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Econ315 Money and Banking: Learning Unit #12: Risk Structure of Interest Rates

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Econ315 Money and Banking: Learning Unit #12: Risk Structure of Interest Rates

  1. 1. Learning Unit #12 Risk Structure of Interest Rates
  2. 2. Why There Are So Many Different Interest Rates? In the previous Learning Unit, you learned how a market interest rate is determined in the bond market framework. The market interest rate determined on this framework is considered as the base rate in the economy such as U.S. Treasury bill rate. In reality there are many different interest rates in the U.S. economy. This Learning Unit and next will explain why there are so many market interest rates and how they are determined in markets.
  3. 3. Characteristics of Bonds and Interest Rates • Heterogeneous financial instruments: Each financial instrument has different characteristics such as risk, liquidity, and maturity. − It depends on characteristics of issuers (spender/borrowers) and specific characteristics attached on a particular financial instrument. • Heterogeneous preference: Saver/lenders have different preferences on characteristics of financial instruments. − Saver/lenders prefer a particular characteristic over another. • These heterogeneities lead to different demand and supply among financial instruments. − They result in different market interest rates.
  4. 4. Objectives of Learning Unit ■ Three Important Characteristics of Financial Instruments • Liquidity • Default Risk • Tax Attribute ■ Risk Premium and Demand
  5. 5. Variations in Long-term Interest Rates in U.S. Although all interest rates tend to move together, • Some (Corporate Baa Bonds) almost always provide higher interest rates than others (U.S. Government Long-Term Bonds). • Spreads (differences in interest rates) change over time (e.g. a large difference in early 1930s).
  6. 6. Risk Premium • Risk premium: An additional interest rate, that an issuer of financial instruments pay to buyers, over the risk-free instrument due to riskiness of the financial instruments. • If issuers want buyers to purchase financial instruments with less favorable characteristics, they must give some incentive – additional return or interest rate. • i = if + RP i : interest rate on risky instrument if : interest rate on risk-free instrument RP : risk premium
  7. 7. Default Risk • Default risk: Uncertainty that a borrower may not pay back the principal or interest. − Some instruments are very risky, while others are less risky. − Risk of financial instruments depends on riskiness of business investment opportunities for which funds are used to finance (how likely they fail) and conditions (under which borrowers pay back) attached on the instruments. • In general, buyers of financial instruments prefer low risk instruments over high risk instruments. − Higher the risk, the lower the demand.
  8. 8. Default Risk and Interest Rate • Bonds with high risk have low demand, while bonds with low risk have high demand. • Price of high risk bonds (P2 c ) < Price of low risk bonds (P2 T ) • Interest rate on high risk bonds (i2 c ) > Interest rate of low risk bonds (i2 T ) • Risk premium = i2 c – i2 T High Risk Bonds Low Risk Bonds
  9. 9. Default Risk and Risk Premium • Default-free instrument: U.S. Treasury securities are considered as free of default. − How could they be default-risk free? • All other financial instruments have more or less default risk. − Why are they risky, even GM bonds? • An additional interest rate paid by risky instruments over the interest rate on U.S. Treasury securities is a default-risk premium. − There are many types of risk each of which requires own risk premium (i.e. purchasing power risk premium).
  10. 10. Example of Default Risk and Risk Premium • An interest rate on 30-year U.S. Treasury bond is 6% (if ), while an interest rate on 30- year corporate bond is 14% (i). i = if + RP ⇒ 14% = 6% + RP • A risk premium on the corporate bond is 8% (RP). There is a possibility that the corporation which issued the corporate bonds may go out of business and default payments.
  11. 11. Changes in Default Risk and Risk Premium • Default risk of financial instruments may change from time to time, so as their risk premium. • The spread (default-risk premium) between risk-free bonds (U.S. Government Long-term bonds) and risky bonds (Corporate Baa bonds) changes over time. − A large default-risk premium in early 1930s, while small default- risk premium in 1940s.
  12. 12. Causes of Changes in Default Risk • During a recession, some corporations, especially with high debt, are more likely to default their obligations and go bankruptcy. − Default risk increases during a recession. • A default risk of bonds depends on perception of buyers of financial assets. − Even if some bonds are actually risky, buyers may not perceive as risky bonds if they have not defaulted for a long time. − When some bonds default, buyers may perceive that all other bonds are more likely to default than before (even though default risk itself did not change).
  13. 13. Changes in Default Risk during Recession • During a recession risky bonds become even riskier than usual. • Buyers of bonds prefer less of risky bonds and more of risk-free bonds. • Demand for risky bonds decreases (from D0 C to D1 C ), while demand for risk- free bonds increases (from D0 T to D1 T ).
