Chapter 5 Interest Rates

Debt Instruments  Measurement: Yield to Maturity - most accurate measure of interest rates. The interest rate that equates the present value of an asset’s returns with its price today is called the yield to maturity Simple loan – borrower pays back the principal and interest at the same time  Simple interest Fixed payment loan – borrower pays a fixed payment per time period until the loan and interest are repaid Coupon bond –borrower pays the interest every time period and the principal at the end  Coupon rate – is the percentage paid each time Discount bond (zero coupon bond) (Savings bond) – bought at less than face value and paid face value at the maturity date

Terms  Present value – Today’s worth of a future amount  Current Yield: current yield = i = Coupon payment/Price of Coupon Bond  Basis Points: hundredths of a percentage point  Rates of Return The total rate of return, which is the sum of current yield and actual capital gain or loss, can differ from the yield to maturity. RET = (coupon payment + (Future price at t + 1) – (Price at t)/ (Price at t) = Example: $1000 bond earning 10% sold in a year for $1200  RET = /1000 = 300/1000 = 30%  i = 100/1000 = 10%  Real Interest rate. The real interest rate is the nominal interest rate adjusted for changes in purchasing power. The real rate of return equals the nominal rate of return adjusted for expected inflation. Basic: Nominal Interest Rate – Expected Inflation Rate Advanced: ((1 + nominal rate)/(1 + inflation rate)) – 1

Risk Structure of Interest Rates  The default risk on a security is measured relative to U.S. Treasury securities, which are default-risk-free instruments. The default risk premium on a bond is the difference between its yield and the yield on a default-risk-free instrument of comparable maturity. The risk premium reflects in part the bond rating, which is a single statistic summarizing the rating company’s view of the issuer’s likely ability to meet its debt obligations

 Differences in liquidity lead to differences in interest rates.  Differences in the cost of acquiring information lead to differences in interest rates.  Taxation is another reason for differences in interest rates across credit market instruments.

Determinants of Portfolio Choice Wealth: As people become wealthier the size of their portfolio of assets increases Expected Rate of Return: The correct measure of expected return is the expected real rate of return Risk: Because most people are risk-averse savers they evaluate the variability of expected returns as well as their size. Liquidity: Assets with greater liquidity help savers to smooth spending over time or to draw down funds for emergencies Information Costs: Savers prefer to hold assets with low information costs Taxation Inflation

Diversification Not putting “ all of your eggs In one basket”  Reduces risk  Advantages of Diversification To compensate for the inability to find a perfect asset, individuals engage in diversification, which is allocation of savings among many different assets. Returns on assets do not move together perfectly because their risks are imperfectly correlated. The strategy of dividing risk by holding multiple assets ensures steadier income. Diversification reduces the riskiness of the return on a portfolio unless assets’ returns move together perfectly. Savers cannot eliminate risk entirely because assets share some common risk called market (or systemic) risk

Beta To measure systematic risk, financial economists calculate a variable called beta, the responsiveness of a stock’s expected return to changes in the value of all stocks.  If a 1% increase in the value of the market portfolio leads to a 0.5% increase in the value of the asset, the asset’s beta is 0.5.  When an asset has a high value of beta, its return has a lot of systematic risk.

Loanable Funds Market  Demand for funds Interest Rates and Bond Prices move in opposite directions As market interest rates change, the market price of a bond may no longer equal its face value. The current yield on a bond equals the coupon payment, C, divided by the current price of the bond, P.  If the current price of the bond equals its face value, F, then the yield to maturity, i, the current yield, C/P, and the coupon rate, C/F, are all equal. Calculation  i = RET = Expected Return = (F-P)/P  F = 1000 and P = 950 i = 5.3%  F = 1000 and P = 900 i = 11.1%

Who demands (borrows)funds?  Businesses – plant and equipment and inventories  Households – cars, homes and consumer goods  State and Local Govts. – sewers, roads and schools  Federal Govt. – finance the federal budget deficit Determinants  Expected Profits of business increases demand  Tax on Profits of business decreases demand  Tax Subsidies for businesses increases demand  Expected Inflation increases demand  Government Borrowing increases demand

 Supply of loanable funds: Upward slope, as the Pb rises and interest rates fall, more bonds are issued Controlled by the FED Determinants of saving  Wealth increase supply  Expected returns increases the supply  Expected inflation decreases the supply  Expected returns on other assets decreases the supply  Risk on bonds decreases the supply  Liquidity of bonds increases the supply  Information costs decreases supply  Taxation

 Equilibrium: Qbd = Qbs Determines the interest rate Interest rates rise in expansions and fall in contractions

Major Interest Rates  Federal Funds Rate –rate at which banks borrow from each other  Discount Rate – Rate at which banks borrow from the FED  3 Month Treasury Bill  Moody’s Aaa Rating – Rates assigned to corporations based on their risk Investment Grades are: Aaa, Aa, A and Baa Speculative Grades (called Junk Bonds) are: Ba, B and Caa to C Default - D  Prime Rate –rate banks charge on short term loans to their best customers (best credit rating)

Financial Theories  Segmented Market Theory – each financial instrument has it’s own separate market (supply and demand) in which yields are determined The segmented markets theory holds that the yield on each instrument of differing maturity is determined in a separate market.  Preferred Habitat Theory – investors care only about returns and maturity Each investor has their own preferences and consistently invests in the same type of investments which holds that investors care about both expected returns and maturity.

Expectations  Role of Expectations - influence economic behavior, markets and policy Results of Expectations  Good news or high expecations  GDP increases  Prices rise  Unemployment falls  Interest rates will go up  Bond Prices fall  Stock prices rise  Bad news the opposite occurs

Theory of Expectations  Adaptive expectations - expectations formed from the past expectations of changes in prices or returns change gradually over time as data on past prices or returns become available. Adaptive expectations are formed by looking at current and past prices  Rational Expectations - expectations formed from all available information and understanding the economy Rational expectations are formed by looking at past prices and all currently available information about the economy that may affect prices. Most economists believe market participants have rational expectations and use all information available to them.

 Efficient Markets Theory - is rational expectations applied to financial markets The efficient markets hypothesis says that when financial markets are in equilibrium, the prices of all financial instruments reflect all readily available information Equilibrium price reflects all available information and how markets work When a variable changes, then expectations change Unexploited profit opportunities will disappear Past does not always indicate the future  Random walk - as variables change stock prices are unpredictable Stocks will respond to announcements only when they are new and unexpected If it is expected the market has already reacted