Financial market

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Financial market

  1. 1. FINANCIAL MARKET 5-1
  2. 2. Risk Structure of Interest Rates The relationship among term of maturity on bond with different interest rates.The risk and term structure of interest rates contain useful information about overall economic conditions.These indicators are helpful in evaluating both the present health of the economy and its likely future course.Risk spreads provide one type of information, the term structure another. 5-2
  3. 3. Risk Structureof Long Bonds in the U.S. 5-3
  4. 4. Factors Affecting Risk Structure of Interest Rates• Default Risk• Liquidity• Income Tax Considerations 5-4
  5. 5. 1. Default Risk Factor• One attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures.• U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes to pay off its obligations (or just print money). Bonds like these with no default risk are called default-free bonds. 5-5
  6. 6. Default Risk Factor (cont.)• The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium. – Indicates extra amount of interest that people must earn in order to be willing to hold that risky bond.• A bond with default risk will always have a positive risk premium and an increase in its default risk will raise the risk premium. 5-6
  7. 7. Increase in Default Risk on Corporate Bonds 5-7
  8. 8. Analysis of Figure 5.2: Increase in Default on Corporate Bonds• Corporate Bond Market – Re on corporate bonds ↓, Dc ↓, Dc shifts left – Risk of corporate bonds ↑, Dc ↓, Dc shifts left – Pc ↓, ic ↑• Treasury Bond Market  Relative Re on Treasury bonds ↑, DT ↑, DT shifts right  Relative risk of Treasury bonds ↓, DT ↑, DT shifts right  PT ↑, iT ↓• Outcome – Risk premium, ic - iT, rises 5-8
  9. 9. Default Risk Factor (cont.)• Default risk is an important component of the size of the risk premium.• Because of this, bond investors would like to know as much as possible about the default probability of a bond.• One way to do this is to use the measures provided by credit-rating agencies such as Moody’s and S&P, Rating Agency Malaysia Berhad (RAM). 5-9
  10. 10. Bond Ratings 5-10
  11. 11. 2. Liquidity Factor• Another attribute of a bond that influences its interest rate is its liquidity.• A liquid asset is one that can be quickly and cheaply converted into cash if the need arises. The more liquid an asset is, the more desirable it is (higher demand), holding everything else constant. 5-11
  12. 12. Liquidity (cont..)U.S Treasury bonds are the most liquid compare to Corporate bonds. • U.S Treasury are widely traded that easiest to sell quickly and cost of sell it is low. • Corporate bonds have fewer bonds for any one corporation are traded that costly to sell immediately because hard to find quick buyers. 5-12
  13. 13. Decrease in Liquidity of Corporate BondsFigure 5.2 Response to a Decrease in the Liquidity of Corporate Bonds 5-13
  14. 14. Analysis of Figure 5.1: Corporate Bond Becomes Less Liquid• Corporate Bond Market  Liquidity of corporate bonds ↓, Dc ↓, Dc shifts left  Pc ↓, ic ↑• Treasury Bond Market  Relatively more liquid of Treasury bonds, DT ↑, DT shifts right  PT ↑, iT ↓• Outcome – Risk premium, ic - iT, rises• Risk premium reflects not only corporate bonds default risk but also lower liquidity = risk and liquidity premium. 5-14
  15. 15. 3. Income Taxes Factor• Interest payments on municipal bonds are exempt from federal income taxes, a factor that has the same effect on the demand for municipal bonds as an increase in their expected return.• Treasury bonds are exempt from state and local income taxes, while interest payments from corporate bonds are fully taxable. 5-15
  16. 16. Tax Advantages of Municipal Bonds 5-16
  17. 17. Analysis of Figure 5.3: Tax Advantages of Municipal Bonds• Municipal Bond Market – Tax exemption raises relative Re on municipal bonds, Dm ↑, Dm shifts right – Pm ↑• Treasury Bond Market – Relative Re on Treasury bonds ↓, DT ↓, DT shifts left – PT ↓• Outcome – im < iT 5-17
  18. 18. Term Structure of Interest Rates The relationship among interest rates on bonds with different terms to maturityImportant empirical facts:1. Interest rates for different maturities move together over time2. Yield curves tend to have step upward slope when short rates are low and downward slope when short rates are high5. Yield curve is typically upward slopingNOTE: Yield curve is just a plot of i (earned on bonds) against maturity times 5-18
  19. 19. Interest Rates on DifferentMaturity Bonds Move Together 5-19
  20. 20. Three Theories of Term Structure1. Expectations Theory  The proposition that the interest rate on a long-term bond will equal the average of the short-term rates that people expect to occur over the life of the long-term bond .  Assumes that bonds with different maturities are perfect substitutes  Pure Expectations Theory explains 1 and 2, but not 3 5-20
  21. 21. 1. Expectations TheoryKey Assumption: Bonds of different maturities are perfect substitutes.Implication: RETe on bonds of different maturities are equal.Investment strategies for two-period horizon1. Buy $1 of one-year bond and when it matures buy another one-year bond2. Buy $1 of two-year bond and hold it 5-21