  14. 14. Effects of Changes in Default Risk during Recession • Price of risky bonds ↓ (from P0 C to P1 C ) and price of risk-free bonds ↑ (from P0 T to P1 T ) • Interest rate of risky bonds ↑ (from i0 C to i1 C ) and interest rate on risk-free bonds ↓ (from i0 T to i1 T ) • Spread between risky bonds and risk-free bonds ↑ from RP0 to RP1 • A default risk premium increases. P Pi i i0 T i1 T i0 C i1 C P0 T P0 C P1 C P1 T D0 T D1 T D0 CD1 C E0 T E1 T ST SC E0 C E1 C RP0 RP1 Bonds with Default Risk Default Risk-Free Bonds
  15. 15. Application: The Subprime Collapse and the Baa-Treasury Spread As the U.S. financial system moved into crisis since 2007, the spread between corporate bonds and U.S. Treasury bonds increased, because the financial crisis made more difficult firms to obtain necessary funds to continue business and more likely firms to fail. Corporate Bond Risk Premium and Flight to Quality 0 2 4 6 8 10 Jan-07 M ar-07 M ay-07 Jul-07 S ep-07 N ov-07 Jan-08 M ar-08 M ay-08 Jul-08 S ep-08 N ov-08 Jan-09 Corporate bonds, monthly data Aaa-Rate Corporate bonds, monthly data Baa-Rate 10-year maturity Treasury bonds, monthly data
  16. 16. Default Risk and Bond Rating • Credit-rating agencies: investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default. − Ex. Moody’s and Standard & Poor’s • Investment-grade securities: bonds with relatively low risk of default (ratings of Baa/BBB and above). • Junk bonds (high-yield bonds): bonds with high default risk (ratings below Baa/BBB). − With high default risk junk bonds have high interest rates. − Due to high default risk some financial organizations are not allowed to purchase junk bonds.
  17. 17. Bond Ratings by Moody’s and S&P’s Why does United Airlines and Northwest Airlines have low ratings?
  18. 18. Liquidity • Liquidity: How quickly a financial instrument can be sold. − Some instruments are liquid, while others are not so liquid. − Liquidity of financial instruments depends on how many units of the instruments are traded every day and how many buyers participate in market. • In general, buyers of financial instruments prefer liquid instruments over less liquid instruments. − Higher the liquidity, the higher the demand.
  19. 19. Liquidity and Interest Rates • Bonds with low liquidity have low demand, while bonds with high liquidity have high demand. • Price of low liquid bonds (P2 C ) < Price of high liquid bonds (P2 T ) • Interest rate on low liquid bonds (i2 C ) > Interest rate of high liquid bonds (i2 T ) • Liquidity premium = i2 c – i2 T Liquidity Premium Bonds with Low Liquidity Bonds with High Liquidity
  20. 20. Tax and Return • Saver/lenders are concerned with after-tax return rather than before-tax return. • Returns from financial instruments are taxed at different rates. • Saver/lenders prefer instruments with lower tax rate even if the before-tax return is low. • Example − A before-tax returns on taxable bonds is 8% and a before-tax return on tax-free bonds is 6%. − At 50% tax rate, the after-tax return on the taxable bonds is 4% (= 8% x 0.5) and the after-tax return on the tax-free bonds is still 6%.
  21. 21. Tax Attribute • Income tax exempt on municipal bonds − Incomes earned from financial instruments are subject to the federal and state income taxes except for municipal bonds (tax exempt bonds). • Income tax vs. Capital gain tax − Incomes from financial instruments are divided into interest incomes and capital gains. − Interest (coupon) incomes are subject to the income taxes, while capital gains are subject to the capital gain tax. − Income tax rates and capital gain tax rates are different.
  22. 22. Tax-Free Bonds and Taxable Bonds • Price of tax-free bonds (P2 m ) > Price of taxable bonds (P2 T ) • Interest rate on tax-free bonds (i2 m ) < Interest rate of taxable bonds (i2 T ) • Tax premium = i2 T - i2 m • Tax-free (municipal) bonds have high demand, while taxable Bonds have low demand, .
  23. 23. Changes in Tax Rates • Any changes in tax rates on returns on financial instruments will affect the after-tax returns on instruments and their demands. • When tax rates increase, after-tax return on taxable bonds decreases. • Demand for taxable bonds decreases (from D0 T to D1 T ), while demand for tax-free bonds increases (from D0 M to D1 M ).
  24. 24. Effects of Increase in Tax Rates P Pi i i0 M i1 M i0 T i1 T P0 M P0 T P1 T P1 M D0 M D1 M D0 TD1 T E0 M E1 M SM ST E0 T E1 T TP0 TP1 Taxable Bonds Tax-Free Bonds • Price of taxable bonds ↓ (from P0 T to P1 T ) and price of tax-free bonds ↑ (from P0 M to P1 M ) • Interest rate of taxable bonds ↑ (from i0T to i1T) and interest rate on tax- free bonds ↓ (from i0 M to i1 M ) • Spread between taxable bonds and tax-free bonds ↑ from TP0 to TP1 • A Tax premium increases.
  25. 25. Capital Gain Tax Rates and Income Tax Rates • Some financial instruments pay most of return in form of interest incomes such as coupon payments from bonds. Other instruments pay most of return in form of capital gains such as stocks. • If the tax rate of one type changes relative to the tax rate of the other type, saver/lenders may prefer to purchase one type over another.
  26. 26. Example of Changes in Capital Gain Tax Rates • The federal government cut capital gain tax rates in early 2000s. • After-tax return on stocks (which mainly pay return in form of capital gains) increases, while an after-tax return on bonds (which mainly pay return in form of interest income) decrease relative to stocks. • Demand for stocks increases, while demand for bonds decreases. • Prices of stocks increase, while prices of bonds decrease. • Market interest rate (determined in a bond market) increases.
  27. 27. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University
  • MTrn28

    Mar. 28, 2020
  • DeoMsigala

    May. 11, 2019
  • shawlinamim

    Apr. 22, 2018

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