The Fisher Effect: ExampleIf we require a 10% real return and we expect inflation to be 8%, what is the nominal rate?
5-40Term StructureTerm structure is the relationship between time to maturity and yields, all else equal.It is important to recognize that we pull out the effect of default risk, different coupons, etc.Yield curve – graphical representation of the term structure◦Normal – upward-sloping, long-term yields are higher than short-term yields◦Inverted – downward-sloping, long-term yields are lower than short-term yields
5-41Term Structure of Risk-Free U.S. Interest Rates, November 2006, 2007, and 2008
5-43Factors Affecting Required ReturnDefault risk premium – remember bond ratingsTaxability premium – remember municipal versus taxableLiquidity premium – bonds that have more frequent trading will generally have lower required returns (remember bid-ask spreads)Anything else that affects the risk of the cash flows to the bondholders will affect the required returns.
5-44Quick QuizHow do you find the value of a bond, and why do bond prices change?What is a bond indenture, and what are some of the important features?What are bond ratings, and why are they important?How does inflation affect interest rates?What is the term structure of interest rates?What factors determine the required return on bonds?