interest rates part_2
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Interest Rates: Part 2
GD20503Financial Markets and Institutions
OutlinesWhy Debt Securities Yields VaryExplaining Actual Yield DifferentialsEstimating the Appropriate YieldTerm Structure of Interest Rates
Introduction
The annual interest rate offered by debt securities at a given point in time varies among debt securities.
Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered.
In general, securities with unfavorable characteristics will offer higher yields to entice investors.
Yields on debt securities are affected by the following characteristics: (i) Credit risk; (ii) Liquidity; Tax status; and (iv) Term of maturity.
Why Debt Securities Yields Vary1. Credit (Default) Risk
If all other characteristics besides credit (default) risk are
equal, securities with a higher degree of risk will offer higher
yields.
Rating Agencies
1.) Moody’s Investor Service
2.) Standard and Poor’s Corporation
The higher the rating, the lower the perceived credit risk
Accuracy of Credit Ratings
Enron Scandal in 2001
Exhibit 3.1 Rating Classification by Rating Agencies
2. Liquidity
The ease of conversion to cash without loss of value
The lower a securities liquidity, the higher the yield preferred by investor
3. Tax Status
Investors are more concerned with after-tax income.
Taxable securities must offer a higher before-tax yield
To compute the equivalent Before-Tax
Yield:
where τat = After-tax yield
τbt = Before-tax yield
T = Investor’s marginal tax rate
)1( Tbtat
4. Term to Maturity
Maturity dates will differ between debt securities
The term structure of interest rates defines the relationship between term to maturity and the annualized yield
Explaining Actual Yield Differentials
Explaining Actual Yield Differentials
Small differentials can be significantBasis points (bp) are often quoted where
1bp = .01% = .0001
Yield Differentials of Money Market SecuritiesSecurities: commercial paper, certificates of
deposit, bankers acceptances.Yields are just slightly higher than the risk-free T-
bills
Yield Differentials of Capital Market SecuritiesMunicipal bonds have lowest before-tax yieldTreasury bonds may have higher before-tax yield
than municipal bonds but have lowest after-tax yield
Corporate bonds may have highest yields
Exhibit 3.4 Yield Differences of Corporate Bonds
Estimating the Appropriate Yield
Yn = Rf,n + DP + LP + TA
where:
Yn = yield of an n-day debt security
Rf,n = yield of an n-day Treasury (risk-free) security
DP = default premium to compensate for credit risk
LP = liquidity premium to compensate for less liquidity
TA = adjustment due to difference in tax status
Example 1:Suppose that the three-month Treasury bill’s
annualized rate is 8% and Elizabeth Company plan to issue 90-day commercial paper.
Assume that Elizabeth Company believes that a 0.7% default risk premium, a 0.2% liquidity premium and a 0.3% tax adjustment are necessary to sell its commercial paper to investors.
Thus, the appropriate yield is Yn = Rf,n + DP + LP + TA
= 8% + 0.7% + 0.2% + 0.3% = 9.2%
Term Structure of Interest Rates
Pure Expectations Theory: Term structure is determined solely by the
expectations of future rates.Impact of an expected increase in interest rates:
- Leads to an upward sloping yield curveImpact of an expected decline in interest rates:
- Leads to a downward sloping yield curveThe following figures show how interest rate
expectations affect the yield curve.
Liquidity Premium Theory: Investors prefer short-term rather than long-term
securities because a shorter maturity represents greater liquidity.
However, they may be willing to invest in long-term securities only if compensated with a premium for lower liquidity.
Liquidity may be a more critical factor to investors at particular points in time, and the liquidity premium will change over time accordingly.
Impact of Liquidity Premium on the Yield Curve under Three Different Scenarios
Segmented Markets Theory: Investors choose securities with maturities that
satisfy their forecasted cash needsLimitations of the theory: Some borrowers and savers have the flexibility to
choose among various maturities
Integrating the Theories of the Term StructureIf we assume the following conditionsInvestors and borrowers currently expect interest
rates to rise. (E)Most borrowers need long-term funds, while most
investors have only short-term funds to invest. (S)Investors prefer more liquidity to less. (L)
Then all three conditions place upward pressure on long-term yields relative to short term yields leading to upward sloping yield curve
Effect of Conditions in Example of Yield Curve
Use of the Term Structure
Forecast interest ratesForecast recessionsInvestment decision
Why the Slope of the Yield Curve ChangesIf interest rate at all maturities are affected
in the same manner by the existing conditions, the slope of the yield curve would remain the same.
However, conditions may cause short-term yields to change in a manner that differs from the change in long-term yields.
Potential Impact of Treasury Shift from Long-Term to Short-Term Financing
How the Yield Curve Changed over time
Yield Curves among Foreign Countries