STRUCTURE OF INTEREST RATES

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STRUCTURE OF INTEREST RATES CHAPTER 3 STRUCTURE OF INTEREST RATES Dr. David P. Echevarria All Rights Reserved

PRICING DEBT SECURITIES: QUALITATIVE FACTORS Default Risk (chance of not getting your $ back at maturity) Financial strength of the issuer Business strengths of the issuer Industry outlook Term to maturity Credit Agency Rating Liquidity (how easy is it to buy or sell at intrinsic values?) Size of the issue (float) General market conditions Characteristics of the secondary market in bonds Dr. David P. Echevarria All Rights Reserved

PRICING DEBT SECURITIES: QUALITATIVE FACTORS Tax Status (is interest income taxable?) Municipals vs. Treasuries vs Corporate debt issues Before Tax Equivalent Yields Ybt = Yat / ( 1 – Tx) Dr. David P. Echevarria All Rights Reserved

TERM STRUCTURE THEORIES Pure Expectations Theory Investor / borrower expectations and preferred maturities Computing the forward rate (see page 54) Liquidity Premium Theory S-T securities typically more marketable that L-T Increase in marketability, ceteris paribus, should result in lower YTM Segmented Markets Theory Investor preferences for certain maturities investment horizon Nature of assets and liabilities (matching principle) Dr. David P. Echevarria All Rights Reserved

TERM STRUCTURE OF INTEREST RATES Comprehensive Explanation for Term Structure and Shape of the Yield Curve The yield curve has much to do with investor expectations about the economy. Lenders prefer less risk and more liquidity. Borrowers prefer longer terms. Implications of flat and inverted yield curves Dr. David P. Echevarria All Rights Reserved

Inverted Yield Curve Nov 14, 2000 Dr. David P. Echevarria All Rights Reserved

Yield Curve Aug 29, 2011 Dr. David P. Echevarria All Rights Reserved

Yield Curve 8/28/2013 Dr. David P. Echevarria All Rights Reserved

Yield Curve 8/28/2014 Dr. David P. Echevarria All Rights Reserved

HOMEWORK Briefly describe the implications of the following theories; Pure Expectations Theory Liquidity Premium Theory Segmented Markets Theory What factors do we consider when investing in bonds? Why is the normal shape of the Yield Curve upward sloping to the right? What do we mean by a before-tax equivalent yield and why is it important? What is a forward rate and Why is it important? Dr. David P. Echevarria All Rights Reserved

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