Chapter 6 Interest Rates Flashcards
Interest Rates
A “price” that reconciles demands from borrowers and excess funds of savers
4 fundamental factors affecting interest rates
- Production Opportunities
- Time Preference in Consumption
- Expected Inflation
- Risks (Default, Liquidity, Maturity, Reinvestment)
Quoted interest rate
r=r* + IP + DRP + LP + MRP
r*
Risk free rate-risk less security if no inflation were expected
Reflects now/later tradeoff in [1] production opportunities & [2] time preferences in consumption
IP
Inflation Premium-erodes the real value of what you receive from the investment
Worse off when the nominal interest rate is less than the expected inflation rate
DRP
Default Risk Premium- the risk that a borrower will default
LP
Liquidity premium-a “liquid” asset can be converted to cash quickly at a “fair market value”
MRP
Maturity Risk Premium-the bonds of any organization have more interest rate risk, the longer the maturity of the bond
nominal risk-free rate
rrf = r* + IP
Premiums Added to rRF for Different Types of Debt
Inflation
Maturity
Default
Liquidity
Short-Term Treasury-I
Long-Term Treasury -I,M
Short-Term Corporate- I, D, L
Long-Term Corporate-I, M, D, L
Term structure
Relationship between interest rates and maturities
Yield curve
Graph of term structure
BBB-Rated bonds
Corporate bond w/ more default risk
AA Rated Bonds
Corporate bond w/ minimal default risk
Why do corporate bonds always yield more than treasury bonds?
Because of their additional default & liquidity risk. Default risk due to lender’s risk of not getting paid. Liquidity risk due to additional yield for bonds that are difficult to sell in a timely acceptable way except at a discount.
The spread widens as the corporate bond ratings decrease.
