money & banking video 04—interest rates ii the behavior of interest rates (chapter 5) interest...
TRANSCRIPT
![Page 1: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/1.jpg)
Money & Banking
Video 04—Interest Rates II
The Behavior of Interest Rates (Chapter 5)Interest Rate Determination (Chapter 6)
Hal W. Snarr8/20/2015
![Page 2: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/2.jpg)
Chapter 5
The Behavior of Interest Rates
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Bond Demand
P D
The quantity of bonds demanded increases as p falls.
B
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Bond Demand
D
The quantity of bonds demanded increases as p falls.
Bond demand increases in• Expected return relative to other assets • Liquidity relative to other assets • Wealth
P
B
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The quantity of bonds demanded increases as p falls.
Bond demand increases in• Expected return relative to other assets • Liquidity relative to other assets • Wealth
Bond demand decreases in • Riskiness relative to other assets• Expected inflation• Expected interest rate
Bond Demand
DP
B
Expected return relative to other assets
For 1-year discount bonds held for 1 year,
R = i
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S
Bond Supply
P
The quantity of bonds supplied increases as p rises.
B
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The quantity of bonds supplied increases as p rises.
Bond supply increases in• Expected profitability of investment opportunities• Expected inflation• Government budget deficits
Bond Supply
S
P
B
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Supply and Demand
DP
B
S
Excess supply: the price suppliers are asking for is too high
95
15 25
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Supply and Demand
DP
B
S
Excess supply: the price suppliers are asking for is too high• For a zero-coupon $100 bond held for one year
95 1F
P i
i
100
955.3
15 25
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Supply and Demand
DP
B
S
Equilibrium: the quantities of bonds supplied and demanded equal• For a zero-coupon $100 bond held for one year
95
15 25
92
20
i
5.3
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Supply and Demand
DP
B
S
Equilibrium: the quantities of bonds supplied and demanded equal• For a zero-coupon $100 bond held for one year
95
92
20
i
5.3
1F
P i
100
928.7
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Supply and Demand
DP
B
S
Excess demand: the price suppliers are asking for is low• For a zero-coupon $100 bond held for one year
90
15 25
i
5.3
8.7
95
92
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Supply and Demand
DP
B
S
Excess demand: the price suppliers are asking for is low• For a zero-coupon $100 bond held for one year
1F
P i
i
100
9011.190
15 25
5.3
8.7
95
92
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Supply and Demand
DP
B
S
Equilibrium: the quantities of bonds supplied and demanded equal• For a zero-coupon $100 bond held for one year
i
11.190
15 25
5.3
8.7
95
92
20
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The Fisher Effect
DP
B
S
Suppose expected inflation rise by 6 percentage-points.
i
5.395
20
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The Fisher Effect
DP
B
S
Suppose expected inflation rise by 6 percentage-points.
i
15
5.3
8.7
95
92
20
D
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The Fisher Effect
DP
B
S
Suppose expected inflation rise by 6 percentage-points.
i
11.190
15
5.3
8.7
95
92
20
SD
The nominal rate of interest rises by 5.8 pct. pts.
![Page 18: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/18.jpg)
Source: Mishkin (1981) “The Real Interest Rate: An Empirical Investigation” Carnegie-Rochester Conference Series on Public Policy 15: 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends.
The Fisher Effect
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Source: FRED
The Fisher Effect
0 2 4 6 8 10 120
2
4
6
8
10
12
14
16
18
f(x) = 1.13529243123702 x + 1.67610504602249R² = 0.474925680118875
1978-2007
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The Business Cycle and Interest Rates
SPD
i
5.395
B18
Suppose economic growth is accelerating.
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The Business Cycle and Interest Rates
SP
B
Di
23
5.3
8.7
95
92
18
S
Suppose economic growth is accelerating.
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The Business Cycle and Interest Rates
Suppose economic growth is accelerating.
