Week 2 Flashcards
What is the difference between risk structure and term structure of interest rates?
Risk structure of interest rates: same maturity → different risk → different interest rates
Term structure of interest rates: same risk → different maturity → different interest rate
What does the risk structure of interest rates exist of?
risk premium, liquidity premium, and tax premium
What is risk premium and explain the curves
Risk premium; spread between interest rates of (corporate) bonds with default risk and default-free bonds (treasury) = ic - it
Amount of additional interest people must earn in order to be willing to hold riskier bonds.
Increase in default risk corporate bonds means a decrease in demand for corporate bonds and shifts left → lower price for corporate bonds, and a higher ic (risk premium).
What is liquidity premium?
Liquidity premium: spread between interest rates of liquid and less liquid bonds = ic - it
Bonds that are widely traded (e.g. government treasury bonds) are more liquid than corporate bonds. When corporate bonds become less liquid → demand for corporate bonds goes down and shifts to left → interest rates go up and shifts to right → liquidity premium
What is tax premium (discount)?
Tax premium (discount): spread between interest rates of tax-free (municipal) bonds and government bonds.
Municipal bonds have higher after-tax returns (tax advantage), causing increase in demand for municipal bonds, and shift to right → increase in price for municipal bonds → decrease in interest rates for municipal bonds, such that ic < i (tax premium/discount).
What does the term structure of interest rates exist of?
Term structure of interest rates: relationships between interest rates of bonds with different maturities reflected in;
Expectations theory
Segmented markets theory
liquidity premium theory
What is the key assumption of expectations theory, implication and illustration
Key assumption: bonds with different maturities are perfect substitutes
Implication: Expected return, R, on bonds with different maturities must be equal over same period of time, n.
Illustration of the expectations theory; two strategies for a two-year investment horizon using zero-coupon bonds;
‘buy and hold’ strategy → buy a two-year bond of $100 and hold it until maturity
‘rolling’ strategy → buy a one-year bond of $100 and when it matures in one year buy another one-year bond with the sum that you have received at that point of time
Explain the yield cruve implications of the expectations theory
Yield curve implications: term structure change at different times
Upward sloping: average of future short term interest rate expected to be higher than current rate → rising trend in expected short term interest rates → means for longer maturities at the end it will be higher → upward sloping yield curve → short term interest rates expected to rise in the future
Downward sloping: average of future short-term interest rates expected to be lower than current short term rate
Flat: average of future short term interest rates unchanged
What are the three facts of expectation theory?
Fact 1; interest rates for different maturities tend to move together over time → rise in short term rates raise people’s expectations of future short term rates → longer maturity rates also raised because they are equal to average of short term bits
Fact 2; yield curve tend to have upward slope when short term interest rates are low and inverted vice versa → when short term interest rates are low, they expect to rise in the future, thus average rates will be higher than current short term, thus long term interest rate will be higher than current short term rate
Fact 3; in practice, short term interest rates are just as likely to fall as they are to rise → typical yield curve should be flat rather than upward sloping
What is the key assumption and implication of segmented market theory?
Key assumption: bonds of different maturities are no substitutes
Implication: interest rates for each maturity are determined independently by individual supply and demand curve
do intvestors prefer bonds of shorter or longer maturities in segmented market theory?
Investors prefer bonds of shorter maturities (lower interest rate risk);
higher demand for short term bonds (higher price and lower interest)
lower demand for long term (lower price and higher interest)
→ the longer the maturity, n, the higher demanded YTM on bonds, higher interest rates
What are the facts of segmented market theory?
markets for different maturity bonds are completely separate and segmented
interest rate of each bond with different maturity determined by supply and demand, not expected returns on bonds from other maturities
bonds of different maturities not substitutes at all
role of preference; investors have strong preference for bonds of one maturity and not the other → have a certain holding period in mind
Fact 3; yield curve tends to slope upward: investors prefer shorter maturities due to less risk → lower demand for longer maturity bonds (lower prices - higher interest rates) → yield curve slope upwards
What is the key assumption, implication, and graph of liquidity premium theory?
Key assumption: bonds of different maturities are substitutes, but not perfect substitutes, because investors still prefer short-term bonds over long-term bonds (interest rate risk).
Implication: expectations theory is modified as investors must be paid a positive liquidity premium to cover the interest rate risk of long term bonds → give them incentive to hold long-term bonds and reduce the effect of the segmented market theory
→ when short rates remain unchanged yield is still upward sloping, because of liquidity premium
What is the preferred habitat theory in liquidity premium theory?
preferred habitat theory; investors prefer habitat of short term bonds over longer term bonds → only willing to hold longer term bonds if they have higher expected return → similar to liquidity premium theory which states for longer terms, there must be a liquidity premium
produces steeper upward yield curves because investor’s preferences for short term bonds → the liquidity premium makes the one year interest rates for the future bonds much higher
What are the three facts of liquidity premium theory?
