Chapter 4 - Chapter 4 Understanding Yield Spreads 1...

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1 Chapter 4 Understanding Yield Spreads
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2 Introduction Different interest rates At any given point in time, a wide range of interest rates are reported in the market Why are these different interest rates? Due to different debt features (Chapter 1 ) Because of different risks associated with investing in bonds (Chapter 2 ) This chapter takes a closer look at the differences in yields (or interest rates ) offered by bonds in different sectors of the bond market and within the same sector of the bond market
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3 Introduction Level of interest rates We refer to the risk free interest rate as the “ level of interest rates The level of interest rates depends on: 1) The state of the economy 2) The interest rate policies of the central bank (e.g., the Bank of Canada , the Board of Governors of the Federal Reserve System (i.e., the Fed ) in the U.S. etc.) And 3) the government’s fiscal policies Yield on a bond = risk free interest rate + yield spread on the bond
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4 Interest rate policy tools The Fed uses the following interest rate policy tools to directly influence short term interest rates and indirectly impact long term interest rates 1) Open market operations ( OMOs ) : the Fed buys or sells Treasury securities in the open market (also known as the secondary market for Treasury securities) Buying increases funds available for lending, interest rates decrease ; selling has the opposite effect It is the most flexible and most commonly used policy tool of the Fed The Federal Open Market Committee (FOMC) is the Fed’s top monetary policy-making body (they usually meet eight times per year)
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5 Interest rate policy tools 1) Open market operations ( continued from the previous slide ) Example : On March 18, 2009 the Fed announced that in order to stimulate the U.S. economy they would purchase: a) $750 billion of mortgage backed securities (MBSs) b) $200 billion of debt in Fannie Mae and Freddie Mac and c) $300 billion of long term Treasury securities This was called quantitative easing ( QE )
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6 Interest rate policy tools 1) Open market operations ( continued from the previous slide ) Example ( continued from the previous slide ) : In November 2010, the Fed announced it would increase quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011. This is known as QE2
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7 Interest rate policy tools Interest rate policy tools ( continued ) 2) The discount rate is the interest rate charged to commercial banks on short term loans they receive from the Fed’s lending facility: the discount window . That is, the discount rate is the rate at which banks can borrow reserves from the Fed on a collateralized basis A lower discount rate encourages lending, interest rates decrease ; the opposite holds true with a higher discount rate
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8 Interest rate policy tools 2) The discount rate ( continued ) Federal fund rate
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Chapter 4 - Chapter 4 Understanding Yield Spreads 1...

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