Chapter 6 Interest Rates

T-bond yield formula

r t* +IP t + MRP t -the real risk-free rate, r t* changes unpredictably so we use the best guess -IP also varies over time but is more predictable, while MRP always increases with maturity

Corporate bond yield formula

r t* +IP t + MRP t + DRP t +LP t

sound financing decisions often involve a

mixture of short-term debt, long-term debt, and equity issues

real rate of interest refers to

the difference between the nominal rate and the inflation rate

rates also depend on

the expected inflation, risk of default, and differences in liquidity

production opportunities, time preferences of consumption, risk, inflation

Four factors to consider when evaluating the cost of money

Maturity Risk Premium (MRP)

As interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainty. This is the premium that reflects the risk associated with changes in interest rates for a long-term security. This is the premium that reflects the risk associated with changes in interest rates for a long-term security.

default risk premium

DRP -This compensates the lender for taking on the risk that the borrower will default -Treasury securities are assumed to carry no default risk -Corporate bonds tend to use bond ratings to measure default risk; higher ratings mean lower interest rates, and vice versa -DRPs are larger when the economy is weaker, as borrowers are likely to have more difficulty paying back debts

T/F Actions that lower short-term interest rates will always lower long-term interest rates.

F

T/F All else equal, the yield on new bonds issued by a leveraged firm will be less than the yield on the new bonds issued by an unleveraged firm.

F

the inflation premium

IP -inflation decreases the value of the returns on your investments; an increase in prices decreases your purchasing power with the same amount of money -To account for this, the inflation premium is built into interest rates

liquidity risk premium (LP)

It is based on the bond's marketability and trading frequency; the less frequently the security is traded, the higher the premium added, thus increasing the interest rate. This is the premium added to the equilibrium interest rate on a security that cannot be bought or sold quickly enough to prevent or minimize loss. This premium is added when a security lacks marketability, because it cannot be bought and sold quickly without losing value.

the liquidity premium

LP - This compensates the lender for holding on to a less liquid asset (harder to sell) -You can get a sense of an asset's liquidity by looking at its trading volume -Higher trading volume means higher liquidity, which means a lower premium

Maturity risk premium

MRP -Because the prices of long-term bonds fall when interest rates rise, long-term bonds carry what is known as interest rate risk - the MRP is larger for bonds with a longer maturity -When interest rates are volatile, the MRP is higher -When interest rates are volatile, the MRP is higher

r=r* + IP + DRP +LP +MRP

The determinants of market interest rates

T/F A certificate of deposit (CD) for two years will have the same yield as a CD for one year followed by an investment in another one-year CD after one year.

T

T/F Countries with strong balance sheets and declining budget deficits tend to have lower interest rates.

T

T/F During the credit crisis of 2008, investors around the world were fearful about the collapse of real estate markets, shaky stock markets, and illiquidity of several securities in the United States and several other nations. The demand for US Treasury bonds increased, which led to a rise in their price and a decline in their yields.

T

T/F If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the Treasury yield curve is downward sloping. (Assume MRP = 0.)

T

T/F The Federal Reserve Board has a significant influence over the level of economic activity, inflation, interest rates in the United States.

T

T/F The pure expectations theory assumes that investors do not consider long-term bonds to be riskier than short-term bonds.

T

T/F The yield curve for a BBB-rated corporate bond is expected to be above the US Treasury bond yield curve.

T

T/F Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets.

T

foreign trade deficit

The situation that exists when a country imports more than it exports.

Default Risk Premium (DRP)

This is the difference between the interest rate on a US Treasury bond and a corporate bond of the same profile—that is, the same maturity and marketability. This is the premium added as a compensation for the risk that an investor will not get paid in full. It is based on the bond's rating; the higher the rating, the lower the premium added, thus lowering the interest rate.

inflation premium (IP)

This is the premium added to the real risk-free rate to compensate for a decrease in purchasing power over time. This is the premium added to the risk-free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security's entire life. Over the past several years, Germany, Japan, and Switzerland have had lower interest rates than the United States due to lower values of this premium.

nominal risk-free rate (r RF)

This is the rate on a Treasury bill or a Treasury bond. This is the rate for a riskless security that is exposed to changes in inflation. It is calculated by adding the inflation premium to r*.

real risk-free rate (r*)

This is the rate on short-term US Treasury securities, assuming there is no inflation. It changes over time, depending on the expected rate of return on productive assets exchanged among market participants and people's time preferences for consumption This is the rate for a short-term riskless security when inflation is expected to be zero.

