1 The Use of Treasury Securities Yield as Benchmark Interest Rates Rosita P. Chang, Ph.D., CFA Professor of Finance College of Business Administration University of Hawaii Conference on Development of Indonesian Government Bond Market July 25-26, 2000

2 Importance of an Efficient Government Bond Market to finance fiscal deficits and public expenditures to provide instruments and markets for monetary policy implementation to precede development of broad based financial markets: to create benchmark interest rates for pricing of other financial assets and liabilities

3. T-bills K RF Retur n Risk & Return Tradeoff ( ) Risk Intermediate Govt Bond Long-Term Govt Bond Long-Term Corporate Bond Large Company Stock Small Company Stock

4 Determinants of Interest Rate Production opportunities Time preferences for consumption Expected inflation Risk

5 Basic Bond Equation k = k* + IP + DRP + LP + MRP where: k=Nominal interest rate on a debt security k*= Real risk-free rate IP= Inflation premium DRP= Default risk premium LP= Liquidity premium MRP= Maturity risk premium

6 Real versus Risk-Free Rates k* = Real risk-free rate T-bond rate if no inflation = Inflation premium = Rate on Treasury securities = k* + IP IP k RF

7 Historical Rates of Returns ( ) Inflation 4.25% Treasury Bills 4.38% Medium Term Gov’t 5.28% Long Term Gov’t 5.34% Long Term Corporate 5.52% Large Company Stock13.00% Small Company Stock15.92%

8 Premiums Added for Different Types of Debt Securities Inflation: 4.25% Treasury bills, k RF : real interest rate + inflation risk premium [4.38% vs 4.25%] Long Term Treasury: maturity risk premium [5.28% vs 4.38%] Long Term Corporate: default risk premium [5.52% vs 5.34%]

9 Usefulness of Government Bond Yields Treasury securities yields are often used to describe term structure of interest rates and to chart yield curves Term structure: the relationship between interest rates (or yields) and maturities A graph of the term structure is called the yield curve

10 T-Bond Yield Curve Years to Maturity Interest Rate (%) 1 yr = 6.11% 2 yr = 6.43% 5 yr = 6.29% 10 yr = 6.15% 30 yr = 5.19% Yield Curve (June 2000)

11 Yield Curves on Different Types of Debt Instruments Years to maturity Interest Rate (%) 5.5% 6.1% 6.4% BB-Rated AAA-Rated Treasury yield curve

12 Usefulness of the Yield Curve To forecast interest rates To select mis-priced securities in active bond portfolio management

13 Use of K RF in Stock Valuation Models The risk-free interest rate, k RF is also used as a basis for stock valuation models such as Capital Asset Pricing Model (CAPM) Arbitrage Pricing Model Option Pricing Model

14 Use of K RF in Capital Asset Pricing Model (CAPM) The Security Market Line (SML) is part of the CAPM which describes the relations between risk & return for individual stocks: k i = risk-free rate + risk premium = k RF + (k M - k RF )b i

15 V = P[N(d 1 )] - Xe -k RF t [N(d 2 )] d 1 =  t d 2 = d 1 -  t Use of K RF in Black-Scholes Option Pricing Model ln(P/X) + [k RF + (  2 /2)]t

16 Government Securities as Effective Benchmarks The government borrowing program should follow a regular and well publicized timetable The government debt instruments should comprise of differing maturity => will ensure a complete range of benchmark yield curve that facilitates pricing of other financial instruments

17 Government Securities as Effective Benchmarks There should be an active secondary government bond market There should be a complete range of financial derivatives to complement spot trading of government bonds => will supply a critical mass of high quality security to the bond market enhancing investors’ awareness and confidence to debt securities