PowerPoint Slides for:

Financial Markets
and Institutions
6th Edition
By Jeff Madura
Prepared by
David R. Durst
The University of Akron
CHAPTER
Structure of
3 Interest Rates
Chapter Objectives

 Learn why individual interest rates differ or

why security prices vary or change

 Analyze theories explaining why rates vary by

term or maturity, called the term structure of
interest rates

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Factors Affecting Security Yields

 Risk-averse investors demand higher yields

For added riskiness
 Risk is associated with variability Of returns
 Increased riskiness generates lower security
prices or higher investor required rates of
return

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Factors Affecting Security Yields

 Security yields and prices are affected by

levels and changes in:
 Default risk (also called Credit Risk)
 Liquidity
 Tax status
 Term to maturity
 Special contract provisions such as embedded
options

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Factors Affecting Security Yields

 Benchmark—risk-free treasury securities for

given maturity
 Default risk premium = risky security yield –
treasury security yield of same maturity
 Default risk premium = market expected
default loss rate
 Rating agencies set default risk ratings
 Anticipated or actual ratings changes impact
security prices and yields
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Factors Affecting Security Yields

 The Liquidity of a security affects the

yield/price of the security
 A liquid investment is easily converted to cash
At minimum transactions cost
 Investors pay more (lower yield) for liquid
investment
 Liquidity is associated with short-term, low
default risk, marketable securities

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Factors Affecting Security Yields

 Tax status of income or gain on security

impacts the security yield
 Investor concerned with after-tax return or
yield
 Investors require higher yields For higher
taxed securities

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Factors Affecting Security Yields

Yat = Ybt(1 – T)

Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate

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Factors Affecting Security Yields

 Example: a taxable security that offers a

before-tax yield of 14 percent. The investor’s
tax rate is 20 percent. Calculate the after-tax
yield.
Yat = 14%(1 – 0.2)
= 11.2%
 The fully taxable pre-tax equivalent corporate
bond for a 11.2% municipal bond is:
Ybt = 11.2%/(1 – .2) = 14%
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Factors Affecting Security Yields

 Term to maturity
 Interest rates typically vary by maturity.
 The term structure of interest rates defines the
relationship between maturity and yield.
The Yield Curve is the plot of current interest yields
versus time to maturity.

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Yield Curve

Yield
%

Time to Maturity

An upward-sloping yield curve indicates that Treasury

Securities with longer maturities offer higher annual yields
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Yield Curve Shapes

Normal Level or Flat Inverted

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Factors Affecting Security Yields

 Special Provisions
 Call Feature: enables borrower to buy back the
bonds before maturity at a specified price
Call features are exercised when interest rates have
declined
Investors demand higher yield on callable bonds,
especially when rates are expected to fall in the future

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Factors Affecting Security Yields

 Special provisions
 Convertible bonds
Convertibility feature allows investors to convert the
bond into a specified number of common stock shares
Investors will accept a lower yield for convertible bonds
because investor returns include expected return on
equity participation

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Estimating the Appropriate Yield

 The appropriate yield to be offered on a debt

security is based on the risk-free rate for the
corresponding maturity plus adjustments to
capture various security characteristics

Yn = Rf,n + DP + LP + TA + CALLP + COND

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Estimating the Appropriate Yield
Yn = Rf,n + DP + LP + TA + CALLP + COND
Where:
Yn = yield of an n-day security
Rf,n = yield on an n-day Treasury
(risk-free) security
DP = default premium (credit risk)
LP = liquidity premium
TA = adjustment for tax status
CALLP = call feature premium
COND = convertibility discount

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The Term Structure of Interest Rates

Theories Explaining Shape of Yield Curve

 Pure Expectations Theory

 Liquidity Premium Theory
 Segmented Markets Theory

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The Term Structure of Interest Rates

 Pure Expectations Theory

 Long-term rates are average of current short-term
and expected future short-term rates
 Yield curve slope reflects market expectations of
future interest rates
 Investors select maturity based on expectations

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The Term Structure of Interest Rates

 Pure Expectations Theory

 Assumes investor has no maturity preferences and
transaction costs are low
 Long-term rates are averages of current short rates
and expected short rates
Forward rate: market’s forecast of the future interest rate

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The Term Structure of Interest Rates

Downward-
Upward- Sloping
Sloping Yield Curve
Yield Curve

 Expected higher interest  Expected lower interest

rate levels rate levels
 Expansive monetary  Tight monetary policy
policy  Recession soon?
 Expanding economy

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The Term Structure of Interest Rates

 Liquidity Premium Theory

 Investors prefer short-term, more liquid, securities
 Long-term securities and associated risks are
desirable only with increased yields
 Explains upward-sloping yield curve
 When combined with the expectations theory,
yield curves could still be used to interpret interest
rate expectations

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The Term Structure of Interest Rates

 Segmented Markets Theory

 Theory explaining segmented, broken yield curves
 Assumes investors have maturity preference
boundaries, e.g., short-term vs. long-term
maturities
 Explains why rates and prices vary significantly
between certain maturities

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The Term Structure of Interest Rates

 Uses of the term structure

 Forecast interest rates
 The market provides a consensus forecast of expected future
interest rates
 Expectations theory dominates the shape of the yield curve

 Forecast recessions
 Flator inverted yield curves have been a good predictor of
recessions. See Exhibit 3.14.
 Investment and financing decisions
 Lenders/borrowers attempt to time investment/financing based on
expectations shown by the yield curve
 Riding the yield curve
 Timing of bond issuance
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 Exhibit 3.14 Yield Curve as a Signal for
Recessions
Interest Rate Differential (10-Year Rate

7
6
Minus Three-Month Rate)

5
4
3
2
1
0
–1
–2
–3
–4
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2001
Year
*The general shape of the yield curve is measured as the differential between annualized 10-year and three-month interest rates.
Recessionary periods are shaded.

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Treasury Debt Management and the Yield
Curve
 U.S. Treasury attempts to finance federal debt
at the lowest overall cost
 Treasury uses a mixture of Bills, Notes, and
Bonds to finance periodic deficits and
refinance outstanding securities
 Treasury focuses on short-term issuance,
phasing out 30-year bonds
 Treasury 10-year bond now the standard issue
 Leave the long-term issuance to private issuers
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Historic Review of the Term Structure

 Yield curves levels and shapes at various times

indicate:
 Inflation expectations
 Level of economic activity or phase of business cycle
 Monetary policy at the time
 Usually high positive slope in short-term
 Represents demand for liquidity
 Short-term securities desired; higher prices; lower rates
 Short-term securities provide liquidity with maturity

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Exhibit 3.17 Yield Curves at Various
Points in Time
17

16

15 February 17, 1982

14
Annualized Treasury Security Yields

13
January 2, 1985
12

11

10

9
August 2, 1989
8
October 22, 1996
7

6 October 15, 2000

5
September 18, 2001
4

2
0 5 10 15 20 25 30
Number of Years to Maturity
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Exhibit 3.18 Change in Term Premium
Over Time
20

15

30-year
T-Bond
Yield
Percentages

10

5 Three-month
T-Bill
Rate

0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year

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International Structure of Interest Rates

 Capital flows to the highest expected after-tax,

real (inflation and other risk-adjusted),
foreign exchange adjusted rates of return

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International Structure of Interest Rates

 Yield differences between countries are related

to:
 Expected changes in forex rates
 Varied expected real rates of return
 Varied expected inflation rates
 Varied country and business risk
 Varied central bank monetary policy

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