Corporate bonds of equal maturity will have the same risk-free rate, inflation premium, and maturity risk premium as

US Treasury bonds. Corporate bonds, however, are riskier and have a default risk premium. Thus, a corporate bond's yield curve will be higher than that of a US Treasury bond.

Suppose the real risk-free rate and inflation rate are expected to remain at their current levels throughout the foreseeable future. Consider all factors that affect the yield curve. Then identify which of the following shapes that the US Treasury yield curve can take

Upward-sloping yield curve

US Treasury bills, notes, and bonds

are considered to be the least risky among all debt securities, because they are backed by the US government.

T-bond yields

can look at to gauge expected inflation, which are free from default risk and liquidity problems

Impact on yield and cost of borrowing from bond market: Previously, Ferro Co. had only used short-term debt financing. The company now finances its current assets such as inventories and receivables with short-term debt, and it finances its fixed assets such as buildings and equipment with long-term debt.

decrease, less expensive

Impact on yield and cost of borrowing from bond markets: Bellgotts Inc. has increased its market share from 15% to 37% over the last year while maintaining a profit margin greater than the industry average.

decrease, less expensive

Macroeconomic factors and interest rates

federal reserve policy, federal budget deficits, and surpluses, international factors, historical trends in business activity

lenders (investors) want ___ rates, while borrowers want___ rates

higher, lower

shape of the yield curve

in general, long-term rates are higher due to the maturity risk premium

Impact on yield and cost of borrowing from bond markets: ABC Real Estate is a commercial real estate firm that primarily uses short-term financing, while its competitors primarily use long-term financing. Interest rates have recently increased dramatically.

increase, more expensive

Impact on yield and cost of borrowing from bond markets: Ziffy Corp.'s credit rating was downgraded from AAA to A.

increase, more expensive

a corporation looking to finance projects with debt should look at

interest rates and their projections closely

longer maturity bonds are also

less liquid due to the need for credit-checking

default and liquidity risks are also affected by

longer maturities

the probability of default is higher for

longer maturity bonds

interest rate in each market

point where the supply and demand curves meet

the nominal risk-free rate

r RF (r*+ IP) -the interest rate on a risk-free security with inflation -the closest to truly risk-free security in real life (r*) is the treasury inflation-protected security (TIPS) -it increases in value with inflation, and they are free of default, maturity, and liquidity risks -still subject to the risk that r* changing

the real risk-free rate

r*, -the interest rate charged on riskless security in a world without inflation. -Affected by economic conditions such as expected return on productive assets and time preferences -generally around (1-3%) -based on the rate of return on indexed treasury bonds; however they have known to be negative

The term structure of interest rates is

relationship between long-term and short-term rates

recommended that current assets be financed with ___ while fixed assets be financed with

short-term debt, long-term debt

the money market has lenders as the ___ and borrowers as ___

suppliers, demanders

yield spread for the corporate bond is found by

taking the difference between the corporate bond yield and the T-bond yield

pure expectations theory of interest rates

you can infer expected future short-term rates by comparing spot short- and long-term rates. Pure expectations theory does not depend on the yield curve being either upward or downward sloping.

price

you can think of the interest rate as the ____ of money

federal budget deficits and surpluses

○ A deficit is when the government spends more than it gets in taxes ○ A surplus is when it spends less than it gets in taxes ○ Deficits are covered when by additional borrowing, which increases demand for funds ○ This will increase the interest rate ○ The printing of more money will also lead to rising interest rates

international factors

○ Foreign trade deficits (more imports than exports) tend to lead to borrowing ○ Foreigners hold US securities if they're competitive with other nations', which ties US interest rates to that of other nations and limits the effectiveness of monetary policy ○ The United States have been running trade deficits since the mid-70s

The federal reserve policy

○ The Federal Reserve (the Fed) controls the supply of money in the US ○ They do this via issuance and buyback of short-term securities ○ They seek to promote economic growth while curtailing inflation ○ They affect mainly short-term rates, not long-term ones

yield curves

○ The X-axis has the years to maturity of the security ○ The Y-axis has the corresponding interest rate ○ Riskier bonds have higher yield curves ○ Yield curves tend to slope upward, due to the maturity risk premium ○ Thus, ones that slope upward are normal; ones that slope downward are inverted or abnormal ○ They could also have a kink in the middle (humped)

historical trends in business activity

○ There has been a general downward trend in interest rates after 1981 ○ Rates tend to decline in recessions ○ Short-term rates decline more quickly during recessions than long-term rates ■ Fed intervention is most effective in the short-term ■ Long-term rates reflect long-term inflation expectations, which do not change as much