Chapter 6 Interest Rates BUS 320
rRF =
r* + IP or r* + IP + MRP
pure expectations theory contends that...
the shape of the yield curves depends on investors' expectations about future interest rates
best explains why a firm that needs to borrow money would borrow at long-term rates when short-term rates are lower than long-term rates
the use of short-term financing over long-term financing for a long-term project will increase the risk of the firm
liquidity risk premium (LP)
this is the premium added to the equilibrium interest rate on a security that cannot be bought or sold quickly to prevent or minimize loss close to 0% for treasuries
inflation premium (IP)
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
maturity risk premium (MRP)
this is the premium that reflects the risk associated with changes in interest rates for a long-term security
nominal risk-free rate (rRF)
this is the rate on a treasury bill or a treasury bond
expected inflation
more inflation, more expected in return
spread between corporate and treasury yield curves widens as...
the corporate bond rating decreases
the pure expectations theory
assumes that investors do not consider long-term bonds to be riskier than short-term bonds
humped yield curve
A yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities.
inverted yield curve
a downward-sloping yield curve
credit ratings
affect the yields on bonds
the pure expectations theory or the expectations hypothesis
assets that long-term interest rates can be used to estimate future short-term interest rates
assumptions of pure expectations
assumes that the MRP for treasury securities is zero long-term rates are an average of current and future short term rates if the pure expectations theory is correct, you can use the yield curve to "back out" expected future interest rates
corporate risk is higher
because they can't print money
demand
borrowers will borrow more capital for lower rates
must earn these inflation premiums to...
break even vs. inflation these IPs would permit you to earn r* (before taxes)
corporate yields include a DRP and LP corporate bond yield spread =
corporate bond yield - treasury bond yield = DRP + LP
current interest rate =
current inflation rate + current real rate of interest
return rate/earnings =
difference between inflation and interest rate (when interest rate is higher than inflation)
upward sloping yield curve
due to an increase in expected inflation and increasing maturity risk premium real risk-free rate remains level interest rate % on y axis years to maturity on x axis as years to maturity increases, the gap increases
the default risk on Walmart's short-term debt will be higher than the default risk on its long-term debt
false
when the economy is weakening, the Fed is likely to increase short-term interest rates
false
macroeconomic factors that influence interest rate levels
federal reserve policy (balance growth and inflation) federal deficits or surpluses (deficit forces the govt to sell more bonds or print more $ - inflationary) international factors (if trade balance is a deficit must borrow from surplus nations - must be competitive with interest rates in other countries) level of business activity (during recessions, inflation decreases, interest rates decline, short term rates decline more sharply than long term rates
time preferences for consumption
high preference, short term, greater return required low preference, longer term, lower return required
risk
higher risk, higher rate of return expected
a company's credit rating was upgraded from AA to AAA
impact on yield: decrease cost of borrowing money from bond markets: less expensive
a company's interest coverage ratio improves
impact on yield: decrease cost of borrowing money from bond markets: less expensive
a car manufacturing company loses 40% of its market share and has a declining investment in new product development
impact on yield: increase cost of borrowing money from bond markets: more expensive
a start-up company is struggling with finances for its projects
impact on yield: increase cost of borrowing money from bond markets: more expensive
supply
investors will provide more capital for higher rates
real risk-free rate (r*)
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 and this is the rate on short-term US treasury securities assuming there is no inflation
default risk premium (DRP)
it is based on the bond's rating; the higher the rating, the lower the premium added, thus lowering the interest rate close to 0% for treasuries
if interest rates are expected to increase...
long term rates will be higher than short term rates and vice-versa thus, the yield curve can slope up, down, or even bow
more time -->
maturity risk premium increases
demand for capital increased could have been caused by...
new technological advances opening up more production opportunities for businesses
there are five factors that can affect the shape of the corporate yield curve
r*, IP, MRP, DRP, and LP
there are three factors that can affect the shape of the treasury yield curve
r*, IP, and MRP
production opportunities
rate of return producers expect so as to attract investors (rate to expect to offer) (need to get paid back)
term structure of interest rates
relationship between interest rates (or yields) and maturities
general views that lenders prefer...
short term securities and view long term securities as riskier thus, investors demand a premium to persuade them to hold long term securities
premiums added to r for different types of debts
short term treasury = r* + IP long term treausry = r* + IP + MRP short term corporate = r* + IP + DRP + LP long term corporate = r*+ IP + MRP + DRP + LP
BBB has the highest risk
so has the highest interest rate while AAA has the highest rating but lower interest rate
yield curves
stack from top to bottom maturity risk premium inflation premium real risk-free rate
apart from risk components, several macroeconomic factors influence interest rates
such as Federal Reserve (the Fed) policy, federal budget deficit or surplus, international factors, and levels of business activity
businesses use short/long term debt and equity to allow themselves to...
survive in any interest rate environment
yield curve is a graph of the...
term structure
the yield curve reflects...
the aggregation of the impacts from these factors
corporate yield curves are higher than that of...
treasury securities though not necessarily parallel to the treasury curve
countries with strong balance sheets and declining budget deficits tend to have lower interest rates
true
everyone uses money and it is important to understand what factors affect the cost of money
true
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
true
long-term interest rates are not as sensitive to booms and recessions as are short-term interest rates
true
the yield curve for an AA-rated corporate bond is expected to be above the US treasury bond yield curve
true
when the economy is weakening, the Fed is likely to decrease short-term interest rates
true
yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets
true
upward-sloping/normal yield curve
upward sloping the whole time
interest rate risk (long term)
vs. reinvestment rate risk (short term)