06 Chapter model

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06 Chapter model 3/22/2010 7:09 2/14/2006 Chapter 6. Interest Rates Nominal interest rate = r = r* + IP + DRP + LP + MRP WHICH TYPES OF SECURITIES ARE EXPOSED TO WHAT KIND OF RISK? Interest Rate Short-Term Long-Term Short-Term Long-Term Parameter Treasuries Treasuries Corporates Corporates r* X X X X IP X X X X MRP X X DRP X X LP X X Maturity (yrs) Mar-80 Feb-00 Feb-05 0.5 15.0% 6.0% 2.9% 1 14.0% 6.2% 3.1% 5 13.5% 6.7% 3.8% 20 12.8% 6.7% 4.2% 30 12.3% 6.3% 4.6% THE DETERMINANTS OF INTEREST RATES (Section 6.3) Interest rates can easily be observed. All it requires is reading the newspaper, watching television, or surfing the internet. However, it is not so easy to see the factors that determine market interest rates, and the extent to which they shape interest rates. Naturally, the determination of interest rates is a macroeconomic question that has numerous contributing factors. However, in an effort to simplify the composition of interest rates, we will look at nominal interest rates being composed of five driving forces, as outlined here: Here r* represents the real risk-free rate of interest, IP is the inflation premium, DRP is the default risk premium, LP is the liquidity premium, and MRP is the maturity risk premium. Together, these five factors determine the nominal interest rate, denoted by r. THE TERM STRUCTURE OF INTEREST RATES (Section 6.4) The term structure describes the relationship between long-term and short-term interest rates. Graphically, this relationship can be shown in what is known as the yield curve. In practice, the yield curve is relatively easy to obtain. It is published daily in a variety of online and print news sources. However, the "building block approach" to generating a yield curve is more complicated. We will see that later when we build our own yield curve. Before jumping into the creation of our own yield curve, let's look at some historical interest rate data and draw some historical yield curves. Here is some interest rate data from March 1980, August 1999, and February 2000. A B C D E F G H 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34

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From this data, we can plot three line graphs. Each line graph represents the U.S. Treasury yield curve at a different point in time. 0 5 10 15 20 25 30 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% U.S. Treasury Bond Interest Rates on Different Dates Years to Maturity Interest Rate (%) A B C D E F G H 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57
Our Hypothetical Yield Curve Setting up the yield curve INPUT DATA Real risk free rate 2.50% Then, we reproduce the data from the graph in this table, to make it look like it might have appeared in the newspaper. Looking at these three historical yield curves, we see that they paint very different landscapes of the

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## This note was uploaded on 03/21/2010 for the course BUSINESS AB102 taught by Professor Woo during the Spring '10 term at Nanzan.

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06 Chapter model - 1 2 3 4 5 A B 06 Chapter model C D E...

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