Interest Rates on Debt Securities n Rates in general are influenced by n 1) Actions of the Federal Reserve Board n 2) Federal fiscal policy

Federal Reserve Board n The Fed controls two key rates: n 1) Discount rate - rate at which banks borrow directly from Fed when they have insufficient reserves to meet reserve requirement n Thus, rate is set directly by Fed

n 2) Federal Funds rate - Rate one bank charges another for overnight borrowing (in order to meet reserve requirement) n Fed controls this rate indirectly n Sets target for Federal Funds rate n Rate moves toward target in response to changes in money supply

Fed’s Open Market Operations n Fed can control money supply by buying or selling T bills on the open market n Change in money supply leads to change in interest rates n Increase in supply - lower interest rates n Decrease in supply - higher interest rates

Raising Federal Funds Rate n When Fed thinks CPI is growing too fast, it tries to cut spending by raising interest rates n Achieves this by decreasing supply of money n Decreases money supply by SELLING additional T bills (takes money out of circulation)

n Decrease in money supply causes banks’ reserves to be lower n When banks loan to each other, they will charge higher interest rates because they don’t have that much extra to lend n Rates on all lending will be higher when federal funds rate goes up, causing spending to decrease

Lowering Federal Funds Rate n When Fed thinks economy needs a boost, it lowers interest rates to increase spending n Achieves this by increasing the supply of money n Increases money supply by BUYING additional T bills (puts more money out in circulation)

n Increase in money supply causes banks to have more in reserves n Having ample reserves leads banks to charge each other lower rates on federal funds borrowing n Lower federal funds rates lead to lower rates on all bank lending, causing spending to increase

Federal Fiscal Policy n Interest rates in general are also affected by federal government spending and borrowing n When tax receipts aren’t sufficient to cover expenditures, govt must borrow, putting upward pressure on interest rates

n When govt takes in more than it spends, there is a decrease in demand for borrowed funds, which causes interest rates to drop n Govt used to be running a surplus - interest rates have been relatively low for the past decade. n Surplus ran out after 9/11/01 – govt. now running at a deficit.

Interest Rates on Specific Debt Securities n Determined by general level of interest rates plus three factors: n 1) Default Risk n 2) Liquidity n 3) Maturity

Default Risk n The higher the default risk, the higher the interest rate must be to attract investors n The lower the default risk, the lower the interest rate the security must carry n Moody’s & S&P rate debt for default risk

Liquidity n The greater the liquidity (more easily traded, good secondary market), the lower the interest rate the debt security has to carry n The lower the liquidity, the higher the interest rate (in order to attract investors)

Maturity n How does the maturity of a security - whether it is short-term or long-term - affect the interest rate it carries? n Does short-term debt carry a higher or lower interest rate than long-term debt (that has the same default risk and same liquidity)? n Answer = It varies!

Determining Impact of Maturity n Look at securities whose maturities vary but that have same default risk and same liquidity n Look at Treasury Securities - T bills, notes, & bonds n Only difference is maturity n Which yields the higher interest rate?

Yields on Treasury Securities (as of 1/19/11) n 3 month T bill 0.16% n 6 month T bill 0.19% n 2 year T note 0.59% n 3 year T note 0.99% n 5 year T note 1.94% n 10 year T note 3.35% n 30 year T bond 4.54%

Yield Curve n Construct a curve showing these Treasury yields, with maturities on X axis and yields on Y axis n Current yield curve is upward sloping

Observed Shapes of Yield Curves n Upward sloping: long-term rates higher than short-term rates n Downward sloping: long-term rates lower than short-term rates n Flat: no difference between long-term and short-term rates n Intermediate rates higher or lower than long- or short-term rates (bump or dip in middle of curve)

Theories Explaining Term Structure of Interest Rates n Liquidity Preference n Market Segmentation n Expectations

Liquidity Preference n Lenders prefer liquidity (access to funds) n Must reward lenders with higher rates for going without access to their funds for longer periods of time n According to this theory, long-term rates should be higher than short-term rates

Market Segmentation n Market for funds has different segments: short-term, intermediate- term, long-term n Interest rate within a given segment is determined by supply of funds and demand for funds within that segment n This theory could conceivably explain any shape of the yield curve

Expectations n Investors should be able to average the same return whether investing in a series of successive short-term investments or one long-term investment n Therefore, long-term rates give clues to what investors expect will happen to short-term rates in the future

Conclusion on effect of maturity on interest rates n Most of the time in our economic history, short-term rates have been lower than long-term rates n However, that is not always the case, so investors and borrowers need to check yield curve before making decisions as to whether to invest (borrow) short-term or long-term