Lecture-Notes-Chap6-10

Lecture-Notes-Chap6-10 - Chapter 6 - Interest Rates...

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22 Chapter 6 -- Interest Rates Interest rates The determinants of interest rates Term structure of interest rates and yield curves What determines the shape of yield curves Other factors Interest rates Cost of borrowing money Factors that affect cost of money: Production opportunities Time preference for consumption Risk Inflation Demand and supply for funds, see Figure 6-1 The determinants of interest rates r = r* + IP + DRP + MRP + LP where r = the quoted, or nominal rate on a given security r* = real risk-free rate IP = inflation premium (the average of expected future inflation rates) DRP = default risk premium MRP = maturity risk premium LP = liquidity premium and r* + IP = r RF = nominal risk-free rate (T-bill rate) Examples Term structure of interest rates and yield curves Term structure of interest rates: the relationship between yields and maturities Yield curve: a graph showing the relationship between yields and maturities Normal yield curve (upward sloping) Abnormal yield curve (downward sloping) Humped yield curve (interest rates on medium-term maturities are higher than both short-term and long-term maturities)
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23 What determines the shape of yield curves Term structure theories (1) Expectation theory: the shape of the yield curve depends on investor’s expectations about future interest rates (inflation rates) Forward rate: a future interest rate implied in the current interest rates For example, a one-year T-bond yields 5% and a two-year T-bond yields 5.5%, then the investors expect to yield 6% for the T-bond in the second year. (1+5.5%) 2 = (1+5%)(1+X), solve for X(forward rate) = 6.00238% Approximation: (5.5%)*2 – 5% = 6% (2) Liquidity preference theory: other things constant, investors prefer to make short-term loans, therefore, they would like to lend short-term funds at lower rates Implication: keeping other things constant, we should observe normal yield curves Other factors Fed policy; Government budget deficit; Business activity International perspective: trade deficit, country risk, exchange rate risk Exercise ST-1, ST-2, and ST-3 Problems: 2, 3, 5, 7, 10*, 11, and 12* Problem 10: expected inflation this year = 3% and it will be a constant but above 3% in year 2 and thereafter; r* = 2%; If the yield on a 3-year T-bond equals the 1- year T-bond yield plus 2%, what inflation rate is expected after year 1, assuming MRP = 0 for both bonds? Answer: yield on 1-year bond, r 1 = 3% + 2% = 5%; yield on 3-year bond, r 3 = 5% + 2% = 7% = r* + IP 3 ; IP 3 = 5%; IP 3 = (3% + x + x) / 3 = 5%, x = 6% Problem 12: Given r* = 2.75%, inflation rates will be 2.5% in year 1, 3.2% in year 2, and 3.6% thereafter. If a 3-year T-bond yields 6.25% and a 5-year T-bond yields 6.8%, what is MRP 5 - MRP 3 (For T-bonds, DRP = 0 and LP = 0)? Answer: IP
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This note was uploaded on 05/10/2011 for the course FIN 303 taught by Professor Philips during the Spring '08 term at CSU Northridge.

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Lecture-Notes-Chap6-10 - Chapter 6 - Interest Rates...

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