Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 6
THE STRUCTURE OF
INTEREST RATES
Factors that Influence Interest Rate Differences
Term to Maturity.
Default Risk.
Tax Treatment.
Marketability.
Copyright© 2006 John Wiley & Sons, Inc.
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Term (Maturity) Structure
May be studied visually by plotting a yield curve
at a point in time
A yield curve is a smooth line, which shows the
relationship between maturity and a security's
yield at a point in time.
The yield curve may be ascending (normal), flat,
or descending (inverted).
Several theories explain the shape of the yield
curve.
Copyright© 2006 John Wiley & Sons, Inc.
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Yield Curves in the 2000s - Exhibit 6.1
Copyright© 2006 John Wiley & Sons, Inc.
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Yield Curves and the Business Cycle
Interest rates are directly related to the level of
economic activity.
An ascending yield curve notes the market
expectations of economic expansion and/or
inflation.
A descending yield curve forecasts lower rates
possibly related to slower economic growth or
lower inflation rates.
Security markets respond to updated new
information and expectations and reflect their
reactions in security prices and yields.
Copyright© 2006 John Wiley & Sons, Inc.
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Yield-Curve Patterns Over the Business Cycle
Copyright© 2006 John Wiley & Sons, Inc.
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Uses of the Yield Curve
At any point in time, the slope of the yield curve
can be used to assess the general expectations of
borrowers and lenders about future interest rates!
Investors can use the yield curve to identify underpriced securities for their portfolios.
Issuers may use the yield curve to price their
securities.
Investors use the yield curve for a strategy known
as riding the yield curve.
Copyright© 2006 John Wiley & Sons, Inc.
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Default Risk
It is the probability of the borrower not
honoring the security contract
Losses may range from “interest a few days
late” to a complete loss of principal.
Risk averse investors want adequate
compensation for expected default losses.
Copyright© 2006 John Wiley & Sons, Inc.
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Default Risk, cont.
Investors charge a default risk premium
(above riskless or less risky securities) for
added risk assumed
DRP = i - irf
The default risk premium (DRP) is the
difference between the promised or nominal
rate and the yield on a comparable (same
term) riskless security (Treasury security).
Investors are satisfied if the default risk
premium is equal to the expected default
loss.
Copyright© 2006 John Wiley & Sons, Inc.
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Risk Premiums (May 2004)
Copyright© 2006 John Wiley & Sons, Inc.
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Default Risk, cont.
Default risk premiums increase (widen) in
periods of recession and decrease in
economic expansion
In good times, risky security prices are bid
up; yields move nearer that of riskless
securities.
With increased economic pessimism,
investors sell risky securities and buy
“quality” widening the DRP.
Copyright© 2006 John Wiley & Sons, Inc.
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Default Risk, cont.
Credit rating agencies measure and grade
relative default risk security issuers
Cash flow, level of debt, profitability, and
variability of earnings are indicators of
default riskiness.
As conditions change, rating agencies
alter rating of businesses and
governmental debtors.
Copyright© 2006 John Wiley & Sons, Inc.
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Corporate Bond-Rating Systems, Exhibit 6.7
Copyright© 2006 John Wiley & Sons, Inc.
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Tax Effects on Yields
The taxation of security gains and income
affects the yield differences among securities
The after-tax return, iat, is found by multiplying
the pre-tax return by one minus the marginal
tax rate.
iat = ibt(1-t)
Municipal bond interest income is tax exempt.
Coupon income and capital gains have been
taxed differently in the past, but are now both
taxed at the same rate as ordinary income for
individuals.
Copyright© 2006 John Wiley & Sons, Inc.
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To Buy a Municipal or a Corporate Bond?
Copyright© 2006 John Wiley & Sons, Inc.
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Impact of Marketability on Interest Yields
Marketability -- The costs and rapidity with
which investors can resell a security.
Cost of trade.
Physical transfer cost.
Search costs.
Information costs.
Securities with good marketability have
higher prices (in demand) and lower yields.
Copyright© 2006 John Wiley & Sons, Inc.
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Kidwell, Peterson, Blackwell & Whidbee