Assignment 14

What are some factors that influence interest rates for individuals?

-Inflation -The real risk free rate -Default risk -Liquidity risk -Special provisions regarding the use of funds raised by a particular security issuer -The securitys term in maturity

What is the equation of IP?

IP=( (CPI(T+1) -CPI(1) )/CPI (T) x100

WHAT ELSE

REREAD AND LOOK OVER NOTES!

Term structure of interest rates

a comparison of market yields on securities, assuming all characteristics except maturity are the same -The term structure of interest rates compares interest rates on debt securities based on their time to maturity, assuming that all other characteristics (i.e., default risk, liquidity risk) are equal. Interest rates change as the maturity of a debt security changes; in general, the longer the term to maturity, the higher the required interest rate buyers will demand. This addition to the required interest rate is the maturity premium (MP). The MP, which is the difference between the required yield on long- versus short-term securities of the same characteristics except maturity, can be positive, negative, or zero. -Putting together the factors that affect interest rates in different markets, we can use the following general equation to note the influence of the factors that functionally impact the fair interest rate—the rate necessary to compensate investors for all security risks—(ij*) on an individual (jth) financial security. -i j * = f(IP, RFR, DRP j , LRP j , SCP j , MP j ) -The first two factors, IP and RFR, are common to all financial securities, while the other factors can uniquely influence the price of a single security.

Inflation

a continual increase in the price level of a basket of goods and services throughout the economy as a whole -The higher the level of actual or expected inflation, the higher the interest rates -It is the general price index of goods and services and often referred to as inflation premium or IP -The US Dept of inflation uses consumer price index (CPI) and the product price index (PPI) to measure inflation

Real risk free rate

he interest rate that would exist on a default free security if no inflation were expected -risk free rate adjusted for inflation; Generally lower than nominal risk free rates at any particular time -Measures societys relative time preference for consuming today rather than tomorrow -The higher societys preference to consume today, the higher the real risk free rate (RFR) will be

Time to maturity

length of time until a security is repaid -Used in debt securities as the date upon which the security holder get their principal back

Convertibility

offers the holder the opportunity to exchange the bond for for another type of issuers security, often common stock

Special provisions

provisions, such as taxability, convertibility, and callibility, that impact a security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions

Fisher effect

refers to the relationship among real risk free rates, expected inflation, and nominal risk free rates -Theorizes that nominal risk free rates that we observe in financial markets must compensate investors for: -Any inflation related reduction in purchasing power lost on funds lent or principal due -An additional premium above the expected rate of inflation for forgoing present consumption -i= expected ip +RFR

Liquidity risk

risk that a security cant be sold at a predictable price with low transaction costs on a short notice -A highly liquid asset can be sold at a predictable price with low transaction costs, meaning that the holder can convert the asset to a fair market value on short notice -This is added if an asset is ILLIQUID

Default or credit risk premium (DRPj)

the difference between a quoted interest rate on a security (security j) and a treasury security with similar maturity, liquidity, tax, and other features -DRPj= ijt- iTt -ijt= interest rate on a security by a non treasury issuer of maturity m and at t time -tTt= interest rate on a security issued by the us treasury of maturity m at t time

Nominal interest rates

the interest rates actually observed in financial markets -They directly affect most tradable securities values or prices -A lot of time is spect to decide what the rates are, as they affect security prices -Influence investment performance and trigger buy and sell decisions

Default risk

the risk that a security issuer will default on that security by being late on or missing an interest or principal payment -The higher the default risk, the higher the interest rate

True or false. Special provisions that benefit security holders (callibility) require higher interest rates to encourage purchases

true

True or false: special provisions that benefit security holders (tax free status and convertibility) bring with them lower interest rates

true

True or false? Highly liquid assets carry the lowest interest rates

true