Interest Rates by alicejenny

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```									Chapter 5

Interest Rates
Debt Instruments
       Measurement: Yield to Maturity - most accurate
measure of interest rates. The interest rate that equates
the present value of an asset’s returns with its price
today is called the yield to maturity
       Simple loan – borrower pays back the principal and
interest at the same time
      Simple interest
       Fixed payment loan – borrower pays a fixed payment per
time period until the loan and interest are repaid
       Coupon bond –borrower pays the interest every time
period and the principal at the end
      Coupon rate – is the percentage paid each time
       Discount bond (zero coupon bond) (Savings bond) –
bought at less than face value and paid face value at the
maturity date
Terms
       Present value – Today’s worth of a future amount
       Current Yield: current yield = i = Coupon payment/Price of Coupon Bond
       Basis Points: hundredths of a percentage point
       Rates of Return
       The total rate of return, which is the sum of current yield and actual capital
gain or loss, can differ from the yield to maturity.
       RET = (coupon payment + (Future price at t + 1) – (Price at t)/ (Price at t) =
       Example: \$1000 bond earning 10% sold in a year for \$1200
       RET = 100 +1200-1000/1000 = 300/1000 = 30%
       i = 100/1000 = 10%
       Real Interest rate. The real interest rate is the nominal interest rate
adjusted for changes in purchasing power.
       The real rate of return equals the nominal rate of return adjusted for expected
inflation.
       Basic: Nominal Interest Rate – Expected Inflation Rate
       Advanced: ((1 + nominal rate)/(1 + inflation rate)) – 1
Risk Structure of Interest Rates

       The default risk on a security is measured
relative to U.S. Treasury securities, which are
default-risk-free instruments.
     The default risk premium on a bond is the
difference between its yield and the yield on a
default-risk-free instrument of comparable maturity.
     The risk premium reflects in part the bond rating,
which is a single statistic summarizing the rating
company’s view of the issuer’s likely ability to meet its
debt obligations
   Differences in liquidity lead to differences in
interest rates.
   Differences in the cost of acquiring information
lead to differences in interest rates.
   Taxation is another reason for differences in
interest rates across credit market instruments.
Determinants of Portfolio Choice
   Wealth: As people become wealthier the size of their portfolio
of assets increases
   Expected Rate of Return: The correct measure of expected
return is the expected real rate of return
   Risk: Because most people are risk-averse savers they
evaluate the variability of expected returns as well as their
size.
   Liquidity: Assets with greater liquidity help savers to smooth
spending over time or to draw down funds for emergencies
   Information Costs: Savers prefer to hold assets with low
information costs
   Taxation
   Inflation
Diversification

       Not putting “ all of your eggs In one basket”
       Reduces risk
       Advantages of Diversification
      To compensate for the inability to find a perfect asset,
individuals engage in diversification, which is allocation of
savings among many different assets.
      Returns on assets do not move together perfectly because
their risks are imperfectly correlated.
      The strategy of dividing risk by holding multiple assets
ensures steadier income.
      Diversification reduces the riskiness of the return on a
portfolio unless assets’ returns move together perfectly.
      Savers cannot eliminate risk entirely because assets share
some common risk called market (or systemic) risk
Beta

       To measure systematic risk, financial
economists calculate a variable called beta,
the responsiveness of a stock’s expected
return to changes in the value of all stocks.
     If a 1% increase in the value of the market
portfolio leads to a 0.5% increase in the value
of the asset, the asset’s beta is 0.5.
     When an asset has a high value of beta, its
return has a lot of systematic risk.
Loanable Funds Market

       Demand for funds
       Interest Rates and Bond Prices move in opposite
directions
       As market interest rates change, the market price of a
bond may no longer equal its face value.
       The current yield on a bond equals the coupon payment,
C, divided by the current price of the bond, P.
      If the current price of the bond equals its face value, F, then
the yield to maturity, i, the current yield, C/P, and the coupon
rate, C/F, are all equal.
       Calculation
      i = RET = Expected Return = (F-P)/P
      F = 1000 and P = 950 i = 5.3%
      F = 1000 and P = 900 i = 11.1%
       Who demands (borrows)funds?
     Businesses – plant and equipment and inventories
     Households – cars, homes and consumer goods
     State and Local Govts. – sewers, roads and schools
     Federal Govt. – finance the federal budget deficit
       Determinants
     Expected Profits of business increases demand
     Tax on Profits of business decreases demand
     Tax Subsidies for businesses increases demand
     Expected Inflation increases demand
     Government Borrowing increases demand
       Supply of loanable funds: Upward slope, as the Pb rises
and interest rates fall, more bonds are issued
       Controlled by the FED
       Determinants of saving
      Wealth increase supply
      Expected returns increases the supply
      Expected inflation decreases the supply
      Expected returns on other assets decreases the supply
      Risk on bonds decreases the supply
      Liquidity of bonds increases the supply
      Information costs decreases supply
      Taxation
       Equilibrium: Qbd = Qbs
     Determines the interest rate
     Interest rates rise in expansions and fall in
contractions
       Major Interest Rates
       Federal Funds Rate –rate at which banks borrow from
each other
       Discount Rate – Rate at which banks borrow from the
FED
       3 Month Treasury Bill
       Moody’s Aaa Rating – Rates assigned to corporations
based on their risk
     Investment Grades are: Aaa, Aa, A and Baa
     Speculative Grades (called Junk Bonds) are: Ba, B and
Caa to C
     Default - D
       Prime Rate –rate banks charge on short term loans to
their best customers (best credit rating)
Financial Theories

       Segmented Market Theory – each financial
instrument has it’s own separate market (supply
and demand) in which yields are determined
     The segmented markets theory holds that the yield
on each instrument of differing maturity is determined
in a separate market.
       Preferred Habitat Theory – investors care only
about returns and maturity
     Each investor has their own preferences and
consistently invests in the same type of investments
     which holds that investors care about both expected
returns and maturity.
Expectations

       Role of Expectations - influence economic
behavior, markets and policy
       Results of Expectations
       Good news or high expecations
      GDP increases
      Prices rise
      Unemployment falls
      Interest rates will go up
      Bond Prices fall
      Stock prices rise
       Bad news the opposite occurs
       Theory of Expectations
       Adaptive expectations - expectations formed from the
past
     expectations of changes in prices or returns change
gradually over time as data on past prices or returns
become available.
     Adaptive expectations are formed by looking at current
and past prices
       Rational Expectations - expectations formed from all
available information and understanding the economy
     Rational expectations are formed by looking at past
prices and all currently available information about the
economy that may affect prices.
     Most economists believe market participants have rational
expectations and use all information available to them.
       Efficient Markets Theory - is rational expectations
applied to financial markets
       The efficient markets hypothesis says that when
financial markets are in equilibrium, the prices of all
financial instruments reflect all readily available information
       Equilibrium price reflects all available information and how
markets work
       When a variable changes, then expectations change
       Unexploited profit opportunities will disappear
       Past does not always indicate the future
      Random walk - as variables change stock prices are
unpredictable
       Stocks will respond to announcements only when they are
new and unexpected
       If it is expected the market has already reacted

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