Chapter 6 Interest Rates
r*
"real" risk-free rate of interest the interest rate that would exist on a riskless security if no inflation were expected risk free rate is not static - changes over time depending on economic conditions 1. rate of return that corp. and other borrowers expect to earn on productive assets 2. people's time preferences for current versus future consumption
Macroeconomic Factors that influence interest rate level
1. federal reserve policy -increase money supply to stimulate economy - short term rates decline; but increase expected future inflation, so long term rates increase 2. federal budget deficits or surpluses - the larger the deficit, the higher the level of interest rates 3. international factors 4. level of business activity
4 Factors that affect the level of interest rates
1. production opportunities 2. time preferences for consumption 3. risk 4. expected inflation interest rates are built upon inflation rates or how inflation is expected to be
Interest Rates can have different maturity rates
1. short term - more volatle fluctuates more 2. long term - more stable in recessions rates typically decline Interest rates will increase if inflation appears to be headed higher or decrease if inflation is expected to decline
Quoted Interest Rate
=r=r*+IP+DRP+LP+MRP
Nominal or quoted rate
=r=rRF+DRP+LP+MRP Because rRF=r*+IP can rewirte the equation this way
Default Risk Premium (DRP)
Accounts for risk that the borrower will not make scheduled interest or principal payment. The difference between the quoted interest rate on a T-bond and that on a corporate bond with similar maturity, liquidity, and other features tend to get larger when economy is weaker the greater the bond's risk default, the higher the market rate DRP is zero for us treasury securities, but rises as the riskiness of the issuer increases
Which fluctuate more - long term or short term interest rates? why?
Short-term interest rates are more volatile because (1) the Fed operates mainly in the short-term sector, hence Federal Reserve intervention has its major effect here, and (2) long-term interest rates reflect the average expected inflation rate over the next 20 to 30 years, and this average does not change as radically as year-to-year expectations.
Interest Rate Levels
Upward Sloping- investors are willing to supply more capital the higher the interest rates they receive on their capital Downward Sloping- borrowers will borrow more if interest rates are lower Interest Rate is point where supply and demand curves intersect
Pure Expectations Theory
a theory that states the shape of the yield curve depends on investor's expectations about future interest rates long-term interest rates hold a forecast for short-term interest rates in the future. If interest rates are expected to increase, L-T rates will be higher than S-T rates, and vice-versa. theory is indifferent to maturity becasue they do not view long term bonds as being riskier than short term bonds. so the mrp rate is zero and long term interest rates are simply the weighted average of current and epxected short term interest rates. only establish bond prices on basis of expected future interest rates
r
any quoted or nominal rate of interest on a given security
Assumptions For Pure Expectations
assumes bond prices established strictly on basis of expectations for future interest rates and that they are indifferent to maturity because they do not view long term bonds as being riskier than short term bonds the MRP would be zero and LT interest rates would simply be weighted average of current and expected future short term interest rates
Maturity Risk Premium (MRP)
bonds of any org. have more interest rate risk the longer the maturity of the bond. because of this a premium is added to reflect the interest rate risk the rate is higher the greater years to maturity rises when i/y more volatile and incertain and fall when i/y more stable
yield curve
graph showing the relationship between bond yields and maturities slope of curve depends on 2 things: 1. expectations about future inflation 2. effects of maturity on bonds' risk.
Inflation Premium (IP)
inflation has major impact on interest rates because it erodes real value of what you receive from the investment a premium equal to the average expected rate of inflation over life of security it is rate expected in future not rate experience in past not necessary equal to current inflation rate rT-BILL=rRF=r*+IP
humped sloping yield curve
intermediate term rates were higher than either short or long term rates
Liquidity Premium (LP)
premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice and at close to its "fair market value" more liquid assets are preferred so investors include a liquidity premium in the rates charged on different debt securities LP is very low for treasury securities
Downward sloping yield curve
rate of inflation expected to decline so short term rates higher than long term rates aka inverted or abnormal yield curve
rRF
real risk-free rate plus a premium for expected inflation. is the nominal risk free rate Quoted interest rate on a risk free security such as t-bill =r*+IP
term structure of interest rates
relationship between bond yields and maturities
Interest rate risk
risk of capital losses to which investors are exposed because of changing interest rates. prices of long term bonds decline whenever interest rates rise; and because interest rates can and do occasionally rise, all long term bonds, even t bonds, have an element of risk called interest rate risk
Treasury Inflation Protected Security
the one security that is free of most risks value increases wth inflation
reinvestment rate risk
the risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested
upward sloping yield curve
upward due to increase in expected inflation and increasing maturity risk premium short term rates dropped below long term rates because have less interest risk than lt securities. st have smaller MRP's Future I/Y higher aka normal yield curve