The Structure of Interest Rates 1 CHAPTER 4 Copyright © 1999 Addison Wesley Longman
2 Chapter 4: The Structure of Interest Rates Objectives 1. The Importance of Interest Rates 2. Factors that affect Interest Rates 3. How Interest Rates affect Stocks
Copyright © 1999 Addison Wesley Longman 3 Chapter 4: The Structure of Interest Rates Interest rates: The rental price of money. The price changes over time as the demand and supply changes. Factors that impact interest rates Technology Changes Business Environment Federal Reserve Time Preference of Consumption Changes
Copyright © 1999 Addison Wesley Longman 4 Chapter 4: The Structure of Interest Rates FIGURE 4.1 Monthly T-Bill Returns over Time
Copyright © 1999 Addison Wesley Longman 5 Chapter 4: The Structure of Interest Rates Other Factors that determine the level of IR N = r + INF + LP + DRP + MRP N = Nominal Rate r = Real Rate INF = expected inflation LP = liquidity premium DRP = default risk premium MRP = maturity risk premium
Copyright © 1999 Addison Wesley Longman 6 Chapter 4: The Structure of Interest Rates Inflation FIGURE Month T-Bill Returns and Inflation Rates
Copyright © 1999 Addison Wesley Longman 7 Chapter 4: The Structure of Interest Rates Default Risk Ratings by Standard and Poor’s AAACCC AACC AC BBBCI BBD BNR
Copyright © 1999 Addison Wesley Longman 8 Chapter 4: The Structure of Interest Rates FIGURE 4.3 Treasury Yield Curve for July 30, 1997 and July 30, 1980 Term Structure of Interest Rates
Copyright © 1999 Addison Wesley Longman 9 Chapter 4: The Structure of Interest Rates Pure Expectation Theory 2 year rate = average of the one year rates
Copyright © 1999 Addison Wesley Longman 10 Chapter 4: The Structure of Interest Rates Liquidity Preference Theory Borrowers pay a premium to induce lender to make long-term loans.
Copyright © 1999 Addison Wesley Longman 11 Chapter 4: The Structure of Interest Rates FIGURE 4.4 Equilibrium with Market Segmentation Market Segmentation Theory
Copyright © 1999 Addison Wesley Longman 12 Chapter 4: The Structure of Interest Rates Reconciling the Theories They are all probably relevant Expectations and Liquidity Preference explain long term Segmentation explains short term
Copyright © 1999 Addison Wesley Longman 13 Chapter 4: The Structure of Interest Rates Taxes and IR’s Municipal Bonds: Federal Income tax exempt Rat = Rbt (1 – Tr)
Copyright © 1999 Addison Wesley Longman 14 Chapter 4: The Structure of Interest Rates When IR increase, corporate profits decline because of: Increased interest expense Reduced expansion Slower economy As a result, stock prices tend to fall as IR increase.