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    The Level & Structure of Interest Rates

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    armailgm
    The document discusses factors that determine interest rates and the risk structure of interest rates. It explains that the overall level of interest rates is determined by the loanable funds market, where the demand and supply of funds intersect at the equilibrium interest rate. It also discusses how different interest rates incorporate risk premiums for factors like default risk, liquidity risk, and tax treatment. Higher risk is associated with higher interest rates as compensation for investors.

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    The Level & Structure of Interest Rates

    Uploaded by

    armailgm
    47 views49 pages
    The document discusses factors that determine interest rates and the risk structure of interest rates. It explains that the overall level of interest rates is determined by the loanable funds market, where the demand and supply of funds intersect at the equilibrium interest rate. It also discusses how different interest rates incorporate risk premiums for factors like default risk, liquidity risk, and tax treatment. Higher risk is associated with higher interest rates as compensation for investors.

    Original Title

    342 Chapter 11

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    © Attribution Non-Commercial (BY-NC)

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    The document discusses factors that determine interest rates and the risk structure of interest rates. It explains that the overall level of interest rates is determined by the loanable funds market, where the demand and supply of funds intersect at the equilibrium interest rate. It also discusses how different interest rates incorporate risk premiums for factors like default risk, liquidity risk, and tax treatment. Higher risk is associated with higher interest rates as compensation for investors.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    47 views49 pages

    The Level & Structure of Interest Rates

    Uploaded by

    armailgm
    The document discusses factors that determine interest rates and the risk structure of interest rates. It explains that the overall level of interest rates is determined by the loanable funds market, where the demand and supply of funds intersect at the equilibrium interest rate. It also discusses how different interest rates incorporate risk premiums for factors like default risk, liquidity risk, and tax treatment. Higher risk is associated with higher interest rates as compensation for investors.

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    You are on page 1of 49

    Chapter 11.

    The Level & Structure of Interest Rates

    Loanable funds market Risk Structure of Interest Rates

    I. Loanable Funds Market

    determine equilibrium interest rate overall level of interest rates


    but still many different interest rates

    Demand for LF

    behavior of issuers & borrowers interest rate is cost of borrowing


    it is the price of loanable funds demand is downward sloping

    DLF LF

    what shifts demand?

    tax rules
    favorable tax treatment for interest payments increase demand mortgage interest deductible bond interest deductible for issuer

    expected profitability
    increases will encourage investment & borrowing -- increase demand increases w/ economic expansion, decreases w/ recession

    government borrowing
    deficits increase demand surpluses decrease demand

    Supply of LF

    behavior of savers, lenders, bond


    buyers interest rate is reward for saving postpone present consumption supply curve is upward sloping

    i SLF

    DLF LF

    what shifts supply?

    tax rules
    favorable treatment of interest income pensions tax exempt interest

    income & wealth


    increases will increase amount and % of saving rate of time preference people more/less willing to postpone consumption

    FOMC policy
    if Fed buys Treasuries, increase supply of LF

    Example

    Fed sell Treasuries


    decrease SLF Federal govt runs a deficit increase DLF

    i SLF

    interest rate rises

    DLF LF

    What is i?

    benchmark interest rate or base interest rate minimum rate acceptable to lenders
    all other rates compared to benchmark Treasury yield -- default-free, highly liquid

    III. Risk Structure of Interest Rates

    different interest rates on assets


    with same maturity why? assets have different characteristics

    measurement

    difference between two interest rates


    spread measured in percentage points basis points 1 percentage pt. = 100 basis pts.

    example 1

    3 mo. Tbill .95% 3 mo. Commercial paper spread


    .07 percentage pts. 7 basis pts.

    1.02 %

    example 2

    10 yr Tnote 10 BAA corporate spread


    1.07 percentage pts. 107 basis pts.

    3.85% 5.02%

    3/5/2004

    3 mo Tbill 3 mo Commerical Paper 10 yr. Tnote 10 yr. AAA corporate 10 yr. BAA corporate 10 yr. AAA muni 30 yr. mortgage

    .95% 1.02% 3.85% 4.31% 5.02% 3.47% 5.36%

    Patterns

    Baa always the highest yield Municipals always the lowest (1940) Baa > AAA > U.S. > municipal
    size of the spread varies

    Risk premium

    base interest rate + risk premium


    = interest rate on corporate debt

    size of risk premium

    issuer default/credit risk liquidity maturity (chapter 12) options tax treatment

    Issuer

    spreads exist among different


    issuers but usually a function of other factors

    Default risk/ credit risk

    risk of not receiving timely payment


    of principal and interest depends on creditworthiness of issuer structure of bond

    U.S. government debt

    zero default risk backed by full faith and credit


    of U.S. government why? power to tax largest economy power to issue stable currency

    Other issuers

    private foreign municipal all have some default risk rated for default risk

    Bond ratings

    bond issuer pays rating agency


    Moodys, S&P high credit rating low default risk bond ratings may change over time

    default risk & yield

    investors are risk averse


    higher default risk lower credit rating higher yield

    so default risk explains


    Treasury yields

    <

    AAA Corp yields

    <

    BAA Corp yields

    default risk is not constant!

    varies over the business cycle


    higher in recessions lower in expansions Baa vs. Treasury bond yield 12/99 191 basis pts. 2/03 307 basis pts. 3/04 107 basis pts.

    Bond ratings (p. 400)


    S&P Moodys

    AAA AA A BBB BB B CCC CC C

    Aaa Aa A Baa Ba B Caa Ca C

    Investment grade

    High Yield

    B. Liquidity

    how quickly/cheaply can bond be


    sold for cash?

    higher liquidity

    lower yield

    liquidity is not rated

    Treasuries most liquid depends on size of issuer related to default risk


    bonds in default very illiquid higher-rated bonds tend to be more liquid

    Embedded Options

    special rights granted to holder or


    issuer of bond affect on yield spread depends on option beneficial to issuer? beneficial to holder?

    options for issuer

    increase yield relative to option-free


    bond call provision issuer has right to pay off bond early issuer often calls bonds when interest rate falls

    options for holder

    decrease yield relative to an option


    free bond put provision holder has right to sell back bond early holder more likely to exercise right at higher interest rates

    issuer options
    must offer higher yield to get special rights holder options must accept lower yield in exchange for special rights

    Tax treatment

    depends on the issuer


    municipal Treasury corporate

    municipal bond interest

    exempt from federal income tax possibly exempt from state income
    tax if issuer & bondholder are in same state

    Treasury bond interest

    exempt from state income tax


    Corporate bond interest

    fully taxable

    more favorable tax treatment

    lower before-tax yield

    tax treatment explains

    muni yields

    <

    Treasury yields

    <

    Corp yields

    example 1

    10 yr. municipal Baa bond, 6% 10 yr. corporate Baa bond, 8% tax rate 28% after tax yield?
    muni = 6% corporate = 8%(1-.28) = 5.76%

    example 2

    10 yr. municipal Baa bond, 6% tax rate 28% what corporate yield would make
    investors indifferent? corp. yield (1-.28) = 6% corp. yield = 8.33% equivalent taxable yield

    example 3

    10 yr. municipal Baa bond, 6% 10 yr. corporate Baa bond, 8% what tax rate makes investor
    indifferent? 8% (1- t) = 6% t = 25%

    impact of tax rates

    higher tax brackets derive more


    benefit from munis changing tax rates will affect the corporate-municipal yield spread IRS rulings could make muni debt taxable

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