Chapter Five The Structure of Interest Rates

Copyright © Houghton Mifflin Company. All rights reserved.5 | 2 Different Types of Debt Securities Personal saving via indirect finance –CDs and money market accounts –Early withdrawals and/or minimum deposits Personal borrowing –Include loans, mortgages, credit cards, etc. –Collateral and/or adjustable interest rates may apply Saving via direct finance –Purchasing of debt securities, –May be via securitization, guaranteed investment contracts, and/or commercial paper What Explains Differences in Interest Rates?

Copyright © Houghton Mifflin Company. All rights reserved.5 | 3 Debt Securities & Their Yields

Copyright © Houghton Mifflin Company. All rights reserved.5 | 4 Why does yield to maturity vary? –Risk…riskier securities must hold more promise Same holds true for interest paid on credit and interest earned on bonds –Liquidity…transactions costs are lower on securities that are more liquid On-the-run (very liquid) vs. off-the-run securities (less liquid, not recently issued) –Taxation…corporate & government securities are subject to different levels of taxation –Time to maturity…longer terms must hold more promise Secondary Market Supply & Demand

Copyright © Houghton Mifflin Company. All rights reserved.5 | 5 Market participants sometimes worry about the risk of borrowers’ default –eg Russian debt default caused supply of securities to increase (many owners looking to sell) and demand to decrease (new investors did not want to take on risk of default) Please insert Figure 5.1 Secondary Market Supply & Demand (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.5 | 6 Borrowers are concerned with default, as are investors, to ensure future borrowing opportunities –eg. discontinuing of 30 year U.S. Treasury bonds in 2001 resulted in price increase and decrease in yield to maturity Please insert Figure 5.2 Secondary Market Supply & Demand (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.5 | 7 The surprise announcement of the U.S. Treasury in October, 2001 dramatically affected the yield to maturity on U.S. Treasury securities Please insert Figure 5.3 Supply & Change in Yields to Maturity

Copyright © Houghton Mifflin Company. All rights reserved.5 | 8 Can assist in analyzing the economy and making predictions about economic growth Term structure of interest rates = relationship between interest rates with differing times to maturity The Term Structure of Interest Rates

Copyright © Houghton Mifflin Company. All rights reserved.5 | 9 Short and long term interest rates generally move in the same direction Short term rates tend to be more volatile and lower than long term rates Please insert Figure 5.4. Short & Long Term Interest Rates

Copyright © Houghton Mifflin Company. All rights reserved.5 | 10 Plots interest rates on different securities of similar default risk for a given day –Used to demonstrate difference in interest rates based on time to maturity –Upward sloping curves show securities with longer times/higher yields to maturity Please insert Figure 5.5 Yield Curves

Copyright © Houghton Mifflin Company. All rights reserved.5 | 11 Same yield curve, different dates… Can we explain behavior of interest rates overall? Please insert Figure 5.6 Yield Curves (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.5 | 12 Is it better to buy one two-year bond or two one-year bonds? Please insert Table 5.2 The choice depends on the interest rates! Short- vs. Long-Term Securities

Copyright © Houghton Mifflin Company. All rights reserved.5 | 13 Sometimes it’s more convenient to use an approximation rather than calculating the average interest rate of each security. Two important assumptions being made above 1.Investor bears no transactions costs 2.Investor is certain of return on one-year bond Short- vs. Long-Term Securities (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.5 | 14 Establishing a relationship between short- and long-term interest rates Assume zero transactions costs and predictable short-term interest rates Long-term interest rate = average of current and future short-term rates This theory is known as the expectations theory of long-term interest rates Term Structure of Interest Rates in Equilibrium

Copyright © Houghton Mifflin Company. All rights reserved.5 | 15 Investors compare long-term interest rates with comparable successive short-term rates, choosing to purchase those with highest yields As demand for higher yield bonds increases, the price rises, bringing the group of short-term bonds back into equilibrium Please insert Figure 5.7. Shifting Demand

Copyright © Houghton Mifflin Company. All rights reserved.5 | 16 Yield curve shapes will vary based on expectations theory of term structure Different shapes will result when –Short term rates are not expected to change –Short-term rates are expected to fall –Short-term rates are expected to rise Expectations Theory & Yield Curves

Copyright © Houghton Mifflin Company. All rights reserved.5 | 17 Yield Curves of Different Shapes

Copyright © Houghton Mifflin Company. All rights reserved.5 | 18 Forecasts made the earliest tend to be the most inaccurate, based on predictions one, two, and three quarters ahead. Overall, however, accuracy may be a reasonable assumption. Please insert Figure 5.A How Accurate are Short-Term Interest Rates?

