Upload
forrest-riddle
View
31
Download
1
Embed Size (px)
DESCRIPTION
CHAPTER 6 : Interest Rates - Po-Hsuan (Paul) Hsu. What’re interest rates? Determinants of interest rates The term structure and yield curves. What’re interest rates (r)?. Interest is a charge for borrowed capital. - PowerPoint PPT Presentation
Citation preview
6-1
CHAPTER 6: Interest Rates- Po-Hsuan (Paul) Hsu
What’re interest rates? Determinants of interest rates The term structure and yield
curves
6-2
What’re interest rates (r)? Interest is a charge for borrowed
capital. Interest rates vary across different
types of money borrowed (debt securities) – why?
3 major money borrowers: 1. Banks (checking, saving, CD) 2. Governments (Fed, State, City) 3. Firms/corporates
6-3
The duration of the money borrowed: 1. Short-term (1m, 3m, 6m, 9m)
2. Long-term (1y, 2y, 3y, 5y, 10y, 30y, etc.)
We mainly discuss the following 4 types of debt securities:
1. Government: Long-term (T-bonds), short-term (T-bills). “T” denotes treasury
2. Corporate: Long-term bond, short-term (notes)
6-4
“ Nominal” vs. “real” interest rates
r = represents any nominal rate
r* = represents the “real” risk-free rate of interest.
? What’s the most secured debt?
6-5
Determinants of interest rates
r = r* + IP + DRP + LP + MRP
r = required/expected return on a debt security
r* = real risk-free rate of interest – existing?
IP = inflation premiumDRP = default risk premiumLP = liquidity premium – Corporate onlyMRP= maturity risk premium – Corporate
only
6-6
Premiums added to r* for different types of debt
IP MRP DRP LP
Short-term Treasury
Long-term Treasury
Short-term Corporate
Long-term Corporate
6-7
Treasury bills and bonds:Hypothetical T-bond yield curve
An upward sloping yield curve.
Upward slope due to an increase in expected inflation and increasing maturity risk premium.
Years to Maturity
Real risk-free rate
0
5
10
15
1 10 20
InterestRate (%)
Maturity risk premium
Inflation premium
6-8
Calculating inflation premium (IP) IP for future t years: Find the average
expected inflation rate (INFL) over years 1 to t:
t
INFLIP
t
1ii
t
6-9
Assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter.
IP1 = 5% / 1 = 5.00%
IP10= [5% + 6% + 8%(8)] / 10 = 7.50%
IP20= [5% + 6% + 8%(18)] / 20 = 7.75%
- Any nominal r must earn these IPs to break even vs. inflation
6-10
Computing maturity risk premium (MRP) Find the appropriate maturity risk
premium (MRP). The following equation will be used to find a bond’s MRP at t:
) 1 -t ( 0.1% MRPt
6-11
Using the given equation:
MRP1 = 0.1% x (1-1) = 0.0%
MRP10 = 0.1% x (10-1) = 0.9%
MRP20 = 0.1% x (20-1) = 1.9%
Notice that the MRP is increasing in t (as the time to maturity increases), as it should be.
6-12
Add the IPs and MRPs to r* to construct the T-bond yield curve
By adding IP and MRP to r*:
rt = r* + IPt + MRPt
Assume r* = 3%,
r1 = 3% + 5.0% + 0.0% = 8.0%
r10 = 3% + 7.5% + 0.9% = 11.4%
r20 = 3% + 7.75% + 1.9% = 12.65%
6-13
Pure Expectations Hypothesis (PEH)
The yield curve reflects the market’s expectation of “future interest rates”
We can break down a long-term interest rate into an average of current short-term rates and future short-term rates
6-14
An example:Observed Treasury rates and the PEH
Maturity Yield1 year 6.0%2 years 6.2%3 years 6.4%4 years 6.5%5 years 6.5%
If PEH holds, what does the market expect will be the interest rate on one-year securities, one year from now? Three-year securities, two years from now?
6-15
One-year forward rate (i.e. future one-year interest rate)
(1.062)2 = (1.060) (1+x)
1.12784/1.060 = (1+x)
6.4004% = x
PEH says that one-year securities will yield 6.4004%, one year from now.
0 1 2
6.0% x%
6.2%
6-16
Three-year security, two years from now
(1.065)5 = (1.062)2 (1+x)3
1.37009/1.12784 = (1+x)3
6.7005% = x
PEH says that three-year securities will yield 6.7005%, two years from now.
Note: You may want to learn how to use Yx in your financial calculator!!
0 1 2 3 4 5
6.2% x%
6.5%
6-17
How about corporate bond yields? Corporate and Treasury yield curves
0
5
10
15
0 1 5 10 15 20
Years toMaturity
Interest Rate (%)
5.2%5.9%
6.0%TreasuryYield Curve
BB-Rated
AAA-Rated
6-18
Compare T-bill to short-term corporate bond
Interest rate
(yield)
LP DRP
1-year T-bill 4.65% - -
1-year AAA ? % 0.10% 0.40%
1-year BBB ? % 0.20% 0.80%
Hint: Page 5 of this handout!
6-19
End
6-20
Other factors that influence interest rate levels
Federal reserve policy Federal budget surplus or deficit Level of business activity International factors
6-21
Risks associated with investing overseas
Exchange rate risk – If an investment is denominated in a currency other than U.S. dollars, the investment’s value will depend on what happens to exchange rates.
Country risk – Arises from investing or doing business in a particular country and depends on the country’s economic, political, and social environment.
6-22
Country risk rankings
Top 5 countries (least risk)
Rank
Country Score
1 Switzerland 95.2
2 Luxembourg 93.9
3 United States 93.7
4 Norway 93.7
5 United Kingdom
93.6
Bottom 5 countries (most risk)
Rank
Country Score
169 Afghanistan 11.0
170 Liberia 9.4
171 Sierra Leone 9.3
172 North Korea 8.9
173 Somalia 8.2Source: “Country Ratings by Region,” Institutional Investor, www.institutionalinvestor.com, September 2004.