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Chapter 3

Structure of Interest Rates

Financial Markets and Institutions, 7e, Jeff Madura

Copyright 2006 by South-Western, a division of Thoson !earning" #$$ rights reserved"

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Chapter %ut$ine

Chara&teristi&s of debt se&urities that

&ause their yie$ds to vary

'(p$aining a&tua$ yie$d differentia$s

'stiating the appropriate yie$d

# &$oser $oo) at the ter stru&ture

*nternationa$ stru&ture of interest rates

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Chara&teristi&s of ebt Se&urities

Credit defau$t. ris) Se&urities /ith a higher degree of ris) have to offer

higher yie$ds to be &hosen Credit ris) is espe&ia$$y re$evant for $onger-ter

se&urities *nvestors ust &onsider the &redit/orthiness of the

se&urity issuer Can use bond ratings of rating agen&ies The higher the rating, the $o/er the per&eived &redit ris) atings &an &hange over tie as e&onoi& &onditions &hange atings for different bond issues by the sae issuer &an vary

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&ontd. Credit defau$t. ris) &ontd.

ating agen&ies

Moodys *nvestor Servi&e and Standard and 3oorsCorporation are the ost popu$ar

#gen&ies use different ethods to assess the

&redit/orthiness of firs and state governents # parti&u$ar bond issue &ou$d have different ratings fro ea&h

agen&y, but differen&es are usua$$y sa$$ 4inan&ia$ institutions ay be re5uired to invest on$y in

investment-grade bondsrated aa or better by Moodys

and or better by Standard and 3oors

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&ontd. Ratings Assigned by:

Description of Security Moodys Standard and oors

8ighest 5ua$ity #aa ###

8igh 5ua$ity #a ##8igh-ediu 5ua$ity # #

Mediu 5ua$ity aa

Mediu-$o/ 5ua$ity a

!o/ 5ua$ity spe&u$ative.

3oor 5ua$ity Caa CCC

9ery poor 5ua$ity Ca CC

!o/est 5ua$ity in defau$t. C

,

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&ontd. Credit defau$t. ris) &ontd.Shifts in &redit ris) preius

The ris) preiu &orresponding to a parti&u$arbond rating &an &han&e over tie

#&&ura&y of &redit ratings *n genera$, &redit ratings have served as

reasonab$e indi&ators of the $i)e$ihood of defau$t Credit rating agen&ies do not a$/ays dete&t

finan&ia$ prob$es of firs

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&ontd. !i5uidity!i"uidse&urities &an be easi$y &onverted to

&ash /ithout a $oss in va$ue Short-aturity se&urities /ith an a&tive se&ondary

ar)et are $i5uid

Se&urities /ith $o/er $i5uidity have to offer a

higher yie$d to be preferred

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&ontd. Ta( status

*nvestors are ore &on&erned /ith after-ta( in&oe

than before-ta( in&oe Ta(ab$e se&urities have to offer a higher before-ta( yie$d to

be preferred

The after-ta( yie$d is e5ua$ to;

.

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&ontd. Ta( status

Coputing the e5uiva$ent before-ta( yie$d

The before-ta( yie$d ne&essary to at&h the after-ta( yie$don a ta(-e(ept se&urity is;

State ta(es shou$d be &onsidered a$ong /ith federa$ ta(es

.

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:6"

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,

=

+++=

+++++= CONDCALLPTALPDPRYnfn

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Sudden '(pe&tation of !o/er

*nterest ates &ontd.@ie$d Curve

@C0="

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# C$oser !oo) at the Ter Stru&ture

&ontd. 3ure e(pe&tations theory &ontd.

#$gebrai& presentation &ontd.

The one-year interest rate in t/o years the for)ardrate. &an a$so be estiated;

="

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&ontd. 3ure e(pe&tations theory &ontd.

The theory assues that for/ard rates are

unbiased estiators of future interest rates *f for/ard rates are biased, investors shou$d

attept to &apita$i?e on the dis&repan&y

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&ontd. !i5uidity preiu theory

#&&ording to the $i"uidity premium theory, the

yie$d &urve &hanges as the $i5uidity preiu&hanges over tie due to investor preferen&es *nvestors /ho prefer short-ter se&urities /i$$ ho$d $ong-

ter se&urities on$y if &opensated /ith a preiu

Short-ter se&urities are typi&a$$y ore $i5uid than $ong-

ter se&urities The preferen&e for short-ter se&urities p$a&es

up/ard pressure on the s$ope of the yie$d &urve

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&ontd. !i5uidity preiu theory &ontd.

'stiation of the for/ard rate based on a $i5uidity

preiu The yie$d on a se&urity /i$$ not ne&essari$y be e5ua$ tothe yie$d fro &onse&utive investents in shorter-ter

se&urities;

The re$ationship bet/een the $i5uidity preiu and the

ter to aturity is;

2

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&ontd. !i5uidity preiu theory &ontd.

'stiation of the for/ard rate based on a $i5uidity preiu&ontd. The one-year for/ard rate &an be derived as;

# positive $i5uidity preiu eans that the for/ard rateoverestiates the ar)ets e(pe&tations of the future interestrate

# f$at yie$d &urve eans the ar)et is e(pe&ting a s$ightde&rease in interest rates

# s$ight up/ard s$ope eans no e(pe&ted &hange in interestrates

[ ].

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