Chapter 3 Structure of Interest Rates © 2001 South-Western College Publishing Company

2 Factors Affecting Yields Among Securities nDebt securities offer different yields because they exhibit different characteristics 4Unfavorable characteristics result in higher yields to entice investors

3 Factors Affecting Yields Among Securities nSecurity yields and prices are affected by levels and changes in: 4Default risk (also called Credit Risk) 4Liquidity 4Tax status 4Term to maturity 4Special contract provisions such as embedded options

4 Factors Affecting Yields Among Securities nCredit (Default) Risk 4Benchmark: Risk-free treasury securities 4Default Risk Premium = Risky security yield - Treasury security yield of same maturity 4Risk premiums for a particular bond can change over time

5 Factors Affecting Yields Among Securities nCredit (Default) Risk 4Investors can assess default risk by checking bond ratings set by Rating Agencies Moody’s Investor Service Standard and Poor’s Corporation 4Anticipated or actual ratings changes can impact security prices and yields 4Different bonds issued by the same firm can differ in rating

6 Factors Affecting Yields Among Securities nLiquidity 4A liquid investment is easily converted to cash without a loss in value 4Investors pay more (lower yield) for a more liquid investment Securities with lower liquidity must offer a higher yield 4Short-term, low default risk, marketable securities have higher liquidity

7 Factors Affecting Yields Among Securities nTax Status 4Investors are more concerned with after-tax return or yield 4Investors require higher yields for higher taxed securities 4Investors in high tax brackets benefit most from tax-exempt securities

8 Factors Affecting Yields Among Securities nTerm to Maturity 4Interest rates typically vary by maturity 4The term structure of interest rates defines the relationship between maturity and yield The Yield Curve is the plot of current interest yields versus time to maturity

9 % Years Time to Maturity Yield An upward sloping yield curve indicates that Treasury Securities with longer maturities offer higher annual yields

10 Factors Affecting Yields Among Securities nSpecial Provisions 4Call Feature: enables borrower to buy back the bonds before maturity at a specified price Call features are exercised when interest rates have declined Investors demand higher yield on callable bonds, especially when rates are expected to fall

11 Factors Affecting Yields Among Securities nSpecial Provisions 4Convertible Bonds Convertibility feature allows investors to convert the bond into a specified number of common stock shares Investors will accept a lower yield for convertible bonds

12 A Closer Look At the Term Structure nTheories Explaining Shape of Yield Curve 4Pure Expectations Theory 4Liquidity Premium Theory 4Segmented Markets Theory

13 A Closer Look At the Term Structure nPure Expectations Theory 4Long-term rates are average of current short- term and expected future short-term rates 4Yield curve slope reflects market expectations of future interest rates 4Investors select maturity based on expectations

14 A Closer Look At the Term Structure nPure Expectations Theory 4Assumes investor has no maturity preferences and transaction costs are low 4Long-term rates are averages of current short rates and expected short rates Forward rate: market’s forecast of the future interest rate

15 A Closer Look At the Term Structure nPure Expectations Theory 4Upward Sloping Yield Curve Expected higher interest rate levels Expansive monetary policy Expanding economy 4Downward Sloping Yield Curve Expected lower interest rate levels Tight monetary policy

16 A Closer Look At the Term Structure nLiquidity Premium Theory 4Investors prefer short-term, more liquid, securities 4Long-term securities and associated risks are desirable only with increased yields 4Explains upward sloping yield curve 4When combined with the expectations theory, yield curves could still be used to interpret interest rate expectations

17 A Closer Look At the Term Structure nSegmented Markets Theory 4Theory explaining segmented, broken yield curves 4Assumes investors have maturity preference boundaries, e.g., short-term vs. long-term maturities 4Explains why rates and prices vary significantly between certain maturities

18 A Closer Look At the Term Structure nWhich Theory is Correct? 4Although research results differ, there is evidence that expectations theory, liquidity preference theory, and segmented markets theory all have some validity If term structure is used to assess market’s expectations of future rates, should net out liquidity premium and unique segment characteristics

19 A Closer Look At the Term Structure nUses of the Term Structure 4Forecast interest rates 4Forecast recessions 4Investment decisions Individuals Financial institutions 4Financing decisions

20 International Structure of Interest Rates nCapital flows to the highest expected after-tax, real (inflation and other risk-adjusted), foreign exchange adjusted rates of return

21 International Structure of Interest Rates nYield differences between countries are related to: 4Expected changes in forex rates 4Varied expected real rates of return 4Varied expected inflation rates 4Varied country and business risk 4Varied central bank monetary policy