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)