Copyright © Houghton Mifflin Company. All rights reserved.5 | 19 Expectations theory makes it possible to figure out future interest rates on long-term bonds by calculating average interest rate of shorter-term bonds Fluctuations in one-year interest rates over time result in a yield curve of varying slope Please inert Table 5.5Please insert Figure 5.9 Equilibrium Rates & Differing Maturities

Copyright © Houghton Mifflin Company. All rights reserved.5 | 20 Common contradiction to expectations theory –Theory suggests yield curves should remain flat when short-term interest rates are not expected to change –This is not always the case! –Theory ignores how investors respond to risk. (Recall the assumption of zero transactions costs…) –Interest-rate risk is greater on longer-term bonds, which could cause investors’ preferences to shift toward shorter-term bonds The Term Premium

Copyright © Houghton Mifflin Company. All rights reserved.5 | 21 Reconsider the case of the investor choosing between one two-year and two one-year bonds A variable must be added to account for interest rate risk A term premium is the difference between longer-term and shorter-term interest rates to account for the risk of inflation Incorporating a Term Premium

Copyright © Houghton Mifflin Company. All rights reserved.5 | 22 Interest-rate risk one of main sources of risk to any security Rate of discount has a relatively greater effect on the present value of long-term securities, rendering them riskier Present value of bonds with longer time to maturity are higher For a given change in interest rates on all bonds, the prices of long-term bonds are affected more than the prices of short-term bonds Interest-Rate Risk & Long-Term Securities

Copyright © Houghton Mifflin Company. All rights reserved.5 | 23 The longer the time to maturity, the larger the term premium If market interest rate falls below 8%, all bind prices rise, but longer-term bond prices rise relatively more Please insert Figure Bond Price & Market Interest Rates

Copyright © Houghton Mifflin Company. All rights reserved.5 | 24 Even when forecasts suggest that short-term interest rates will remain stable, longer-term securities still carry a term premium Term premiums are (still) smaller the shorter the time to maturity Term Premiums Are Ever Present

Copyright © Houghton Mifflin Company. All rights reserved.5 | 25 People are less likely to save, hence making money available for investment, during a recession Borrowing tends to decline even more than saving Effects a greater supply shift than demand shift As economies emerge from recessions, the reverse trend tends to occur Yield Curves & Business Cycles

Copyright © Houghton Mifflin Company. All rights reserved.5 | 26 During a recession, both saving and borrowing decline, but borrowing more so than saving. Thus, the supply of debt securities decreases more than the demand for them. Yields to maturity of existing securities subsequently decline, while the price of debt securities rises. Securities Equilibrium in Recession

Copyright © Houghton Mifflin Company. All rights reserved.5 | 27 Short-term interest rates change more over the business cycle than long-term The result is an inverted (downward- sloping) yield curve Smaller term premiums cause more of a downward slope Larger term premiums result in a flatter yield curve; without the term premium, long-term rates would be lower that short- term rates Inverted Yield Curves

Copyright © Houghton Mifflin Company. All rights reserved.5 | 28 People expect short-term rates to rise as the economy leaves a recession Long-term interest rates should therefore exceed short-term due to term premium and expectations for short-term rates In the middle of an expansion, there are few expectations for increases in short- term rates; upward slope of yield curves results only from term premium Yield Curves & Recessions

Copyright © Houghton Mifflin Company. All rights reserved.5 | 29 Please insert Figure 5.12 Fairly flat slopes to yield curves above indicate people were not surprised by this recession Yield Curves & Recessions (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.5 | 30 Please insert Figure 5.13 Steeper yield curves indicate an expectation of rising short-term interest rates, typical in a period of expansion Yield Curves & Expansions

Copyright © Houghton Mifflin Company. All rights reserved.5 | 31 Please insert Figure 5.14 Three years into an expansion, yield curves are flattening, as the expectations for rising short- term interest rates diminish Yield Curves & Expansions (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved.5 | 32 Difficult to plot yield curves over time due to profusion of data points Term spreads can simplify the process A term spread is the interest rate on a long-term debt security, minus the interest rate on a short-term debt security Predictable Recessions?

Copyright © Houghton Mifflin Company. All rights reserved.5 | 33 Predictable Recessions? (cont.) Negative or low terms spreads are sometimes indicative of recession Two possible scenarios can lead to low/negative spread, both of which increase the odds of recession 1)Rising short-term rates as the effect of tight monetary policy to slow the growth of the economy 2)Reduction in bank lending as banks are squeezed by higher short-term rates not counterbalanced by their long-term loan rates

Copyright © Houghton Mifflin Company. All rights reserved.5 | 34 The spread between short-term interest rates and long-term rates gets smaller before and rises during recessions Please insert Figure 5.15 Term Spreads & Recessions