The document discusses factors that affect the cost of money such as production opportunities, time preference for consumption, risk, and inflation. It then covers interest rate levels and determinants such as the supply and demand for loans. The term structure of interest rates is also examined, showing that long term rates are usually higher than short term rates due to maturity risk premium. Finally, sample problems are provided to calculate bond yields based on given rates, inflation expectations, risk premiums, and liquidity premiums.
The document discusses factors that affect the cost of money such as production opportunities, time preference for consumption, risk, and inflation. It then covers interest rate levels and determinants such as the supply and demand for loans. The term structure of interest rates is also examined, showing that long term rates are usually higher than short term rates due to maturity risk premium. Finally, sample problems are provided to calculate bond yields based on given rates, inflation expectations, risk premiums, and liquidity premiums.
The document discusses factors that affect the cost of money such as production opportunities, time preference for consumption, risk, and inflation. It then covers interest rate levels and determinants such as the supply and demand for loans. The term structure of interest rates is also examined, showing that long term rates are usually higher than short term rates due to maturity risk premium. Finally, sample problems are provided to calculate bond yields based on given rates, inflation expectations, risk premiums, and liquidity premiums.
The document discusses factors that affect the cost of money such as production opportunities, time preference for consumption, risk, and inflation. It then covers interest rate levels and determinants such as the supply and demand for loans. The term structure of interest rates is also examined, showing that long term rates are usually higher than short term rates due to maturity risk premium. Finally, sample problems are provided to calculate bond yields based on given rates, inflation expectations, risk premiums, and liquidity premiums.
1. Production Opportunities opportunity to generate cash from assets 2. Time Preference for Consumption willingness to spend as opposed to saving 3. Risk chance that there is low or negative return 4. Inflation amount by which prices increase over time
If the market is low, Time preference for saving is high Interest rate will be high (to encourage investment) Capital formation is difficult
INTEREST RATE LEVELS Supply curve (Market H) - upward sloping which indicates that investors are willing to supply more if the rate of return is also high
Demand curve (Market L) - downward sloping, which indicates that borrowers will borrow more if the interest rates are lower
INTEREST RATE LEVELS Market rate (going rate) - Point at which supply and demand curve in Market H and Market L intersect Example: 5% is the going rate
Risk premium - the expected return in exchange of risk
Example: The suppliers will provide rate of return of 7% higher than going rate to obtain more finances. 7% - 5% = 2% = Risk premium
DETERMINANTS OF MARKET INTEREST RATES Market interest rates (Quoted)
r = r * + IP + DRP + LP + MRP
r RF = (r * + IP) r* = real risk free rate (no inflation is expected) (ex. Treasury certificates) r RF = quoted rate on a risk free security (ex. T-bond) DRP = default risk premium (risk that investment will not be paid on time) LP = liquidity premium (risk that investment cannot be converted to cash) MRP = marturity risk premium (reflects interest rate risk) THE TERM STRUCTURE OF INTEREST RATES - relationship between long term and short term rates
Yield curve graph to show the structure
Long term rates are usually higher than short term rates due to maturity risk premium
Normal yield curve - upward Abnormal - downward WHAT DETERMINES THE SHAPE OF THE YIELD CURVE?
Long term rates are usually higher than short term rates due to maturity risk premium
T-bond yield = r t + IP t + MRP t
Corporate bond yield = r t + IP t + MRP t + DRP t + LRP t
Corporate Bond yield premium = DRP + LRP
USING THE YIELD CURVE TO ESTIMATE FUTURE INTEREST RATES Pure expectations theory the yield curve depends on investors expectation about future interest rates
Example: assume that a 1 year Treasury bond currently yields 5.00%, while a 2 year bond yields 5.50%. Investors who want to invest for a two year horizon has two options: Option 1 - Buy a 2 year T-bond @ 5.50% Option 2 Buy 1 year T-bond @ 5.00%
Future Value at end of year 2 Option 1 = $1 x (1.055) 2 = $1.113025
USING THE YIELD CURVE TO ESTIMATE FUTURE INTEREST RATES
If the expectations theory is correct, such that 1.05 (1 + x) = 1.055
Future Value at Option 2 = $1 x (1.055) 1 + $1 x (1+x%) 1 = $?
1+x = (1.055) 2 /1.05 = 6.00238%
SAMPLE PROBLEMS Given: The real risk free rate of interest, r*, is 3% and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The maturity risk premium is equal to (0.1) x (t -1 )%, where t=bonds maturity The default risk premium for a BBB-rated bond is 1.3%
Compute for the following : a) What is the average expected inflation rates over the next 4 years. b) What is the yield on a 4 year Treasury bond? c) What is the yield on a 4 year BBB-rated corporate bond with a liquidity premium of 0.5%? d) What is the yield on an 8 year Treasury bond? SAMPLE PROBLEMS