Interest Rates

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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
        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
            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
   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

       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

       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
            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
       Major Interest Rates
           Federal Funds Rate –rate at which banks borrow from
            each other
           Discount Rate – Rate at which banks borrow from the
           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.

        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
             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
           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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