Richard Constand

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I-rate Terminology Nominal Rates - observed market rates Real rates - inflation adjusted market rates of interest Nominal Rate = Real Rate + (Inflation Premium) ========================================== Types of Risk: Default risk - non-payment Inflation risk - loss of purchasing power due to rise in price level (purchasing power risk) Liquidity risk - inability to sell at fair market value (due to thin market) Interest rate risk - risks associated with changes in interest rates; price risk o inverse relationship between I-rate change and price

Richard Constand

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reinvestment rate risk o direct relationship between I-rate change and reinvestment rate ==========================================

Richard Constand

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========================================== Fisher Equation - explains the relationship between Nominal (krf) and Real (k*) risk-free rates of interest and IP is an inflation premium

01 krf = k* + EI + [(k*)(EI)] is exact Fisher equation

IP = EI + [(k*)(EI)] EI = Expected Inflation

krf = k* + EI some simplify to this but technically incorrect

You demand a 3% real return and expect 3% inflation, what nominal rate of riskfree interest will you require? a. b. c. d. 6.00% 6.09% 15.00% none of the above

Richard Constand

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krf = .03 + .03 + (.03)(.03) = .0609 = 6.09%

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Richard Constand

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Risky Market Rate = k = krf + DRP + LP + MRP krf DRP LP MRP = default free riskless rate (includes IP) = default premium = liquidity premium = price risk premium

Richard Constand

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Yield Curve - plot of yield/maturity relationship for debt of same risk class Yield

AAA Corporate

Maturity Note: Yield or percentage return on vertical axis Maturity (units of time) on horizontal axis This yield curve identified as being for AAA rated corporate debt

Richard Constand

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The curve is upsloping. Normally we say, all other things held constant, yield curves are upsloping. This is due to the additional maturity risk associated with longer maturities and the positive relationship between risk and return. (Liquidity Preference) Default Risk Premium - differences in yield curves due to default risk

Yield
BBB Corporate Debt AAA Corporate Debt
RP

Treasury Issues
RP RPTAX
EFFECT

Municipal Debt

Maturity
A

Notes: Municipal debt yield curve is lower than Treasuries not because of less risk but due to tax advantages
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Richard Constand

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The higher the risk class, the greater the yield The difference between yield for any two risk classes at any particular maturity is called risk premium Not true for municipals since risk effect confounded by tax effect

Richard Constand

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INTEREST RATE THEORIES Market Segmentation - supply & demand forces in different maturity segments of market determine rate for that segment Yield

Maturit y
3 month 1 year 2 year 3 year 4 year

Note:

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Supply and demand forces create an equilibrium in each maturity segment Yield curve constructed by connecting the equilibrium points

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Richard Constand

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Business Cycle

Business Cycle Peak Slowing Economy Expansion Another Recession Recession

Time

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Richard Constand

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Shape of Yield Curve over Business Cycle Yield Upsloping - Recession

Maturity

Yield Flat or Inverting - Expansion

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Maturity

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Yield Downsloping Cycle Peak

Maturity

Yield Humped Slowing Economy

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Maturity

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Shape of Yield Curve over Business Cycle Yield

Stage 3

Stage 4

Stage 2

Stage 1

Maturity

Business Cycle and the Shape of Yield Curve Stage 1 recession: upsloping yield curve Stage 2 expansion: flat or inverting yield curve

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Richard Constand

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Stage 3 cycle peak: downsloping yield curve Stage 4 slowing economy: humped yield curve Back to stage 1

Pure Expectations Theory ( PET ) (Unbiased expectations theory) Yield curve determined by investors expectations of future rates. "Observable, current market interest rates today on bonds of different maturities imply future ST interest rates Observable LT yields are the geometric average of expected, but directly unobservable, ST yields" "The implied future rates are unbiased estimates of the rates expected in the future." Relationship forced by Arbitrage

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Richard Constand

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Assume: a 2-year investment horizon We have 2 choices: 1. 2. buy a 2 year bond buy a 1 year bond, let it mature, then 1 year in future, buy another 1 year bond [---------------I---------------] 1 year 1 year [-------------------------------] 2 year (compound) Pure (unbiased) expectations theory implies Return on 2 year bond ( 1 + t i2 )2=
t 2

Combined return on two 1 year bonds ( 1 + t i1 ) ( 1 + t+1r1 )

i = annual rate on a 2 year bond observed today t i2 = annual rate on a 1 year bond observed today t+1r1 = expected rate on a 1 year bond in year 2

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Richard Constand

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( 1 + t i2 )2= ( 1 + t i 2 )2 ---------------( 1 + t i1 ) ( 1 + t i 2 )2 ---------------( 1 + t i1 )

( 1 + t i1 ) ( 1 + t+1r1 )

( 1 + t+1r1 )

-1

t+1 1

This can be used to estimate future expected 1-year rate

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We read the WSJ and find that the annual rate on a one year bond is 10% and the 1 year rate on a 2 year bond is 11%. What is the expected rate on a 1-year bond in the second year? Annual return on 2 year bond is 11% = t i2 = 11% Annual return on 1 year bond today is 10% = t i1 = 10% What is expected return on 1-year bond in second year?
t+1 1

= [ (1.11)2 / (1.10) ] 1 = .12009090909 12.009 %

or approximately

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