Money & Banking - ECO 473 - Dr. D. Foster

Interest Interest

Rates III:Rates III:

Term Term StructurStructur

ee

Why do Interest Rates differ?Why do Interest Rates differ?

Default risk

(Il)liquidity risk

“Risk premium” = i - iT-Bill

where the T-Bill is the riskless rate.

How do you distinguish default from liquidity risk?

Dealing with Risk

Risk is an example of asymmetric information, where bond rating services are the market solution

for this problem.

Case: GM Bond Rating

Case: GM Bond Rating

Case: GM Bond Rating

Case: GM Bond Rating

Quick HitsQuick Hits

Fisher equation: i = r + e

Market for LF determines r. “r” is ex ante – before the fact. e can be based on adaptive/rational expectations.

Adjusting for risk premiums, i still differs … by maturities; aka “term structure of interest

rates.” a positive “term premium” normal yield curve. a negative “term premium” inverted yield curve.

Term Structure of Interest Term Structure of Interest RatesRates

Causes of the term structureCauses of the term structure

Segmented markets Different terms are not good substitutes.

Expectations If we expect r to rise, longer-term bonds will

earn a higher interest rate. Preferred habitat

Longer terms require a premium . . . usually. [Unanticipated] Inflation premium (ua). .

.

Unanticipated Inflation Unanticipated Inflation PremiumPremium

Consider a 1 yr. bond and a perpetuity

The bond has a face value of $1000 and has a $50 coupon. In one year the bond holder will be able to redeem the total, $1050.

The perpetuity redeems $50 per year forever.

Bond

$1000 $50$50

Perpetuity

Unanticipated Inflation Unanticipated Inflation PremiumPremium

Assume that the current market (nominal) rate of interest for these instruments is 5% and that the inflation rate (π) is 2%. We can easily calculate the price of each financial instrument:

Bond

$1000 $50$50

Perpetuity

Bond price = $1050/1.05 = $1000Perpetuity price = $5/.05 = $1000

Unanticipated Inflation Unanticipated Inflation PremiumPremium

What happens to prices if actual inflation, , (say tomorrow) rises to 4%?

The bond price will fall to $105/1.07 = $98.13$98.13

The perpetuity price falls to $5/.07 = $71.43$71.43

So, we can interpret the “normal” yield curve with respect to unanticipated inflation (ua). Longer terms command higher yields to account for this outcome.

Money & Banking - ECO 473 - Dr. D. Foster

Interest Interest

Rates III:Rates III:

Term Term StructurStructur

ee