lecture_3_ba_105(3)

LECTURE 3

INTEREST RATE AND TERM STRUCTURE OF INTERESTFinancial Markets and Institution

2012 Pearson Prentice Hall. All rights reserved.3-*

Learning ObjectivesTo review the four basic types of credit market instruments. To differentiate between real and nominal interest rate.To determine the factors affect the changes in interest rate equilibrium. To understand the risk structure of interest rate and the term structure of interest rate.

2012 Pearson Prentice Hall. All rights reserved.


Learning OutcomesAt the end of the chapter, you will be able toreview the four basic types of credit market instruments. differentiate between real and nominal interest rate.determine the factors affect the changes in interest rate equilibrium. understand the risk structure of interest rate and the term structure of interest rate.



Four Types of Credit Market InstrumentsSimple Loans require payment of one amount which equals the loan principal plus the interest. Fixed-Payment Loans are loans where the loan principal and interest are repaid in several payments, often monthly, in equal dollar amounts over the loan term (e.g. auto and mortgage loans).



Four Types of Credit Market InstrumentsCoupon Bond pays the owner of the bond affixed interest payment every year until the maturity date, when the face value is repaid. Discount bond is bought at a price lower than its face value, and the face value is repaid at the maturity date.



Yield on a Discount BasisOne-Year Bill (P = $900, F = $1000)



Global perspectiveIn November 1998, rates on Japanese 6-month government bonds were negative! Investors were willing to pay more than they would receive in the future.Best explanation is that investors found the convenience of the bills worth somethingmore convenient than cash as a store of value. But that can only go so farthe rate was only slightly negative.



Distinction Between Real and Nominal Interest RatesReal interest rateInterest rate that is adjusted for expected changes in the price levelir = i peReal interest rate more accurately reflects true cost of borrowingWhen the real rate is low, there are greater incentives to borrow and less to lend



Distinction Between Real and Nominal Interest RatesReal interest rateir = i peWe usually refer to this rate as the ex ante real rate of interest because it is adjusted for the expected level of inflation. After the fact, we can calculate the ex post real rate based on the observed level of inflation.



Distinction Between Real and Nominal Interest Rates (cont.)If i = 5% and pe = 0% thenIf i = 10% and pe = 20% then



U.S. Real and Nominal Interest RatesSample of current rates and indexeshttp://www.martincapital.com/charts.htm



Determinants of Asset DemandAn asset is a piece of property that is a store of value. The quantity demanded of an asset differs by factor. Wealth: Holding everything else constant, an increase in wealth raises the quantity demanded of an assetExpected return: An increase in an assets expected return relative to that of an alternative asset, holding everything else unchanged, raises the quantity demanded of the assetRisk: Holding everything else constant, if an assets risk rises relative to that of alternative assets, its quantity demanded will fallLiquidity: The more liquid an asset is relative to alternative assets, holding everything else unchanged, the more desirable it is, and the greater will be the quantity demanded



Supply & Demand in the Bond MarketExamine how interest rates are determinedfrom a demand and supply perspective. Keep in mind that these forces act differently in different bond markets. That is, current supply/demand conditions in the corporate bond market are not necessarily the same as, say, in the mortgage market. We assume that there is one interest rate for the entire economy.Bond price and interest rate have inverse relationship.



Shifts in the Demand for BondsWealth: in a business cycle expansion with growing wealth, the demand for bonds rises, conversely, in a recession, when income and wealth are falling, the demand for bonds fallsExpected returns: higher expected interest rates in the future decrease the demand for long-term bonds, conversely, lower expected interest rates in the future increase the demand for long-term bonds



Shifts in the Demand for Bonds Risk: an increase in the riskiness of bonds causes the demand for bonds to fall, conversely, an increase in the riskiness of alternative assets (like stocks) causes the demand for bonds to riseLiquidity: increased liquidity of the bond market results in an increased demand for bonds, conversely, increased liquidity of alternative asset markets (like the stock market) lowers the demand for bonds


Factors That Shift Demand Curve (b)4-* 2012 Pearson Prentice Hall. All rights reserved.



Shifts in the Supply of BondsExpected Profitability of Investment Opportunities: in a business cycle expansion, the supply of bonds increases, conversely, in a recession, when there are far fewer expected profitable investment opportunities, the supply of bonds fallsExpected Inflation: an increase in expected inflation causes the supply of bonds to increaseGovernment Activities: higher government deficits increase the supply of bonds, conversely, government surpluses decrease the supply of bonds



Factors That Shift Supply Curve



Changes in pe: The Fisher Effect If pe Relative Re , Bd shifts in to left Bs , Bs shifts out to right P , i



Summary of the Fisher EffectIf expected inflation rises from 5% to 10%, the expected return on bonds relative to real assets falls and, as a result, the demand for bonds fallsThe rise in expected inflation also means that the real cost of borrowing has declined, causing the quantity of bonds supplied to increaseWhen the demand for bonds falls and the quantity of bonds supplied increases, the equilibrium bond price fallsSince the bond price is negatively related to the interest rate, this means that the interest rate will rise



Risk Structure of Interest RatesBonds with same term to maturity have different interest rates. The relationship among these interest rates is called the risk structure of interest rates. The relationship among interest rates on bonds with different terms to maturity is called the term structure of interest rates.



Risk Structure of Long Bonds in the U.S.



Risk Structure of Long Bonds in the U.S.The figure shows two important features of the interest-rate behavior of bonds.Rates on different bond categories change from one year to the next.Spreads on different bond categories change from one year to the next.



