1 definitions term structure of interest rates: relationship between the yields on bonds and their...
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Definitions
• Term structure of interest rates: relationship between the yields on bonds and their terms to maturity.
• Yield curve: graphical portrayal of the term structure of US Treasuries.
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Yield Curve
flat descending (or inverted)ascending (includes steep and normal) humped
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Factors Influencing Bond Yields
• General level of interest rates• Default risk• Term to maturity• Tax treatment• Marketability• Call or Put features
– Call: issuer can retire bond early – Put: holder can retire bond early
• Convertibility (for instance to stock)
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Example 1: Geometric Average
Over the past 4 years your investment advisor says he grew your money at 10%, 50%, -60%, 40%. Should you be happy?
10 50 60 40Arith Ave 10%
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Example 1: Geometric Average
Over the past 4 years your investment advisor says he grew your money at 10%, 50%, -60%, 40%. Should you be happy?
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10 50 60 40Arith Ave 10%
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Geom Ave (1 .10)(1 .50)(1 .60)(1 .40) 1
(1.1)(1.5)(.4)(1.4) 1
.98043 1
1.967%
Always true that:
Geometric Average ≤ Arithmetic Average
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U-3 and U-6 Unemployment Rates
Civilian Labor Pool = 156 million
U-3 = 5.9% of civilian labor pool (7.2 last year) Those without jobs, who are available to work and who have actively sought work in the prior four weeks.
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U-6 = 11.8% (13.6 last year) Includes “marginally attached workers” (1) neither working nor looking for work, but say they want
a job, and (2) want to work full-time but are working part-time
because that is best they can find.
11/7
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(1) Expectation Theory
• Shape of yield curve determined by expectations about future rates.
• This theory assumes investors are indifferent between a long-term security and a series of short-term securities.
First of four theories used to explain shape of yield curve is expectation theory:
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Term Structure Formula
0 1 1 1 2 1 1 1 0
01 1
0 1 1 1 2 1
01 1
0 1 1 1 2 1
1 1 1 1 1
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1 1 1
substituting
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1 1 1
n
n n n
n
nn
n
n
nn
n n n n
f f f f R
Rf
f f f
Rf
R R R
• Long-term interest rates are the geometric average of future period rates.
where: 0Rn observed YTM on n-year bond t fq forward rate on q-year bond that starts at
time t (where t = 0 is now)
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Implied 1-Year Forward Rate Formula
01 1 1
0 1
11
1
n
nn n
n
Rf
R
Example of how to apply:
1. Want implied yield of a 1-year security that starts 6 years from now.
2. Look up yields on 6-year security and 7-year security.
3. Use formula above with n = 7.
This results in the implied forward rate formula for the n-th period coming up
Example 2: Calculating Forward Rates
Assume following Treasury security quotes:yrs to
maturity YTM
1 2015 11-Nov 0.8953
2 2016 11-Nov 1.3725
3 2017 11-Nov 1.8770
4 2018 11-Nov 2.3172
5 2019 11-Nov 2.6626
Find the 1-year implied forward rates during nth year (where n = 2,3,4,5) using
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01 1 1
0 1
11
1
n
nn n
n
Rf
R
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Example 3: Another Example
find the 1-year implied forward rate for the period that begins 2 years from now where
1-year Treasury bill 1.9%2-year Treasury note 2.4%3-year Treasury note 2.7%
01 1 1
0 1
11
1
n
nn n
n
Rf
R
When doing, note for example: 4th period starts 3 years from now, and ends 4 years from now.
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(2) Liquidity Premium Theory Says…
• Long-term securities have greater price risk, and generally less marketability.
• Liquidity premiums contribute to an upward tendency of a yield curve.
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(3) Market Segmentation Theory Says…
• Market participants may have strong preferences for particular maturities, and buy and sell securities consistent with these preferences.
• Can theoretically lead to discontinuities in yield curve.
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(4) Preferred Habitat Theory Says…
• Preferred Habitat Theory (an extension of Market Segmentation Theory) allows market participants to trade outside of their preferred maturities if adequately compensated.
• Preferred Habitat Theory allows for humps in the yield curve.
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Which Theory is Right?
• Each has its point.
• Day-to-day changes in the term structure seem consistent with the Preferred Habitat Theory.
• Many economists also feel that Expectations and Liquidity Premiums are important, too.
• Market Segmentation Theory appears to be least realistic of the four.
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Bond RatingsFitch, too
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NRSROs• Nationally Recognized Statistical Rating Organizations
• NRSROs are credit-rating agencies authorized by the SEC and banking regulators. Currently 10 (best known Moody’s, Standard & Poor’s, Fitch).
• BBB- (Baa3) and above are investment-grade, below are speculative-grade or “junk.”
• Issuers pay to have their bonds rated. Banks, insurance companies, pension funds, many mutual funds can only hold investment-grade bonds.
• As conditions change, rating agencies change their ratings. Bad when an issue’s rating drops below cutoff.
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Default Rates
AAA 0.52%AA 1.31A 2.32BBB 6.64BB 19.52B 35.76CCC 54.38
Non-mortgage bond default history, when initially rated:
History with recent mortgage securities entirely different.
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Default Risk
• Investors require a default risk premium.
• DRP = i – irf > 0
• Default risk premiums tend to increase in periods of recession (when people scared) and decrease in periods of economic expansion (when people overconfident).
• “flight-to-quality”• Bond ratings are only for default risk.
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Call Options
• Call option permits the issuer to call (refund) the obligation before maturity.
• Issuers will “call” if interest rates decline.
• investors demand a call interest premium.
• CIP = ic – inc > 0
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Put Options
• Put option permits the investor to terminate the contract at a designated price before maturity.
• Investors are likely to “put” their bond back to the issuer during periods of high interest rates.
• Difference in interest rates between putable and nonputable contracts is called the put interest discount.
• PID = ip – inp < 0
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Conversion Options• Permits the investor to convert a security contract
into another security
• Conversion yield discount is the difference between the yields on convertibles relative to nonconvertibles.
• CYD = icon – incon < 0