquidity risk premium

14 Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ 9505 5 6 4 975 925 Risk Structure Illiquidity risk premium

15 Corporate Bond Market U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ 6 4 975 925 2 Risk Structure Illiquidity risk premium

16 Treasury N = 1 I% = A PV = -1058 PMT = 80 FV = 1000 Corporate N = 1 I% = A PV = -1001 PMT = 80 FV = 1000 You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Explain why the Treasury is selling for $1058 while the corporate bond is selling for $1001 if both have the same bond rating, and compute the yields on the two bonds. Risk Structure Illiquidity risk premium

17 Risk Structure Illiquidity risk premium Treasury N = 1 I% = 2.079 PV = -1058 PMT = 80 FV = 1000 Corporate N = 1 I% = 7.892 PV = -1001 PMT = 80 FV = 1000 You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Explain why the Treasury is selling for $1058 while the corporate bond is selling for $1001 if both have the same bond rating, and compute the yields on the two bonds.

18 Income tax considerations – Interest payments on municipal bonds are exempt from federal income taxes. – Tax exemption risk discount ( ) is the spread between the interest rate on a tax exempt municipal bond and the interest rate on Treasury bonds, holding,, n, l nt, and i nt – i t equal. – The discount shrinks if o federal income taxes are lowered or there is talk of doing so o politicians seriously consider ending the exemption o the exemption is repealed. Risk Structure Tax exemption risk discount

19 Municipal Bond Market U.S. Treasury Bond Market PPii 9505 DcDc DtDt QQ ScSc StSt 5 Risk Structure Tax exemption risk discount

20 U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc QQ 9505 5 6925 DtDt Risk Structure Tax exemption risk discount Municipal Bond Market

21 U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ 9505 5 6 4 975 925 Risk Structure Tax exemption risk discount Municipal Bond Market

22 U.S. Treasury Bond Market PPii ScSc StSt DcDc DcDc DtDt DtDt QQ 6 4 975 925 -2 Risk Structure Tax exemption risk discount Municipal Bond Market

23 Tax-free municipal N = 1 I% = 3.5 PV = A PMT = 80 FV = 1000 Risk Structure Tax exemption risk discount Corporate N = 1 I% = 3.5 PV = A PMT = 40 FV = 1000 You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a tax-free municipal, and both have an 8% coupon rate. If the bonds have a current yield of 3.5%, and you intend to hold them for their final year, compute the price you would be willing to pay assuming a federal income tax rate is 50%.

24 Risk Structure Tax exemption risk discount Tax-free municipal N = 1 I% = 3.5 PV = -1043.48 PMT = 80 FV = 1000 Corporate N = 1 I% = 3.5 PV = -1004.83 PMT = 40 FV = 1000

25 Figure 1Long-Term Bond Yields, 1919–2011 Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm. Risk Structure

26 Interest Rate Determination Nominal Rate = Real Rate +Expected Inflation +Default Risk Premium +Illiquidity Risk Premium –Tax exemption discount

27 Term Structure Time to maturity affects interest rates because – Time increases exposure to risk, causing investors to demand higher yields on securities with longer maturities. The term structure of interest rates refers to difference in the yields on instruments that are identical except for term to maturity. Term structure is represented graphically by a yield curve. – Yield curves consider only the relationship between maturity or term of a security and its yield at a moment in time, otrs.

28 Facts that the theory must explain: 1.Interest rates on bonds of different maturities move together over time Term Structure

29 Figure 4Interest rate movements on Treasuries with different maturities Sources: Federal Reserve; www.federalreserve.gov/releases/h15/data.htm. Term Structure

30 Facts that the theory must explain: 1.Interest rates on bonds of different maturities move together over time 2.When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted 3.Yield curves almost always slope upward Term Structure

31 31 February 4, 2005 Term Structure

32 Figure 7 Yield Curves for U.S. Government Bonds Term Structure

33 Figure 6 Term Structure

34 Facts that the theory must explain: 1.Interest rates on bonds of different maturities move together over time 2.When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted 3.Yield curves almost always slope upward Term Structure Three Theories that explain these facts 1.Segmented markets theory explains fact three but not the first two 2.Expectations theory explains the first two facts but not the third 3.Liquidity premium theory combines the two theories to explain all three facts

35 Term Structure maturity premium Expectations theory says the yield on a long-term bond equals the average of the short-term interest rates people expect to occur over its life – Maturity Premium is the spread between the interest rates on bonds with n years and 1 year to maturity, holding,,, and l nt equal. i nt – i t – Buyers of bonds o do not prefer bonds of one maturity over another o do not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity o consider bonds with different maturities to be perfect substitute

36 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

37 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

38 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

39 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

40 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

41 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

42 The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond. Term Structure maturity premium

43 Graph the maturity adjusted yields over maturity Term Structure maturity premium i n

44 Graph the maturity adjusted yields over maturity Term Structure maturity premium i n maturity premium for a 1-year bond 0%

45 Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 2-year bond 0.325%

46 Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 3-year bond 0.57%

47 Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 4-year bond 0.7675%

48 Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 5-year bond 0.93%

49 Term Structure maturity premium Graph the maturity adjusted yields over maturity i n maturity premium for a 6-year bond 1.06%

50 Term Structure Expectations Theory i n Yield Curve

51 Term Structure liquidity premium The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond Bonds of different maturities are partial (not perfect) substitutes – Liquidity premium is the spread between the interest rates on bonds with n and one years to maturity, holding,,, and i nt – i t equal l nt

52 Suppose the liquidity premium is linear in maturity: l nt = 0.08n Term Structure liquidity premium

53 Term Structure Expectations Theory Yield Curve

54 Term Structure Liquidity Premium Theory Yield Curve

55 Interest Rate Determination Nominal Rate = Real Rate +Expected Inflation +Default Risk Premiums +Illiquidity Risk Premium –Tax exemption risk discount +Maturity Premium +Liquidity Premium


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