Fact 1. Interest rates of different maturities move together over time a rise in short term interest rates means short term interest rates will be higher in the future, and on average, the long term will rise along with them
Fact 2. Yield curve tend to have steep upward slope when short term rates are low and to be inverted when short term rates are high a investors expect short-term rates to rise when they are low so average of future expected short term rates will be higher relative to current short term rate, plus the liquidity premium, long term rates will be substantially higher than current short-term rates
Fact 3. Yield curves typically slope upwards à liquidity premium rises with bond’s maturity because investor’s preference for short-term bonds à even if short term rates expected to stay, still due to liquidity premium, it will still mostly slope upwards
Theory shows what market predicts about future short-term interest rates just from the slope of the yield curve (whether expected to rise/sharp steep, expected to not fall or rise/moderate steep upwards, or expected to fall/flat slope, or fall sharply/downward sloping)
What three valuation models are there?
one period stock valuation model, generalized divident valuation model, and gordon growth model
Explain the one period stock valuation model and its calculations
based on scenario of BUY stock, HOLD for one period to get dividend, then SELL stock
Investment decision: if P0 greater than current price à choose to buy à CONSIDERATION: current price may be lower because others place different risk and estimate on cash flow (have lower/higher required return)
Explain the generalized dividend valaution model and its calculation
adapting one period dividend valuation to any number of periods –> value is PV of ALL future cash flows: dividends each year + final sales price when sold at period n
Issue: must know value of infinite stream of dividends à sometimes you don’t know the dividends or are even unsure how the dividends will be in infinite years –> simplified by Gordon growth model
What is the Gordon growth model and its calculation?
assume constant dividend growth (since firms strive to increase dividend at constant rate each year) –> similar to generalized dividend valuation model BUT dividend grows each year (in a same rate)
Assumption:
* Dividends assumed to continue to grow at constant rate forever –> model will yield reasonable results under that assumption à cancels out any errors about distant cash flows that then becomes small when discounted to the present
* Growth rate < required return on equity (k)
–> otherwise firm growth would be too large
What is the role of information in how markets set stock prices?
More information –> Ke lower –> price higher –> willing to pay more (sets higher price) since knows what to do with the asset and can take the most advantage
Less information –> Ke higher –> price lower –> willing to pay less (sets lower price) since unaware of risk etc
What is the role of monetary policy on how markets set stock prices?
o Monetary expansion: lowers interest rate à return on bonds decline
1) investors accept lower required rate of return (ke) on stocks
2) rise in dividend growth rate due to stimulation of the conomy –> lower denominator in Gordon growth model –> higher value P –> stock prices rise
o Monetary contraction: increase interest rate –> return on bonds increase –> ke increase and g increase –> denominator of model increase –> lower value P –> stock prices decline
What is the role of financial crisis on how markets set stock prices?
o Lowers dividend growth rate (g) –> increase in denominator –> decline in P0 –> decline in stock prices
o Increased uncertainty –> higher required return (ke) –> decline in P0 –> decline in stock prices
What is the theory of rational expectations?
expectations will be identical to optimal forecasts (best guess of the future) using all available information –> if we expect other values, it would not be rational because it is not equal to optimal forecast –> does not have to be 100% accurate every single time
–> in the availability of any new information, expectations should be revised to become rational
What is efficient market hypothesis?
application of rational expectations –> expectations in financial markets are equal to optimal forecasts, given all available information –> prices of securities reflect all available information –> Also: all unexploited profit opportunities will be eliminated, and there is an incentive for people to commit to optimal forecasting to not let out any profit opportunities
How does arbitrage lead to efficient market hypothesis?
o When current equilibrium price (P) lower than optimum forecast price –> equilibrium return lower than optimum forecast return –> people know they can earn more in the future/unexploited profit opportunities (due to high Rof) –> buy more stocks and drive up the price until optimum forecast Rof falls down –> Rof will eventually no longer be much higher than equilibrium returns –> unexploited profit opportunity disappears
o When current equilibrium price (P) higher than optimum forecast price –> equilibrium return higher than optimum forecast return
–> forecasted to earn less in the future –> sell the stocks and drive down the price until Rof increase –> Rof will eventually increase to be up to par with equilibrium returns –> Rof equal R* again
