PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 4 Interest Rates

Copyright © 2004 South-Western. All rights reserved.4–2 Fundamental Issues 1.Why must we compute different interest yields? 2.How does risk cause market interest rates to differ? 3.Why do market interest rates vary with differences in financial instruments’ terms to maturity? 4.What is the real interest rate?

Copyright © 2004 South-Western. All rights reserved.4–3 Fundamental Issues (cont’d) 5.How are interest yields on bonds issued in different countries related? 6.What interest rates are the key indicators of financial market conditions?

Copyright © 2004 South-Western. All rights reserved.4–4 Calculating Interest Yields: Key Terms Principal:  The amount of credit extended when one makes a loan or purchases a bond. Interest:  The payment, or yield, received for extending credit by holding any financial instrument. Interest rate:  The percentage return, or percentage yield, earned by the holder of a financial instrument.

Copyright © 2004 South-Western. All rights reserved.4–5 Different Concepts of Interest Yield Coupon return:  A fixed interest return that a bond yields each year. Nominal yield:  The coupon return on a bond divided by the bond’s face value; r n =C/F. Current yield:  The coupon return on a bond divided by the bond’s market price; r c =C/P.

Copyright © 2004 South-Western. All rights reserved.4–6 Different Concepts of Interest Yields (cont’d) Yield to maturity:  The rate of return on a bond if it is held until it matures, which reflects the market price of the bond, the bond’s coupon return, and any capital gain from holding the bond to maturity. Capital gain:  An increase in the value of a financial instrument at the time it is sold as compared with its market value at the date it was purchased.

Copyright © 2004 South-Western. All rights reserved.4–7 Calculating Discounted Present Value Discounted present value:  The value today of a payment to be received at a future date.  Payment one year from now/(1+ r).  Discounted present value of payment to be received n years in the future:  Payment n years from now/(1+ r) n.

Copyright © 2004 South-Western. All rights reserved.4–8 Compounded Annual Interest Rate Year3%5%8%10%20% Present Values of a Future Dollar Table 4–1

Copyright © 2004 South-Western. All rights reserved.4–9 Calculating the Yield to Maturity Perpetuity:  A bond with an infinite term to maturity.  Perpetuity price = C/r. Simple rule:  Prices of existing bonds are inversely related to changing market interest rates.

Copyright © 2004 South-Western. All rights reserved.4–10 The Discounted Present Value of $7.8 Million Per Year for 25 Years at Alternative Rates of Interest Table 1–2 Interest Rate 3%5%8%10%20% Present value$139,900,000$115,400,000$90,300,000$77,900,000$46,300,000

Copyright © 2004 South-Western. All rights reserved.4–11 Yields On Treasury Bills Published T-bill rates:  Are based on a fictitious 360-day year calculated from the equation: Coupon yield equivalent:  An annualized T-bill rate (that can be compared with annual yields on other financial instruments) is calculated from the equation:

Copyright © 2004 South-Western. All rights reserved.4–12 Interest Rates on Money Market Instruments Table 4–3 Federal funds1.74% Commercial paper Nonfinancial 1-month month month1.68 Financial 1-month month month1.68 Certificates of deposit (secondary market) 1-month month month1.69 Eurodollar deposits (London) 1-month month month1.69 U.S.Treasury bills (secondary market) 1-month month month1.57 SOURCE: : Board of Governors of the Federal Reserve System,G.13 (415) Statistical Release, August 7,2002.

Copyright © 2004 South-Western. All rights reserved.4–13 The Risk Structure of Interest Rates Risk structure of interest rates:  The relationship among yields on financial instruments that have the same maturity but differ because of variations in default risk, liquidity, and tax rates. Default risk:  The chance that an individual or a firm that issues a financial instrument may be unable to honor its obligations to repay the principal and/or to make interest payments.

Copyright © 2004 South-Western. All rights reserved.4–14 The Risk Structure… (cont’d) Risk premium:  The amount by which one instrument’s yield exceeds the yield of another instrument as a result of the first instrument being riskier and less liquid than the second. Investment-grade securities:  Bonds with relatively low default risk. Junk bonds:  Bonds with relatively high default risk.

Copyright © 2004 South-Western. All rights reserved.4–15 Long-Term Bond Yields Figure 4–1 SOURCE: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues.

Copyright © 2004 South-Western. All rights reserved.4–16 Municipal and Treasury Bond Yields Figure 4–2 SOURCE: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues.

Copyright © 2004 South-Western. All rights reserved.4–17 The Term Structure of Interest Rates Term structure of interest rates:  The relationship among yields on financial instruments with identical risk, liquidity, and tax characteristics but differing terms to maturity. Yield curve:  A chart depicting the relationship among yields on bonds that differ only in their terms to maturity.  Inverted yield curve: A downward-sloping yield curve.