The quantity and price of bonds both increase
SP
B
Di
23
5.3
8.7
95
92
18
S
D
23
7.593
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The Business Cycle and Interest Rates
Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
The quantity and price of bonds both increase
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= 0 if bond market in
equilibrium
= 0 if loanable funds market in
equilibrium
Keynes’ liquidity preference framework
i
8.7
Bond Market
B
92
BD
BS
Loanable funds Market
LS
LDP
L 15
• holding money and buying bonds are the only stores of wealth• the quantity of loanable funds people and firms supply = the value of bonds purchased
Total Wealth = Bs + Ms = Bd + Md
Bs – Bd =Ms – Md
= 0 if the market for money is in
equilibrium
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Keynes’ liquidity preference framework
• holding money and buying bonds are the only stores of wealth• the quantity of loanable funds people and firms supply = the value of bonds purchased
Loanable funds Market
15
8.7
LS
LD i
L 15
8.7
LS
LDi
L
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Keynes’ liquidity preference framework
.
Loanable funds Market
15
8.7
LS
LDi
L
i
MD
M
• holding money and buying bonds are the only stores of wealth• the quantity of loanable funds people and firms supply = the value of bonds purchased• The interest rate in these markets are the same
The market for money
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15
8.7
LS
LDi
L
.
Loanable funds Market
i
MD
M
The market for money
7.5
• Money supply shifts to the right (increases) ifo The Fed injects money into the banking system with OMPo Banking lending increases
The Liquidity Effect
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B
95
BD BS
P
L 15
15
5.3
LSLD
i
L
i
MD
M
Bond Market Loanable funds Market The market for money
92
8.7
5.3
8.7
• A one time increase in MS permanently raises the price level by end of year: i = r + p o bond demand falls because the return falls o bond supply rises because the cost of borrowing fallso money demand increases
(the supply of loanable funds falls)(demand for loanable funds rises)
The Price-level Effect
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• An increase in MS causes inflation expectations to rise, which may diminish over time.o bond demand falls (the supply of loanable funds falls)o bond supply rises (demand for loanable funds rises)o money demand increases
15
5.3
LSLD
i
L
i
MD
M
Loanable funds Market The market for money
The Expected-Inflation Effect
5.3
8.7 8.7
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• An increase in MS is an expansionary influence on the economy.o demand for loanable funds riseso money demand increases
15
5.3
LSLD
i
L
i
MD
M
Loanable funds Market The market for money
The Income Effect
5.3
7.1 7.1
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Figure 11 Response to an
Increase in MS Growth
The Total Effect
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Figure 11 Response to an
Increase in MS Growth
The Total Effect
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Figure 12 Annual M2 Growth and 3-month T-bill (1950–2011)
Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
The Total Effect
2
2
3
34
4
5
5
6
6
88 9
9
a
a
1
1
bb
7 7
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Chapter 6
Interest Rate Determination
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Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
![Page 37: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/37.jpg)
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)
Risk structure
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The Risk and Term Structures of Interest Rates
• Risk structure: Bonds with the same maturity (n) have different interest rates because of – default risk premium (d)– illiquidity risk premium (l)– income tax risk discount (t)
• Term structure: For bonds with identical characteristics, the interest rate (i) increases as maturity (n) increases– maturity premium (int – it)
– liquidity premium (lnt)
– The yield curve is the relationship between i and n.
![Page 39: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/39.jpg)
Risk Structure Default risk premium
• Default risk is the probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face valueo U.S. Treasury bonds are considered default free
o Default risk premium (d) is the spread between the interest rates on bonds with default risk and the interest rates on Treasury bonds, holding l, t, n, lnt, and int – it equal
![Page 40: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/40.jpg)
TABLE 1
Risk Structure Default risk premium
![Page 41: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/41.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi i
950 5
DcDt
Q Q
Risk Structure Default risk premium
Sc St
950 5
![Page 42: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/42.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDc
Q Q
Risk Structure Default risk premium
950 5 950 5
6925
Dt
![Page 43: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/43.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
Risk Structure Default risk premium
950 5 950 5
6
4975
925
![Page 44: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/44.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
Risk Structure Default risk premium
6
4975
925
2
![Page 45: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/45.jpg)
Pre-bailout
N = 1I% = APV = -1068PMT = 100FV = 1000
Post-bailout
N = 1I% = APV = -1023PMT = 100FV = 1000
You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout.
Risk Structure Default risk premium
![Page 46: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/46.jpg)
Pre-bailout
N = 1I% = 2.996PV = -1068PMT = 100FV = 1000
Post-bailout
N = 1I% = 7.527PV = -1023PMT = 100FV = 1000
You own a $1000, 10% GM bond that matures next year. The Obama Administration abrogated 100 years of bankruptcy law when it stripped primary bond holders of their first claim rights on corporate assets during the GM bailout. Explain why corporate bond prices would be lower in the post bailout era, holding all else equal. If the GM bond sold for $1068 before the bailout but sells for $1023, compute the yields on the bonds before and after the bailout.
