Interest rates part_2
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Interest rates part_2 Interest rates part_2 Presentation Transcript

  • GD20503Financial Markets and Institutions
  • Outlines Why Debt Securities Yields Vary Explaining Actual Yield Differentials Estimating the Appropriate Yield Term Structure of Interest Rates
  • Introduction The annual interest rate offered by debt securities at a given point in time varies among debt securities. Debt securities offer different yields because they exhibit different characteristics that influence the yield to be offered. In general, securities with unfavorable characteristics will offer higher yields to entice investors. Yields on debt securities are affected by the following characteristics: (i) Credit risk; (ii) Liquidity; Tax status; and (iv) Term of maturity.
  • Why Debt Securities Yields Vary 1. Credit (Default) Risk  If all other characteristics besides credit (default) risk are equal, securities with a higher degree of risk will offer higher yields.  Rating Agencies 1.) Moody’s Investor Service 2.) Standard and Poor’s Corporation  The higher the rating, the lower the perceived credit risk  Accuracy of Credit Ratings  Enron Scandal in 2001
  • Exhibit 3.1 Rating Classification by Rating Agencies
  • 2. Liquidity The ease of conversion to cash without loss of value The lower a securities liquidity, the higher the yield preferred by investor3. Tax Status Investors are more concerned with after-tax income. Taxable securities must offer a higher before-tax yield
  • To compute the equivalent Before-Tax Yield: at bt (1 T )where τat = After-tax yield τbt = Before-tax yield T = Investor’s marginal tax rate
  • 4. Term to Maturity Maturity dates will differ between debt securities The term structure of interest rates defines the relationship between term to maturity and the annualized yield
  • Explaining Actual Yield DifferentialsExplaining Actual Yield Differentials Small differentials can be significant Basis points (bp) are often quoted where 1bp = .01% = .0001
  • Yield Differentials of Money Market Securities Securities: commercial paper, certificates of deposit, bankers acceptances. Yields are just slightly higher than the risk-free T-billsYield Differentials of Capital Market Securities Municipal bonds have lowest before-tax yield Treasury bonds may have higher before-tax yield than municipal bonds but have lowest after-tax yield Corporate bonds may have highest yields
  • Exhibit 3.4 Yield Differences of Corporate Bonds
  • Estimating the Appropriate Yield Yn = Rf,n + DP + LP + TA where: Yn = yield of an n-day debt security Rf,n = yield of an n-day Treasury (risk-free) security DP = default premium to compensate for credit risk LP = liquidity premium to compensate for less liquidity TA = adjustment due to difference in tax status
  • Example 1: Suppose that the three-month Treasury bill’s annualized rate is 8% and Elizabeth Company plan to issue 90-day commercial paper. Assume that Elizabeth Company believes that a 0.7% default risk premium, a 0.2% liquidity premium and a 0.3% tax adjustment are necessary to sell its commercial paper to investors. Thus, the appropriate yield is Yn = Rf,n + DP + LP + TA = 8% + 0.7% + 0.2% + 0.3% = 9.2%
  • Term Structure of Interest RatesPure Expectations Theory: Term structure is determined solely by the expectations of future rates. Impact of an expected increase in interest rates: - Leads to an upward sloping yield curve Impact of an expected decline in interest rates: - Leads to a downward sloping yield curve The following figures show how interest rate expectations affect the yield curve.
  • Liquidity Premium Theory: Investors prefer short-term rather than long-term securities because a shorter maturity represents greater liquidity. However, they may be willing to invest in long-term securities only if compensated with a premium for lower liquidity. Liquidity may be a more critical factor to investors at particular points in time, and the liquidity premium will change over time accordingly.
  • Impact of Liquidity Premium on the Yield Curveunder Three Different Scenarios
  • Segmented Markets Theory: Investors choose securities with maturities that satisfy their forecasted cash needs Limitations of the theory: Some borrowers and savers have the flexibility to choose among various maturities
  • Integrating the Theories ofthe Term StructureIf we assume the following conditions Investors and borrowers currently expect interest rates to rise. (E) Most borrowers need long-term funds, while most investors have only short-term funds to invest. (S) Investors prefer more liquidity to less. (L) Then all three conditions place upward pressure on long- term yields relative to short term yields leading to upward sloping yield curve
  • Effect of Conditions in Example of Yield Curve
  • Use of the Term Structure Forecast interest rates Forecast recessions Investment decision
  • Why the Slope of the Yield CurveChanges If interest rate at all maturities are affected in the same manner by the existing conditions, the slope of the yield curve would remain the same. However, conditions may cause short-term yields to change in a manner that differs from the change in long-term yields.
  • Potential Impactof Treasury Shiftfrom Long-Termto Short-TermFinancing
  • How the Yield Curve Changed over time
  • Yield Curves among Foreign Countries