350-05a_note[1]

350-05a_note[1] - 350-05a_note, 11S TOPIC 5: INTEREST RATES...

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350-05a_note, 11S Page 1 of 9 TOPIC 5: INTEREST RATES (CHAPTER 6) I. Outline A. Determinants of interest rates 1. Factor affecting interest rates 2. Risk premium B. The term structure and yield curves 1. Definition 2. Constructing the yield curve C. Pure Expectations Hypothesis II. Homework Assignment Chapter 6 Question 2, 4-6 Problem 2-4, 8, 12, 18 ================================================================ Class Notes I. Determinants of Interest rates A. What four factors affect the level of interest rates? (Case A) Factor Impact on Interest Rate Expected Inflation ? Risk ? Production Opportunities (Expected Return Rate) ? Current Consumption ?
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350-05a_note, 11S Page 2 of 9 B. Determinants (Case B) 1. Definition: a) Risky Rate r = represents any nominal rate b) Real Rate * r = represents any real rate c) Risk-Free Rate RF r = represents the rate of interest on Treasury securities. (Free of default risk). T-bill rate or T-bond rate. d) Real Risk-Free Rate * RF r = represents the “real” risk-free rate of interest. (1) Like a T-bill rate, if there was no inflation. Treasury Inflation Protected Security (TIPS), whose value increases with inflation. (2) Correction: Textbook notation: * r (Make sure you change it to * RF r ) e) Remember: All the stated interest rates are annual rates!!!!! 2. Risk Premium Nominal Real IP Risky Rate Risk-Free Rate a) IP = inflation premium b) DRP = default risk premium c) MRP = maturity risk premium d) LP = liquidity premium 3. Risk Premiums for different types of debt (Case C) r * RF r IP DRP MRP LP ST Treasury r LT Treasury r ST Corporate r LT Corporate r
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350-05a_note, 11S Page 3 of 9 II. Yield Curve and the Term Structure A. Term structure – relationship between interest rates (or yields) and maturities. (Case D) Years to Maturity (T) Yield ( r ) 0.25 3.96% 0.50 4.25% 2.00 4.42% 5.00 4.47% 10.00 4.58% 30.00 4.77% B. The yield curve is a graph of the term structure 3 3.2 3.4 3.6 3.8 4 4.2 4.4 4.6 4.8 5 0.25 0.5 2 5 10 30 Maturity (years) Yield (%) 1. Upward sloping yield curve 2. Downward sloping yield curve 3.
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350-05a_note[1] - 350-05a_note, 11S TOPIC 5: INTEREST RATES...

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