  22. 22. Expectations Theory• Expected return from strategy 1 (1 + it )(1 + i ) − 1 = 1 + it + i e t +1 e t +1 + it (i ) − 1 e t +1Since it(iet+1) is also extremely small, expectedreturn is approximately it + iet+1 5-22
  23. 23. Expectations Theory• Expected return from strategy 2 (1 + i2t )(1 + i2t ) − 1 = 1 + 2(i2t ) + (i2t )2 − 1Since (i2t)2 is extremely small, expected return isapproximately 2(i2t) 5-23
  24. 24. Expectations Theory• From implication above expected returns of two strategies are equal• Therefore 2(i2t ) = it + i e t +1Solving for i2t it + ite+1 i2t = (1) 2 5-24
  25. 25. Expectations Theory• To help see this, here’s a picture that describes the same information: 5-25
  26. 26. More generally for n-period bond… it + it +1 + it + 2 + ... + it + (n−1) int = (2) nIn words: Interest rate on long bond = average short rates expected to occur over life of long bondNumerical example:One-year interest rate over the next five years 5%, 6%, 7%, 8% and 9%:Interest rate on two-year bond: (5% + 6%)/2 = 5.5%Interest rate for five-year bond: (5% + 6% + 7% + 8% + 9%)/5 = 7%Interest rate for one to five year bonds: 5%, 5.5%, 6%, 6.5% and 7%. 5-26
  27. 27. Expectations Theory and Term Structure Facts• Explains why yield curve has different slopes – When short rates are expected to rise in future, average of future short rates = int is above todays short rate; therefore yield curve is upward sloping. – When short rates expected to stay same in future, average of future short rates same as todays, and yield curve is flat. – Only when short rates expected to fall will yield curve be downward sloping. 5-27
  28. 28. Expectations Theory and Term Structure Facts• Pure expectations theory explains fact 1 that short and long rates move together: – Short rate rises are persistent – If it ↑ today, iet+1, iet+2 etc. ↑ ⇒ average of future rates ↑ ⇒ int ↑ – Therefore: it ↑ ⇒ int ↑ (i.e., short and long rates move together) 5-28
  29. 29. Expectations Theory and Term Structure Facts• Explains fact 2 that yield curves tend to have step slope when short rates are low and downward slope when short rates are high. – When short rates are low, they are expected to rise to normal level, and long rate = average of future short rates will be well above todays short rate; yield curve will have step upward slope. – When short rates are high, they will be expected to fall in future, and long rate will be below current short rate; yield curve will have downward slope. 5-29
  30. 30. Expectations Theory and Term Structure Facts• Doesnt explain fact 3 that yield curve usually has upward slope – Short rates are as likely to fall in future as rise, so average of expected future short rates will not usually be higher than current short rate: therefore, yield curve will not usually slope upward. 5-30
  31. 31. Three Theories of Term Structure1. Market Segmentation Theory  A theory of term structure that sees markets for different maturity bonds as completely separated and segmented such that the interest rate for bonds of a given maturity is determined solely by supply of and demand for bonds of that maturity.  Assumes that bonds of different maturities are not substitutes at all  Market Segmentation Theory explains 3, but not 1 and 2 5-31
  32. 32. 2. Market Segmentation Theory• Key Assumption: Bonds of different maturities are not substitutes at all• Implication: Markets are completely segmented; interest rate at each maturity are determined separately Explains Fact 3 that yield curve is usually upward sloping – People typically prefer short holding periods and thus have higher demand for short-term bonds, which have higher price and lower interest rates than long bonds. Does not explain Fact 1 or Fact 2 because assumes long and short rates determined independently 5-32
  33. 33. Three Theories of Term Structure1. Liquidity Premium Theory  The theory that the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a positive term (liquidity) premium  Solution: Combine features of both Pure Expectations Theory and Market Segmentation Theory to get Liquidity Premium Theory and explain all facts 5-33
  34. 34. 3. Liquidity Premium Theory• Key Assumption: Bonds of different maturities are substitutes, but are not perfect substitutes• Implication: Modifies Pure Expectations Theory with features of Market Segmentation Theory Investors prefer short rather than long bonds ⇒ must be paid positive liquidity (term) premium, lnt, to hold long-term bonds Results in following modification of Expectations Theory: it + ite+1 + ite+ 2 + ... + ite+ (n−1) int = + l nt n 5-34
  35. 35. Liquidity Premium Theory 5-35
  36. 36. Liquidity Premium Theory: Term Structure Facts• Explains All 3 Facts: Explains fact 3 that usual upward sloped yield curve by liquidity premium for long-term bonds Explains fact 1 and fact 2 using same explanations as pure expectations theory because it has average of future short rates as determinant of long rate 5-36
  37. 37. NEXT CHAPTER 5: FISCAL POLICY– Please find government budget 2011/2012– TQ 5-37

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