Finance Chapter 6
Default Risk
the majority of corporate bond yield spread can be attributed to
Treasury Inflation-Protected Securities (TIPS)
there is no truly risk-free rate BUT this is free of most
Maturity Risk Premium (MRP)
1. it varies somewhat over time, rising when interest rates are more volatile and uncertain, and falling when interest rates are more stable. 2. in recent years, this on 20 year T-bonds = 1-2%.
1. Interest rates will vary 2. Interest rates will increase if inflation appears to be headed higher or decrease if it is expected to decline
2 things are certain:
Production Opportunities, Time Preferences for Consumption, Risk, and Inflation
4 most fundamental factors affecting the cost of money
1. Federal Reserve Policy 2. Federal Budget Deficit/Surplus 3. International Factors 4. level of business activity
4 primary macro factors that influence Interest rate levels
Interest rate
= equilibrium on supply/demand curve
increase money supply
to stimulate the economy, the fed
Expectations for future inflation
are closely but not perfectly correlated with past inflation rates.
U.S. Treasury Securities
are free from default risk, which means you can be certain that the federal government will pay interest on its bonds and pay them off when they mature. (assume DR = 0)
Short-term bonds
are more exposed to reinvestment risk
Short-term rates
are more responsive to current economic conditions
Long-term; Short-term
Because MRPs are positive, if other things were held constant, ____ would always have higher interest rates than ____
above Treasury Securities
Because corporate securities include default risk premiums and other higher liquidity premiums, their yields are
MRP
Because investors consider long-term bonds to be riskier than short-term bonds because of IR risk, the ____ always increases with maturity
trading volume
Can get a sense of an asset's liquidity by looking at its
r*t + IPt + MRPt + DRPt + LPt
Corporate Bond Yield equation
Corporate Bond Yield Spread
Corporate bond yield - treasury bond yield = DRP + LP (compares corporate and treasury bond yields)
maturity
Corporate bond's DR and LR are affected by their
Short-Term rates
are more volatile than long-term rates.
Long-term rates
are not as much affected by Fed intervention.
Short-term rates; long-term rates
During recession, ____ decline more sharply than ____.
the Fed operates mainly in the short-term sector so its intervention has the strongest effect there, and because long-term rates reflect the average expected inflation rate over the next 20 to 30 years.
During recessions, short-term rates decline more sharply than long-term rates because
the current inflation rate is low due to a recession or high because of a boom
During recessions, short-term rates decline more sharply than long-term rates because long-term rates reflect the average expected inflation rate over the next 20 to 30 years, and this expectation generally does not change much even when
inflationary pressures
are strongest during business booms, also exerting upward pressure on rates. (conditions are reversed during recessions)
Short-term rates to decline
Fed buys and sells short-term securities, so the initial easing would be to cause
hold U.S. debt if and only if the rates on U.S. securities are competitive with rates in other countries
If a country has a trade deficit and has to borrow money from other nations with export surpluses, the foreigners will
MRP would be zero, and long-term interest rates would be a weighted average of current and expected future short-term interest rates
If pure expectations theory was true,
Indexed Treasury Securities
are the closest thing that we have to a diskless security, but even they are not totally riskless because r* can change and cause a decline in prices of these securities.
quoted interest rate
Inflation rate reflected in the _____ on any security is the average inflation rate expected over the security's life.
1. the rate of return that producers expect to earn on invested capital 2. on savers' time preferences for current vs. future consumption 3. on riskiness of the loan 4. on expected future rate of inflation
Interest rate to savers depends on 4 things:
real risk-free rate (r*)
Interest rates that would exist on a diskless security if no inflation were expected. It may be thought as the rate of interest on short-term U.S. treasury securities in an inflation-free world.
High Time Preference
Mr. Friday being unwilling to "lend" a fish today for anything less than three fish next year because he needs all of is current fish for his wife and kids.
Low Time Preference
Ms. Robinson might be thinking of retirement and she might be willing to trade fish in the future on a one-for-one basis.
Long-term bonds
Price of _____ decline when interest rates rise and because of this, even treasury bonds have an element of risk (interest risk).
set an upper limit to how much they can pay for savings
Producers'' expected returns on their business investments
QIR = r = r* + IP + DRP + LP +MRP
Quoted or Nominal IR equation
r
Quoted or Nominal interest rates
Bond ratings
are used to measure default risks on corporate bonds.
r*t + IPt + MRPt
T-Bond Yield equation (r* changes are random rather than predictable but best forecasts are current value)
True
T/F actions that lower short-term rates won't necessarily lower long-term rates
Long-term interest rates
are volatile because investors are not sure if inflation is truly under control or is about to jump back to higher levels like in the 1980s.
Firms with the most profitable investment opportunities
are willing and able to pay the most for capital, so they tend to attract it away from less efficient firms or from those whose products are not in demand.
Pure expectations theory
assumes that bond traders establish bond prices and interest rates strictly on the basis of expectations for future interest rates and that they are indifferent to maturity because they are riskier than short-term bonds.
