chapter 6 - key concepts (interest rates)

Question 1

What are the four factors that affect the level of interest rates?

Answer 1

• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation

Question 2

Production opportunities and how it impacts interest rates

Answer 2

Production opportunities (higher interest rates)

Borrowing more money

• Determined by number of investment opportunities in productive assets
  If there are many good investments opportunities that will produce profits, then firms want to borrow money to fund those investments
• Result: more demand pushes interest rates higher

Question 3

time preferences for consumption and how it impacts interest rates

Answer 3

Time preferences for consumption (lower interest rates)

Amount of savings available

• Now: Interest rates go up if savings will drop/they spend tons of money. If they continue to save money interest rates will go down.
• The preference of consumers to delay consuming today in favor of consuming in the future
• Willingness to save

Question 4

risk and how it impacts interest rates

Answer 4

Risk (higher interest rates)

• The chance that investment will provide a low or negative rate of return
• The riskier investments are, the higher the interest rate will be – otherwise no one is willing to lend money.
• More risky a company is, the more the interest rate is because really good interest rates (high) will attract borrowers. Riskier is higher interest rates.

Question 5

expected inflation and how it impacts interest rates

Answer 5

Inflation (higher interest rates)

Higher inflation erodes the value of money

• Amount by which prices increase over time
• Borrowers want to recapture the impact of inflation, so more inflation causes interest rates to be higher
• Money becomes less valuable over time because inflation (increases over time)

Question 6

What is the nominal vs real interest rate?
* Which is usually larger?

Answer 6

Real interest rate (can be negative/lose money) = nominal interest rate - inflation rate

Nominal interest rate = real interest rate + inflation rate

nominal rates are ually larger than real because real interest rates take inflation into account when they are expressed.

Question 7

Understand the relationship between nominal rates, real rates, and inflation.
* If the risk-free rate increases, what will happen to interest rates?

Answer 7

Inflation rate = nominal rate (R) - real interest rate

Determinants of interest rates
R = r* + IP + DRP + LP + MRP

r* = real risk-free rate of interest

if the risk-free rate (r*) increases interest rates (R) increase

Question 8

Why is the inflation rate and interest rates so highly correlated?

Answer 8

When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. When inflation is too low, the Federal Reserve typically lowers interest rates to stimulate the economy and move inflation higher

Question 9

What are the four premiums that investors
received for holding interest-paying securities

Answer 9

Inflation premium (IP): a premium equal to average expected rate of inflation over the lifetime of the security

Default risk premium (DRP): the premium that compensates investors for the possibility of default (may not get all your interest rate payments or your principal back at the end)

Liquidity premium: premium added to the equilibrium interest rate on a security if that security cannot be converted to cash on short notice

Maturity risk premium: a premium that reflects the degree of interest rate risk – that changes in interest rates will cause significant change in asset value

Question 10

What are the five determinants of interest rates

Answer 10

R = r* + IP + DRP + LP + MRP

R = required return on a debt security
This is the nominal interest rate

r* (r-star) = real risk-free rate of interest

IP = inflation premium

DRP = default risk premium (bankruptcy)

LP = liquidity premium (reflection how difficult it is to sell a bond quickly)

MRP = maturity risk premium (longer you go/bond matures, the more risky it is)
Premium is building block for return on a bond/determine interest rates

Question 11

Know what premiums that different types of bonds have: treasury

Answer 11

Treasury interest rate = r* + IP + MRP
r* is the same for all treasury bonds, so only:
- IP and MRP varies across bonds
- IP can be higher or lower depending on the economic outlook
- MRP is ALWAYS higher for longer-maturing bonds
- Because MRP is always higher for longer-maturing bonds, yield curve is normally upward sloping

Question 12

Know what premiums that different types of bonds have: corporate

Answer 12

Corporate bonds always have higher interest rates than government bonds because they have more risk

corporate bond yield spread = drp + lp

Question 13

Know what premiums that different types of bonds have: short vs. long-term

Answer 13

Longer term bonds almost always have a higher interest rate than short term bonds. Because longer term bonds have MRP which is a compensation for investors. MRP is the risk to compensate for investors.

Longer term bonds are riskier than short-term bonds usually

Question 14

What are the three types of term structures?
- What does an upward sloping and downward sloping yield curve suggest about the
future state of the economy?

Answer 14

1. Upward sloping: positive, growing economy
2. Flat yield curve: neutral
3. Downward or inverted yield curve: negative, expect economy to slow

Question 15

Will BBB+ bonds have a higher or lower interest rate than AA- bonds?

Answer 15

A is high quality
B is medium quality

AA- has lower interest than BBB+
BBB HAS HIGHER

Question 16

What is the junk bond spread? Why do junk bonds have higher interest rates?
* Do the higher rates always result in a higher rate of return?

Answer 16

when the economy gets weaker the interest rate for risky companies that could go bankrupt go up. Higher the ratio, the more risky they have become and higher interest rate they have to pay. This will cause mass employee fires so no it means lower rates of return.

Question 17

Why do longer-dated bonds have higher interest rates (on average) than lower-
rated bonds?

Answer 17

A longer-term bond carries greater risk that higher inflation could reduce the value of payments, as well as greater risk that higher overall interest rates could cause the bond’s price to fall.

Question 18

What is pure expectations theory? What is a key assumption of the pure
expectations theory? What are long-term rates composed of?

Answer 18

The pure expectations theory contends that the shape of the yield curve depends on investors’ expectations about future interest rates.

assumptions:
- maturity risk premium for treasury securities is zero
- long-term rates are an average of current and future short term rates
- you can use the yield curve to back out expected future interest rates using a table of forward rates

long-term rates are composed of average of current and future short term rates

Question 19

Is pure expectations theory an accurate reflection of real life? Why not?

Answer 19

The maturity risk premium is positive, the MRP =/= 0, so pure expectations theory needs to be adjusted for accurate calculations
Because investors need for a premium for holding longer-term securities
MRP can be estimated using model
Can calculate forward rate using adjustments

Question 20

how to calculate the forward rate using pure expectations theory.

Answer 20

Step 1: Find the average expected inflation rate over Years 1 to N:
Step 2: (Maturity Risk) Find the appropriate maturity risk premium (MRP). For this example, the following equation will be used to find a security’s appropriate maturity risk premium.
Step 3: (add the IPS and MRPS to * to find the appropriate nominal rates) Adding the premiums to r*