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INTEREST RATES (1)

The document provides an overview of interest rates, including their definition, how they work, and the factors that influence their levels, such as production opportunities, risk, and inflation. It also discusses the term structure of interest rates, the shapes of yield curves, and the relationship between Treasury and corporate yield curves. Additionally, it highlights the role of the Federal Reserve and macroeconomic factors in setting interest rates.

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20 views

INTEREST RATES (1)

The document provides an overview of interest rates, including their definition, how they work, and the factors that influence their levels, such as production opportunities, risk, and inflation. It also discusses the term structure of interest rates, the shapes of yield curves, and the relationship between Treasury and corporate yield curves. Additionally, it highlights the role of the Federal Reserve and macroeconomic factors in setting interest rates.

Uploaded by

Ruzui
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 24

The Elements

of Interest
Rates
By: Shaira Mae Krystine O.
Asilum
What is Interest rates?
- It is typically expressed as a %
called an APR (Annual Percentage
Rate).
- It is a rate of return paid by a
How do they work?
borrower of funds to a lender of
- When you borrowed the money to
them, or a price paid by a borrower
the lender, you will receive the
for a service, the right to make use
principal amount. And when you
of funds for a specified period.
pay back you repay the lender a
Thus it is one form of yield on
principal plus interest.
financial instruments.
4 Factors that affect level
of Interest Rates
1.) Production Opportunities
- This refers to the potential for
businesses to invest in projects that
generate future income.

2.) Time Preferences for Consumption


- This reflects how much people value
spending money now versus saving it
for the future.
4 Factors that affect level
of Interest Rates
3.) Risk
- This refers to the chance of a
borrower defaulting on a loan (not
repaying it).

4.) Inflation
- This refers to the rise in prices over
time.
7 Determinants of Interest Rates

1.) Quoted or 2.) Real Risk-Free


Nominal Rate Rate (r*)
The rate of interest on a - r* represents the theoretical risk-free
security that is free of all return in an inflation-free economy. It
risk; rRF is proxied by the T- reflects the time value of money and
bill rate or the T-bond rate. changes based on economic conditions.
rRF includes an inflation
premium.
3.) Risk-Free Rate 4.) Inflation Premium

includes an inflation A premium equal to


premium equal to the expected inflation that
average expected inflation investors add to the real
rate over the remaining life risk-free rate of return.
of the security.
5.) Default Risk Premium 6.) Liquidity Premium (LP)
(DRP)
A premium added to the
The risk that a borrower will equilibrium interest rate on
default, which means not a security if that security
make scheduled interest or cannot be converted to cash
principal payments. on short notice and at close
to its fair market value
7.) Maturity Risk 2 types of MRP
Premium (MRP)
1.) Interest Rate Risk
It is the premium that It is the risk of capital losses to
reflects interest rate risk. which investors are exposed
because of changing interest
rates.

2.) Reinvestment Rate risk


The risk that a decline in interest
rates will lead to lower income
when bonds mature and funds are
reinvested.
Premiums Added to r* for
Different Types of Debt.
The Term Structure of Interest
Rates Term structure
describes the
relationship between
long-term and short-
term interest rates.

Important for A graph of the term


businesses deciding to structure is called
issue long-term or the yield curve
short-term debt.

Important for investors


deciding to buy long-
term or short-term
bonds.
Illustration: U.S Treasury Bond Interest Rates on Different
Dates (Brigham & Houston, 2007)
Three main shapes a yield curve
can take and uses the graph
Normal Yield Curve. It is an upward-sloping curve. In the illustration above, the rates on February 2005 is
considered a Normal Yield Curve.

Abnormal Yield Curve (Inverted Yield Curve): This is a less common situation where the curve slopes
downwards. In the March 1980 line, interest rates are higher for short-term maturities compared to long-term
ones.

Humped Yield Curve: This curve is less common than the others and appears like a hill. The February 2000
line shows this shape, where interest rates for medium-term maturities are higher than both shorter and
longer-term ones.
Constructing the Yield
Curve
Average Expected Inflation Rate (IP)
Sample:
Assume inflation is expected to be 5% per year for the next year, and 6 percent the following year and 8%
thereafter.

IP = 5%/1 = 5.00%
IP = [5% + 6% + 8%(8)/10 = 7.50%
IP = [5% + 6% + 8%(8)/20 = 7.75%
.
Constructing the Yield
Curve
Appropriate Maturity Risk Premium (MRP)
Sample:
The following equation will be used to find a security’s appropriate maturity risk
premium.

Hence, the maturity risk premium is increasing as the time to maturity increases.
The longer the maturity, the higher the rates
Constructing the Yield
Adding the Premiums to r*
Curve
Sample:
This is to get the appropriate nominal rates.
Hypothethical Yield Curve
The Relationship Between Treasury Yield Curve and Yield
Curves for Corporate Issues.

• The Treasury yield curve serves as a baseline for corporate yield curves.
• Corporate bond yields are typically higher than Treasury yields of similar maturities,
reflecting the additional risk of default.
• The spread between corporate bond yields and Treasury yields (the credit spread) can
indicate the perceived risk of the corporation and the overall risk premium demanded by
investors.
• When the Treasury yield curve is upward sloping, it often corresponds to higher
corporate bond yields as well. This might reflect expectations of rising interest rates.
• Deviations between the two curves can be informative. For example, a wider than usual
spread between a corporate bond's yield and the Treasury yield of similar maturity might
indicate that investors perceive an increased risk associated with that specific company.
Illustration:
Pure Expectations
Theory
The pure expectations theory
contends that the shape of the
yield curve depends on
investors’ expectations about
future interest rates.
Assumptions of Pure Expectations

• Assumes that the maturity risk premium


for Treasury securities is zero.

• Long-term rates are an average of


current and future short-term rates.

• If the pure expectations theory is correct,


you can use the yield curve to “back out”
expected future interest rates.
Example:
The yield on one-year Treasury securities is 6 percent,
2-year securities yield 6.2 percent, and three-year
securities yield 6.3 percent. There is no maturity risk
premium. Using expectations theory, forecast the
yields on the following securities:

a. A 1-year security, 1 year from now?


b. A 1-year security, 2 years from now?
c. A 2-year security, 1 year from now?
Macroeconomic Factors That Influence
Interest Rate Levels.
Federal Reserve International
Policy Factors
The Federal Reserve (Fed) is Global interest rates and
the central bank of the economic conditions can
United States and plays a influence domestic interest
critical role in setting interest rates.
rates. Level of Business
Federal Budget Deficits or Activity
Surpluses
A government budget deficit A strong economy with high
occurs when spending exceeds business activity and rising profits
revenue. To finance the deficit, can lead to increased demand for
the government may need to loans from businesses. This
borrow money by issuing increased demand for credit can
bonds. push interest rates upward.
Thank You and
God Bless!
Do you have any questions?

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