Term Structure of Interest Rates
because short-term rates are more responsive to current economic conditions, they are sometimes above and below long-term rates.
higher the required rate of return
The higher the perceived risk, the
on rates in other countries
U.S. interest rates are highly dependent on ____, which limits the ability of the Fed Reserve to use monetary policy to control economic activity in U.S.
higher the yield curve
The riskier the corporation, the
long-term corporate bonds have more DR and LR than short-term bonds (both of these premiums are absent in Treasury Bonds)
The spread between corporate and treasury bonds is larger the longer the maturity because
Borrowers
bid for the available supply of debt capital using interest rates.
the larger the required dollar return
the higher the expected rate of inflation,
1. how long and short-term rates relate to each other 2. what causes shifts in relative levels.
When both borrowers and lenders are trying to decide on short-term or long-term bonds, they should understand:
Short term debt
When dealing with current assets like inventories and receivables, it is more feasible to use
Real assets; financial assets
___ are less liquid than ____
Long-term rates; short-term rates
____ are generally above ___ because of MRP, so all yield curves slope upward.
increase in inflation and long-term rates and a decrease in short-term rates
a large money supply may lead to an
Sound Financial Policy
calls for using a mix of long and short-term debt as well as equity to position the firm so that it can survive in any interest rate environment.
Consumer price
change with a lag following changes at producer lever. Example: price of oil increases this month, gasoline prices are likely to increase in the coming months.
Federal Reserve Board
controls money supply
interest
cost of money in debt instrument =
lower rates
could cause foreigners to sell their holdings of U.S. bonds, so they would buy their own currencies, which would lower the value of the dollar, making U.S. goods less expensive, and help manufacturers and thus lower the trade deficit.
real risk-free rate (r*)
current interest - expected future inflation rate
Current real rate of interest
current interest rate - current inflation rate (a gap between the inflation bars and the interest rate curve) and it shows how much investors really earned after the effects of inflation are removed
During recessions
demand for credit is reduced, inflation falls, and the Federal Reserve increases the supply of funds to help stimulate the economy. Decline in interest rates
Market Interest Rates
depend on expected inflation, DR, Liquidity, each can vary with maturity
Consumers' time preferences for consumption
establish how much consumption they are willing to defer and hence how much they will save at different interest rates.
money supply
has a significant effect on the level of economic activity, inflation, and interest rate.
Federal Government
has agencies that help designated individuals or groups obtain credit on favorable terms, and among those eligible are small businesses, certain minorities, and firms willing to build plants in areas with high unemployment.
increase in inflation and interest rates
if the government printed money for the deficit, the result will be an
increase in demand for funds and increase in IR
if the government runs a deficit and it has to borrow, there is an
Risk-free rate
includes an inflation rate over the remaining life of the security. (T-Bond for Long-term and T-Bill for Short-term)
inflation rate expected in the future
inflation rate built into interest rates is
BBB
interest is more expensive because lower credit = more risk
allocating capital
interest rates are
risk premium
investors are willing to accept higher risks for a higher
Most capital in the U.S.
is allocated through the price system, where interest rate=price.
Quoted or Nominal Interest Rate (r)
is composed of a real risk-free, r*, plus several permiums that reflect inflation, the securities risk, its liquidity (or marketability), and the years to its maturity.
Default risk premium (DRP)
is the difference in quoted interest rates on a T-bond and that on a corporate bond with similar maturity, liquidity, and other features.
Short-term debt has less default risk
long-term corporate bonds tend to be less liquid than short-term because
Yield Curve
may be distorted when the Fed is actively intervening in the markets.
Short-term rates
may be driven below the long-run equilibrium level if Fed is easing credit and above equilibrium if tightening credit.
Higher trading volume
means easier to sell, so more liquid
Real risk-free rate
no default risk, no maturity risk, no liquidity risk, no risk of loss if inflation increases
real risk-free rate (r*)
not static; changes overtime depending on economic conditions like: 1. the rate of return that corporations and other borrowers expect to earn on productive assets. 2. people's time preferences for current consumption vs. future consumption.
Long-term rates
reflect long-run expectations of inflation
higher risk - lower risk
risk premium =
Nominal or Quoted Risk-free rate of interest
rrf = r* + IP
Default
the borrower will not make scheduled interest or principal payments
the more feasible it is to use more short-term debt
the easier it is to sell assets to generate cash,
the higher the market rate
the greater the bond's risk of default
the lower the default risk and interest rates
the higher the bonds rating,
Treasury Inflation-Protected Securities (TIPS)
value increases with inflation. Short-term are free of DRP, MRP, LP, and risks due to changed in general level of interest rates. This is not free of changes in real rate.
Average liquid premiums and liquidity of real assets
vary over time.
Default Risk Premiums
vary overtime and tend to get larger when economy is weaker and borrowers are more likely to have a hard time paying off debt.
it is value in the
when money is used as a medium in exchange,
Inflationary Psychology
when people have fear of inflation, inflation happens, and when people don't have fear of inflation, it decreases.
Flight to quality
when risk for a market increases, many investors shift toward safer investments
Reinvestment Risk
when short-term bills mature, and the principal must be reinvested, or "rolled over," a decline in interest rate would necessitate this a reinvestment at a lower rate, which would result in a decline in interest income.
Interest Risk
when the price of long-term bonds decline as interest rates rise. The longer the maturity the bond the greater this risk.
1. focus on treasury bonds 2. assume that treasury bonds contain no maturity risk premiums
when using the yield curve to estimate future IRs