Chapter 3
Structure of Interest Rates
© 2001 South-Western College Publishing Company
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Factors Affecting Yields Among Securities
Debt securities offer different yields because they exhibit different characteristicsUnfavorable characteristics result in higher
yields to entice investors
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Factors Affecting Yields Among Securities
Security yields and prices are affected by levels and changes in:Default risk (also called Credit Risk)LiquidityTax statusTerm to maturitySpecial contract provisions such as
embedded options
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Factors Affecting Yields Among Securities
Credit (Default) RiskBenchmark: Risk-free treasury securitiesDefault Risk Premium = Risky security yield -
Treasury security yield of same maturityRisk premiums for a particular bond can
change over time
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Factors Affecting Yields Among Securities
Credit (Default) Risk Investors can assess default risk by
checking bond ratings set by Rating Agencies • Moody’s Investor Service• Standard and Poor’s Corporation
Anticipated or actual ratings changes can impact security prices and yields
Different bonds issued by the same firm can differ in rating
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Factors Affecting Yields Among Securities
LiquidityA liquid investment is easily converted to
cash without a loss in value Investors pay more (lower yield) for a more
liquid investment
• Securities with lower liquidity must offer a higher yield
Short-term, low default risk, marketable securities have higher liquidity
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Factors Affecting Yields Among Securities
Tax Status Investors are more concerned with after-tax
return or yield Investors require higher yields for higher
taxed securities Investors in high tax brackets benefit most
from tax-exempt securities
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Factors Affecting Yields Among Securities
Term to Maturity Interest rates typically vary by maturityThe 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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%
YearsTime to Maturity
Yield
An upward sloping yield curve indicates that TreasurySecurities with longer maturities offer higher annual yields
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Factors Affecting Yields Among Securities
Special ProvisionsCall 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
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Factors Affecting Yields Among Securities
Special ProvisionsConvertible 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
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A Closer Look At the Term Structure
Theories Explaining Shape of Yield CurvePure Expectations TheoryLiquidity Premium TheorySegmented Markets Theory
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A Closer Look At the Term Structure
Pure Expectations TheoryLong-term rates are average of current short-
term and expected future short-term ratesYield curve slope reflects market expectations
of future interest rates Investors select maturity based on
expectations
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A Closer Look At the Term Structure
Pure Expectations TheoryAssumes investor has no maturity
preferences and transaction costs are lowLong-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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A Closer Look At the Term Structure
Pure Expectations TheoryUpward Sloping Yield Curve
• Expected higher interest rate levels
• Expansive monetary policy
• Expanding economyDownward Sloping Yield Curve
• Expected lower interest rate levels
• Tight monetary policy
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A Closer Look At the Term Structure
Liquidity Premium Theory Investors prefer short-term, more liquid,
securitiesLong-term securities and associated risks are
desirable only with increased yieldsExplains upward sloping yield curveWhen combined with the expectations theory,
yield curves could still be used to interpret interest rate expectations
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A Closer Look At the Term Structure
Segmented Markets TheoryTheory explaining segmented, broken yield
curvesAssumes 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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A Closer Look At the Term Structure
Which Theory is Correct? Although research results differ, there is
evidence that expectations theory, liquidity preference theory, and segmented markets theory all have some validity
• If term structure is used to assess market’s expectations of future rates, should net out liquidity premium and unique segment characteristics
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A Closer Look At the Term Structure
Uses of the Term StructureForecast interest ratesForecast recessions Investment decisions
• Individuals
• Financial institutionsFinancing decisions
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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 ratesVaried expected real rates of returnVaried expected inflation ratesVaried country and business riskVaried central bank monetary policy
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