1. The Structure of Interest Rates 1 CHAPTER 4 Copyright © 1999 Addison Wesley Longman

2. 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

3. 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

4. Copyright © 1999 Addison Wesley Longman 4 Chapter 4: The Structure of Interest Rates FIGURE 4.1 Monthly T-Bill Returns over Time

5. 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

6. Copyright © 1999 Addison Wesley Longman 6 Chapter 4: The Structure of Interest Rates Inflation FIGURE 4.2 3-Month T-Bill Returns and Inflation Rates

7. 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

8. 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

9. 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

10. 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.

11. Copyright © 1999 Addison Wesley Longman 11 Chapter 4: The Structure of Interest Rates FIGURE 4.4 Equilibrium with Market Segmentation Market Segmentation Theory

12. 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

13. 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)

14. 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.