Exam 2 Flashcards
Interest rate levels
Price of capital. Borrows are willing to pay and lenders are going to recieve
What are the four factors that affect interest rates?
Production opportunities, time preferences for consumption, risk, and expected inflation
Time preferences for consumption
Supply side. More in future high supply =lower interest rate
Risk
Higher risk=higher interest
Expected inflation
High inflation = high IR
R*
Real risk free rate of interest
Rrf
The nominal rate of interest on treasury securities
Rrf=
R*+IP
Interest rate equation
R*+IP+DRP+LP+MRP
R
Required return on a debt security
DRP
Default risk premium. Chance for borrower not to make payment
LP
Liquidity premium. Convertibility to cash at fair market value
MRP
Maturity risk premium. Price of long term bonds changes over time as interest rate changes. Risk of capital loss
Short term treasury
IP
Long term treasury
IP and MRP
Short term corporate
IP DRP LP
Long term corporate
IP MRP DRP LP
Term structure
Relationship between interest rates and maturities
Yeild curve step one
Find the average expected inflatiob rate over years
Yeild curve step two
Find the appropriate maturity risk premium. .1%(t-1)
Yeild curve step 3
Add the premiums to r*
Upward sloping yeild curve
Due to an increase in expected inflation and MRP
Corporate yeild curves
Are higher than that of treasury securities though not parallel to t-curve
The spread between corporate and treasury yeild curves
Widens as fhe corporate bond rating decreases