Copyright © 2004 South-Western. All rights reserved.4–18 The Yield Curve Figure 4–3 SOURCE: :Federal Reserve H.15 Statistical Release,August 8,2002.

Copyright © 2004 South-Western. All rights reserved.4–19 Segmented Markets Theory Segmented markets theory:  A theory of the term structure of interest rates that views bonds with differing maturities as nonsubstitutable, so their yields differ because they are determined in separate markets. Drawbacks to theory:  Yields tend to move together.  Does not explain natural tendency of the yield curve to slope upward or downward.

Copyright © 2004 South-Western. All rights reserved.4–20 Treasury Security Yields Figure 4–4 SOURCES: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (various issues) and G.13 (415) Statistical Release.

Copyright © 2004 South-Western. All rights reserved.4–21 Expectations Theory Expectations theory:  Explains how expectations about future yields can cause yields on instruments with different maturities to move together.  It can provide insight into why the yield curve may systematically slope upward or downward:  An upward-sloping yield curve indicates a general expectation by savers that short-term interest rates will rise.  A downward-sloping yield curve indicates a general expectation that short-term interest rates will decline.

Copyright © 2004 South-Western. All rights reserved.4–22 Sample Yield Curves for the Expectations Theory Figure 4–5

Copyright © 2004 South-Western. All rights reserved.4–23 The Preferred Habitat Theory Preferred habitat theory:  A theory of the term structure of interest rates that views bonds as imperfectly substitutable, so yields on longer-term bonds must be greater than those on shorter-term bonds even if short-term interest rates are not expected to rise or fall.

Copyright © 2004 South-Western. All rights reserved.4–24 The Preferred Habitat Theory (cont’d) Term premium:  An amount by which the yield on a long-term bond must exceed the yield on a short-term bond to make individuals willing to hold either bond if they expect short-term bond yields to remain unchanged.

Copyright © 2004 South-Western. All rights reserved.4–25 Sample Yield Curves for the Preferred Habitat Theory Figure 4–6

Copyright © 2004 South-Western. All rights reserved.4–26 Nominal versus Real Rates of Interest Nominal interest rate:  A rate of return in current-dollar terms that does not reflect anticipated inflation. Real interest rate:  The anticipated rate of return from holding a financial instrument after taking into account the extent to which inflation is expected to reduce the amount of goods and services that this return could be used to buy.

Copyright © 2004 South-Western. All rights reserved.4–27 Market Yields on Treasury Inflation- Indexed Securities and the Nasdaq Composite Index. Figure 4–7 SOURCES: SOURCE:William Emmons,“Expectations and Fundamentals,” Federal Reserve Bank of St.Louis Monetary Trends, July 2001.

Copyright © 2004 South-Western. All rights reserved.4–28 Interest Rates in an Interdependent World Exchange rate:  The value of one currency in terms of another. Depreciation:  A decline in the value of one currency relative to another. Appreciation:  A rise in the value of one currency relative to another.

Copyright © 2004 South-Western. All rights reserved.4–29 International Interest Parity Interest rate parity:  The willingness to hold either of two different governments’ (e.g., United States and Japan) bonds only if the anticipated returns on the two bonds are equal.

Copyright © 2004 South-Western. All rights reserved.4–30 International Interest Parity Uncovered interest parity:  A relationship between interest rates on bonds that are similar in all respects other than that they are denominated in different nations’ currencies.  The yield on the bond denominated in the currency that holders anticipate will depreciate must exceed the yield on the other bond by the rate at which the currency is expected to depreciate.

Copyright © 2004 South-Western. All rights reserved.4–31 Key Interest Rates in the Global Economy Federal funds rate:  A short-term (usually overnight) interest rate on interbank loans in the United States. Prime rate:  The interest rate that American banks charge on loans to the most creditworthy business borrowers. London Interbank Offer Rate (LIBOR):  The interest rate on interbank loans traded among six large London banks.

Copyright © 2004 South-Western. All rights reserved.4–32 The Prime Rate Figure 4–8 SOURCES: 2000 Economic Report of the President and Federal Reserve Bulletin, various issues.

Copyright © 2004 South-Western. All rights reserved.4–33 Estimated Probabilities of a Recession Based on Spreads between Long-Term Bond Rates and Three-Month Treasury Bill Rates Figure 4–9 SOURCE: Christopher Neely,“What Is the Slope of the Yield Curve Telling Us?” Federal Reserve Bank of St.Louis Monetary Trends, August 2000.