CHAPTER 6 Four factors affect interest rate level : production opportunities, time preferences for consumption, risk and expected inflation Different Consumption preferences: borrow or lend to achieve the individual consumption desired “Real” rates r* represents the “real” risk-free rate of interest. Like a T-bill rate, if there was no inflation. From 1% to 4% per year. rRF = rate of interest on Treasury securities. (no risk of default); rRF =r* + IP= avg. inflation rate expected over life of security & compensate expected loss of purchasing power. r = r* + IP + DRP + LP + MRP (inflation premium, default risk premium, liquidity premium, maturity risk premium) IP MRP DRP LP ST Treasury X LT Treasury X X ST Corporate X X X LT Corporate X X X X Upward slope due to ↑ expected inflation and ↑ maturity risk premium. Corporate yield curves are higher than that of Treasury securities , though not necessarily parallel to the Treasury curve. The spread between corporate and Treasury yield curves widens as the corporate bond rating decreases. Interest rates: BB>AAA>treasury Yield Curve Other factors that influence interest rate: Fed. Reserve policy, Fed. Budget surplus or deficit, level of business activity, International factors CHAPTER 7: Types: Treasury-government bonds-no default risk, Agency - quasi government, corporate bonds, Municipal bonds, foreign bonds Bond Markets primarily traded in the over-the-counter (OTC) market. Most bonds are owned by and traded among large financial institutions. WSJ: key developments in the Treasury, corp. and municipal markets. The discout rate (Ki) is the opportunity cost of capital, and is the rate that could be earned on alternative investments of equal risk. if coupon rate > YTM , bond’s value > par value - sold at premium Current yield (CY) = annual coupon payment/current price Capital gains yield (CGY) = change in price/beginning price Expected total return = YTM = Expected CY + Expected CGY Interest rate risk : rising YTM will cause the value of a bond to fall. The 10-year bond is more sensitive and hence has more interest rate risk. Reinvestment rate risk : YTM will fall, and future CFs will have to be reinvested at lower rates, hence reducing income. Conclusions: nothing is riskless! ST and/or high coupon bonds LT and/or low coupon bonds Interest rate risk low high Reinvestment rate risk high low Default risk: Expected return on corporate and municipal bonds is less than the promised return. Influenced by the issuer’s financial strength and the terms of the bond contract. Factors affecting default risk and bond ratings:
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