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CHAPTER 6 : Interest Rates - Po-Hsuan (Paul) Hsu

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.

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CHAPTER 6 : Interest Rates - Po-Hsuan (Paul) Hsu

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  1. CHAPTER 6: Interest Rates- Po-Hsuan (Paul) Hsu What’re interest rates? Determinants of interest rates The term structure and yield curves

  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

  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)

  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?

  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 premium DRP = default risk premium LP = liquidity premium – Corporate only MRP = maturity risk premium – Corporate only

  6. Premiums added to r* for different types of debt

  7. Interest Rate (%) 15 Maturity risk premium 10 Inflation premium 5 Real risk-free rate Years to Maturity 0 1 10 20 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.

  8. Calculating inflation premium (IP) • IP for future t years: Find the average expected inflation rate (INFL) over years 1 to t:

  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

  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:

  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.

  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%

  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

  14. An example:Observed Treasury rates and the PEH MaturityYield 1 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?

  15. One-year forward rate (i.e. future one-year interest rate) 6.0% x% 0 1 2 6.2% (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.

  16. Three-year security, two years from now 6.2% x% 0 1 2 3 4 5 6.5% (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!!

  17. BB-Rated AAA-Rated How about corporate bond yields? Corporate and Treasury yield curves Interest Rate (%) 15 10 Treasury Yield Curve 6.0% 5.9% 5 5.2% Years to Maturity 0 0 1 5 10 15 20

  18. Compare T-bill to short-term corporate bond Hint: Page 5 of this handout!

  19. End

  20. Other factors that influence interest rate levels • Federal reserve policy • Federal budget surplus or deficit • Level of business activity • International factors

  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.

  22. Country risk rankings Source: “Country Ratings by Region,” Institutional Investor, www.institutionalinvestor.com, September 2004.

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