1. Structure of Interest Rates
CHAPTER 3
Structure of Interest Rates

2. CHAPTER 3 OVERVIEW This chapter will:
A. Show how characteristics of debt securities cause their yields to vary
B. Demonstrate how to estimate the appropriate yield for any particular debt security
C. Explain the theories behind the term structure of interest rates

3. A. Characteristics of Debt Securities that Cause Their Yields to Vary
1. Debt (Default) Risk
a. Rating Agencies
1.) Moody’s Investor Service
2.) Standard and Poor’s Corporation
b. Accuracy of Credit Ratings
c. Shifts in Credit Risk Premiums

4. A. Characteristics of Debt Securities that Cause Their Yields to Vary
2. Liquidity
a. the ease of conversion to cash without loss of value.
b. the lower a securities liquidity, the higher the yield preferred by investor.

5. A. Characteristics of Debt Securities that Cause Their Yields to Vary
3. Tax Status
Investors are more concerned with after-tax income.
Taxable securities must offer a higher before-tax yield

6. A. Characteristics of Debt Securities that Cause Their Yields to Vary
To compute the equivalent Before-Tax Yield:
where τat = After-tax yield
τbt = Before-tax yield
T = Investor’s marginal tax rate

7. A. Characteristics of Debt Securities that Cause Their Yields to Vary
4. Term to Maturity
maturity dates will differ between debt securities
The term structure of interest rates defines the relationship between term to maturity and the annualized yield

8. B. Estimating Debt Yield
1. Explaining Actual Yield Differentials
a. Small differentials can be significant
b. Basis points (bp) are often quoted where
1bp = .01% = .0001

9. B. Estimating Debt Yield
2. Yield Differentials of Money Market Securities
a. Securities: commercial paper, certificates of deposit, bankers acceptances.
b. Yields are just slightly higher than the risk- free T-bills

10. B. Estimating Debt Yield
3. Yield Differentials of Capital Market Securities
a. Municipal (munis) bonds have lowest before-tax yield
b. Treasury bonds may have higher before- tax yield than munis but have lowest after- tax yield
c. Corporate bonds may have highest yields

11. C. Term Structure of Interest Rates
1. Three prevailing theories:
a. Pure Expectations Theory
emphasizes the impact of an expected change in interest rates
b. Liquidity Premium Theory
emphasizes estimation of the Forward Rate based on a Liquidity Premium
c. Segmented Markets Theory

12. C. Term Structure of Interest Rates
2. Uses of the Term Structure
a) Forecast Interest Rates
b) Forecast Recessions
c) Investment Decisions
d) Financing Decisions
3. Impact of Debt Management on Term Structure