chapter 6: interest rate determinants Flashcards
what are base interest rates usually quoted on
an annual percentage basis
common to refer to changes in interest rates in terms of
basis points or 1/100th of 1%
ex 250 basis point is 2.5%
a decrease of 10 basis points indicates what
that interest rates declined by 0.1%
interest is the price of
borrowed money
interest is determined by
the laws of supply and demand
if demand for loanable funds rise
the interest rates rise
if the demand for loanable funds falls
the interest rates fall
what are nominal interst rates
rates charged for lending today’s dollars in return for getting dollars back in the future, without taking into account the purchasing power of those future dollars
one of the most important factors in determining nominal interest rates is
the expected rate of inflation
- this determins the purchasing power of those future dollars
what is the risk free rate
the rate of return on risk-free investments
- often used as the base interest rate
- it is an abstract concept, and usually the yield on short term gov. T-bills is used as a proxy for practical purpsoes
what is the risk free rate made up of
- the real rate
- compensation for deferring consumption - expected inflation rate
- compensation for the expected loss of purchasing power over the term of the short-term T-bill
what is real rate
compensation for deferring consumption
what is expected inflation rate
compensation for the expected loss of purchasing power over the term of the short-term T-bill
T-bills yields are considered
risk free because they possess no risk of default
- gov. controls the bank of Canada and can always have it buy any bonds that are issued
- also their term to maturity is short
what does risk free rate =
real rate + expected inflation
what is the risk free rate often called
the fisher effect
- after Irvine fisher
- describves how investors attempt to protect themselves form the loss in purchasing power caused by an inflation by increasing their required nominal yield
estimating the real rate of return
if T-bills rates are currently 4.5% and the expected level of inflation is 2%, estimate the approximate real rate of return
4.5 -2 = 2.5%
Canadian interest rates are heavily influenced by what
changes in interst rates in other countries
macroeconomic factors also play an important role in
both domestic and global rates
what is IRP interest rate parity theory
foreign exchange forward rates will be established that equalize the yield an investor can earn whether investing domestically or in a foreign place
- ex. a country with both high inflation and high interst rates will have a depreciating currency
the term structure of interest rates is
the set of rates (YTM) for ALL maturities of a given risk calss of debt securities (eg. gov of Canada bonds) at a given POINT IN TIME
when plotted on a graph the term structure of interest rates the result is
called a yield curve
what are the 3 typical shapes of a yield curve
- upwardsloping,
- normal
- downward sloping
what is the term strucuture of interest rates
the relationship b/w interst rates and the term to maturity on underlying debt instruments
what is the yield curve
the graphic representation fo the term structure of interest rates, based on debt instruments from the same issuer
the yield curve must be constructed based on
interest rates on debt instruemtns that are from the same issuer
otherwise, default risk and other risk factors in addition to maturity differntials, will affect the difference in yields
yield curves are usally
upward sloping
what are the 3 most common theories fo the yield curve
- expections theory
- market segmentaitons theory
- liquidity preference theory
what is expections theory
longer-term interest rates are the result of expectations of future short-term interest rates
in otherwords
the interst rates of various marturities are dependant on each other
upward yield curve - would say expecting interst rates ot increase
what is market segmenation theory
distinct markets (or market segments) exist for interest rate securities of various maturities and - that the rates are determined within these independent market segments by the forces of supply nd demand within that market
what is liquidation theory
investors prefer short term debt instruments
- because they exhibit less interst rate risk, while debt issuers prefer to lock in borrowing rates for logner periods to avoid the risk of having to refinance at higher rates
(short term insturments = more liquid instruments)
- long term debts are riskier than short term
- expect a premium or higher rate for taking on a long-term bond
yild curbves are generally upward slopping because long term rates will be higher
- this theory does not properly account for downward sloping or flat term strucutures
what is risk premium
investors expect extra compensation for assuming additional risk
- require a higher rate of return
what is maturity yield differential
refers to the term structure impact
what is the spread
difference in yield tha compensates the investor for the assumption of additional risks
what may the spread include
- default or credit risk (the risk associated with the bond issuer and its ability to pay
- liquidity
- issue specific features
yield spread is the difference
bw the YTM on a BBB-rated corporate bond and the gov of Canada bond of the same maturity and it represents the default risk premium investros demand for investing in more risky corp. bonds
what are debt ratings
ratings assigned by professional debt-rating services after detailed analysis of bond issuers to determine their ability to sustain the required interest and principal payments
what is the yield spread during recession and economic expansion
widen during recession
narrow during economic expansion
what is investment grade debt
debt obligation with a credit rating of AAA, AA, A or BBB
what is speculative debt
debt that is not investment grade
- rated below BBB or Baa
- also called high yield debt, junk bonds or low grade debt
is all debt rated?
no, some investors don’t require it
