Chapter 9 concept questions

What are pure discount securities? Give two examples.

A pure discount security is a financial instrument that promises a single fixed payment (the face value) in the future with no other payments in between. Such a security sells at a discount relative to its face value, hence the name. Treasury bills and commercial paper are two examples.

Compare and contrast commercial paper and Treasury bills. Which would typically offer a higher interest rate? Why?

Both are pure discount money market instruments. T-bills, of course, are issued by the government; while commercial paper is issued by corporations. The primary difference is that commercial paper has default risk, so it offers a higher interest rate.

What are the three different types of Treasury STRIPS that are publicly traded?

Each STRIPS represents a particular piece of a Treasury note or bond. The three types of Treasury STRIPS that are traded are coupon payments on a note or bond, the final principal payment on a Treasury note, and the final principal payment on a Treasury bond.

What is LIBOR? Why is it important?

LIBOR is the London Interbank Offered Rate. It is the interest rate offered by major London banks for dollar-denominated deposits. Interest rates on loans are often quoted on a LIBOR-plus basis, so the LIBOR is an important, fundamental rate in business lending, among other things.

Based on the history of interest rates, what is the range of short-term rates that has occurred in the United States? The range of long-term rates? What is a typical value for each?

Short-term rates have ranged between zero and 14 percent. Long-term rates have fluctuated between about two and 13 percent. Long-term rates, which are less volatile, have historically been in the fourto-five percent range (the 1960 - 1980 experience is the exception). Short-term rates have about the same typical values, but more volatility (and lower rates in the unusual 1930 - 1960 period).

Why do you suppose rates on some money market instruments are quoted on a bank discount basis? (Hint: Why use a 360-day year?)

Such rates are much easier to compute by hand; they predate (by hundreds of years or more) computing machinery.

Compare and contrast the Fed funds rate and the discount rate. Which do you think is more volatile? Which market do you think is more active? Why?

The Fed funds rate is set in a very active market by banks borrowing and lending from each other. The discount rate is set by the Fed at whatever level the Fed feels is appropriate. The Fed funds rate changes all the time; the discount rate only changes when the Fed decides; the Fed funds rate is therefore much more volatile. The Fed funds market is much more active. Banks usually borrow from the Fed only as a last resort, which is the primary reason for the Fed's discount rate-based lending.

Evaluate the following statement: "Treasury inflation protected securities (TIPS) pay a fixed coupon."

This statement is true if it is referring to the coupon rate. However, since the accrued principal changes with inflation, the dollar amount of the coupon (even though it is a fixed percentage) will change. So, it is false with regard to the dollar amount of the coupon.

When we observe interest rates in the financial press, do we see nominal or real rates? Which are more relevant to investors?

We observe nominal rates almost exclusively. Which one is more relevant actually depends on the investor and, more particularly, what the proceeds from the investment will be used for. If the proceeds are needed to make payments that are fixed in nominal terms (like a loan repayment, perhaps), then nominal rates are more important. If the proceeds are needed to purchase real goods (like groceries) and services, then real rates are more important

Discuss how each of the following theories for the term structure of interest rates could account for a downward-sloping term structure of interest rates: A. Pure expectations B. Maturity preference C. Market segmentation

a. The pure expectations theory states the term structure of interest rates is explained entirely by interest rate expectations. The theory assumes that forward rates of interest embodied in the term structure are unbiased estimates of expected future spot rates of interest. Thus, the pure expectations theory would account for a declining yield curve by arguing that interest rates are expected to fall in the future rather than rise. Investors are indifferent to holding (1) a short-term bond at a higher rate to be rolled over at a lower expected future short-term rate, and (2) a longerterm bond at a rate between the higher short-term rate and the lower expected future short-term rate. b. Liquidity preference theory (Maturity preference) states that the term structure is a combination of future interest rate expectations and an uncertainty "risk" or uncertainty yield "premium." The longer the maturity of a bond, the greater the perceived risk (in terms of fluctuations of value) to the investor, who accordingly prefers to lend short term and thus requires a premium to lend longer term. This yield "premium" is added to the longer-term interest rates to compensate investors for their additional risk. Theoretically, liquidity preference could account for a downward slope if future expected rates were lower than current rates by an amount greater than their respective term risk premium. Liquidity preference theory is consistent with any shape of the term structure but suggests and upward bias or "tilt" to any term structure shape given by unbiased expectations. c. Market segmentation theory states that the term structure results from different market participants establishing different yield equilibriums between buyers and sellers of funds at different maturity preferences. Market segmentation theory can account for any term structure shape because of the different supply/demand conditions posted at maturity ranges. Borrowers and lenders have preferred maturity ranges, based largely on institutional characteristics, and the yield curve is the average of these different suppliers' and demanders' maturity preferences. These maturity preferences are essentially fixed; that is, the participants do not tend to move between or among maturity ranges, so different supply and demand conditions exist across the maturity spectrum. In each maturity range, a higher demand for funds (supply of bonds) relative to the supply of funds will drive bond prices down, and rates up, in that maturity range. A downward sloping yield curve, in the context of market segmentation, indicates that a larger supply of short-term debt relative to demand has led to lower short-term bond prices and/or a small supply of long-term debt relative to demand has led to higher long-term bond prices. Either set of supply/demand conditions works to drive long-term rates lower and short-term rates higher.