Factors Affecting Risk Structure of Interest RatesTo further examine these features, we will look at three specific risk factors.Default RiskLiquidityIncome Tax Considerations



Default Risk FactorOne attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised.U.S. Treasury bonds - no default risk (called default-free bonds).The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium



Increase in Default Risk on Corporate Bonds



Bond Ratings



Case: The Subprime Collapse and the Baa-Treasury SpreadStarting in 2007, the subprime mortgage market collapsed, leading to large losses for financial institutions.Because of the questions raised about the quality of Baa bonds, the demand for lower-credit bonds fell, and a flight- to-quality followed (demand for T-securities increased.Result: Baa-Treasury spread increased from 185 bps to 545 bps.



Liquidity FactorA liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (higher demand), holding everything else constant.



Corporate Bond Becomes Less LiquidCorporate Bond Market1.Liquidity of corporate bonds , Dc , Dc shifts left2.Pc , ic Treasury Bond Market1.Relatively more liquid Treasury bonds, DT , DT shifts right2.PT , iT Outcome Risk premium, ic - iT, risesRisk premium reflects not only corporate bonds default risk but also lower liquidity (called as risk & liquidity premium).



Income Taxes FactorMunis are not as liquid a Treasuries, but had lower interest rate than U.S. T-bonds. Why?Interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return.Treasury bonds are exempt from state and local income taxes, while interest payments from corporate bonds are fully taxable.



Tax Advantages of Municipal Bonds Municipal Bond Market1.Tax exemption raises relative Re on municipal bonds, Dm , Dm shifts right2.Pm Treasury Bond Market1.Relative Re on Treasury bonds , DT , DT shifts left2.PT Outcomeim iT



Term Structure of Interest RatesBonds with different maturities tend to have different required rates, all else equal.Besides explaining the shape of the yield curve, a good theory must explain why:Interest rates for different maturities move together. We see this on the next slide.



Interest Rates on Different Maturity Bonds Move Together



Term Structure Facts to Be ExplainedBesides explaining the shape of the yield curve, a good theory must explain why:Interest rates for different maturities move together. Yield curves tend to have steep upward slope when short rates are low and downward slope when short rates are high.Yield curve is typically upward sloping.



Three Theories of Term StructureExpectations Theory Pure Expectations Theory explains 1 and 2, but not 3Market Segmentation TheoryMarket Segmentation Theory explains 3, but not 1 and 2Liquidity Premium TheorySolution: Combine features of both Pure Expectations Theory and Market Segmentation Theory to get Liquidity Premium Theory and explain all facts



Expectations Theory and Term Structure FactsPure expectations theory explains fact 1that short and long rates move togetherShort rate rises are persistent If it today, iet+1, iet+2 etc. average of future rates int Therefore: it int (i.e., short and long rates move together)



Expectations TheoryKey Assumption: Bonds of different maturities are perfect substitutesImplication: Re on bonds of different maturities are equal



Expectations Theory and Term Structure FactsExplains fact 2that yield curves tend to have steep slope when short rates are low and downward slope when short rates are highWhen short rates are low, they are expected to rise to normal level, and long rate = average of future short rates will be well above today's short rate; yield curve will have steep upward slope.When short rates are high, they will be expected to fall in future, and long rate will be below current short rate; yield curve will have downward slope.



Expectations Theory and Term Structure FactsDoesnt explain fact 3that yield curve usually has upward slopeExplains why yield curve has different slopesWhen short rates are expected to rise in future, average of future short rates = int is above today's short rate; therefore yield curve is upward sloping.When short rates expected to stay same in future, average of future short rates same as todays, and yield curve is flat.Only when short rates expected to fall will yield curve be downward sloping.



Market Segmentation TheoryKey Assumption: Bonds of different maturities are not substitutes at allImplication: Markets are completely segmented; interest rate at each maturity are determined separately



Market Segmentation TheoryExplains fact 3that yield curve is usually upward slopingPeople typically prefer short holding periods and thus have higher demand for short-term bonds, which have higher prices and lower interest rates than long bondsDoes not explain fact 1or fact 2 because its assumes long-term and short-term rates are determined independently.



Liquidity Premium TheoryKey Assumption:Bonds of different maturities are substitutes, but are not perfect substitutesImplication: Modifies Pure Expectations Theory with features of Market Segmentation Theory



Liquidity Premium TheoryInvestors prefer short-term rather than long-term bonds. This implies that investors must be paid positive liquidity premium, int, to hold long term bonds.



Liquidity Premium Theory



Liquidity Premium Theory: Term Structure FactsExplains All 3 FactsExplains fact 3that usual upward sloped yield curve by liquidity premium for long-term bondsExplains fact 1 and fact 2 using same explanations as pure expectations theory because it has average of future short rates as determinant of long rate



Tutorial QuestionMishkin & Eakins. 2012. Financial Markets and Institutions, 7th ed. Pearson (Pg. 126-127 )Question 7,9,10,12,13Quantitative problems 1,2,3,4


Ex-ante real interest rate is important to the economic decisions as the expected level of inflation need to be as accurate as possible.Ex-post real interest rate shows how well a lender done in real terms after the fact. 1. During business expansion, firms expect more project can be invested, hence, borrow more to finance those projects via issuing bonds.2. When expected inflation increase, the real cost of borrowing fall and hence the supply of bond increase. 3. Government treasury issue bond to finance deficit and decrease the supply of the bond when government has surpluses. 1. High expected inflation real interest rate fall supply increase (cost of borrowing drop) & demand decrease (return drop)For example, suppose you are in the 35% tax bracket. From a 10%-coupon Treasury bond, you only net $65 of the coupon payment because of taxesHowever, from an 8%-coupon muni, you net the full $80. For the higher return, you are willing to hold a riskier muni (to a point).

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