Risk Structure Default risk premium
![Page 47: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/47.jpg)
• Liquidity is the relative ease with which an asset can be converted into casho Cost of selling a bond
o Number of buyers/sellers in a bond market
o Illiquidity risk premium (l) is the spread between the interest rate on a bond that is illiquid and the interest rate on Treasury bonds, holding d, t, n, lnt, and int – it equal.
o E.g., assume an investor is looking at buying two corporate bonds that have the same coupon rates and maturities, but only one is traded on a public exchange. The investor is not be willing to pay as much for the non-public bond. The difference in yields the investor is willing to pay for each bond is the liquidity premium.
Risk Structure Illiquidity risk premium
![Page 48: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/48.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi i
950 5
DcDt
Q Q
Sc St
950 5
Risk Structure Illiquidity risk premium
![Page 49: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/49.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDc
Q Q
950 5 950 5
6925
Dt
Risk Structure Illiquidity risk premium
![Page 50: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/50.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
950 5 950 5
6
4975
925
Risk Structure Illiquidity risk premium
![Page 51: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/51.jpg)
Corporate Bond Market
U.S. Treasury Bond Market
P Pi iSc St
DcDcDt
Dt
Q Q
6
4975
925
2
Risk Structure Illiquidity risk premium
![Page 52: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/52.jpg)
Treasury
N = 1I% = APV = -1058PMT = 80FV = 1000
Corporate
N = 1I% = APV = 1001PMT = 80FV = 1000
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Why is the price of Treasuries higher than corporate bonds with the same attributes? If the price of treasuries is $1058 and the price of a similar corporate bond with the same bond rating is $1001, compute the yields on the two bonds.
Risk Structure Illiquidity risk premium
![Page 53: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/53.jpg)
Risk Structure Illiquidity risk premium
Treasury
N = 1I% = 2.079PV = -1058PMT = 80FV = 1000
Corporate
N = 1I% = 7.892PV = 1001PMT = 80FV = 1000
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a Treasury, and both have an 8% coupon rate. Why is the price of Treasuries higher than corporate bonds with the same attributes? If the price of treasuries is $1058 and the price of a similar corporate bond with the same bond rating is $1001, compute the yields on the two bonds.
![Page 54: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/54.jpg)
• Income tax considerationso Interest payments on municipal bonds are exempt from federal income
taxes.
o Tax exemption risk discount (t) is the spread between the interest rate on a tax exempt municipal bond and the interest rate on Treasury bonds, holding d, l, n, lnt, and int – it equal.
o The discount shrinks ifo federal income taxes are lowered or there is talk of doing so
o politicians seriously consider ending the exemption
o the exemption is repealed.
Risk Structure Tax exemption risk discount
![Page 55: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/55.jpg)
Municipal Bond Market
U.S. Treasury Bond Market
PP ii
950 5
DtDm
ScSt
950 5
Risk Structure Tax exemption risk discount
![Page 56: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/56.jpg)
U.S. Treasury Bond Market
PP iiScSt
DtDt
950 5950 5
6925
Dm
Risk Structure Tax exemption risk discount
Municipal Bond Market
![Page 57: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/57.jpg)
U.S. Treasury Bond Market
PP iiScSt
DcDcDt
Dm
950 5950 5
6
4975
925
Risk Structure Tax exemption risk discount
Municipal Bond Market
![Page 58: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/58.jpg)
U.S. Treasury Bond Market
PP iiScSt
DtDtDt
Dt
6
4975
925
-2
Risk Structure Tax exemption risk discount
Municipal Bond Market
![Page 59: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/59.jpg)
Tax-free municipal
N = 1I% = 3.5PV = APMT = 80FV = 1000
Risk Structure Tax exemption risk discount
Corporate
N = 1I% = 3.5PV = APMT = 40FV = 1000
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a tax-free municipal, and both have an 8% coupon rate. If the bonds have a current yield of 3.5%, and you intend to hold them for their final year, compute the price you would be willing to pay assuming a federal income tax rate of 50%.
![Page 60: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/60.jpg)
You are considering owning two $1000 bonds that mature next year. One is a corporate bond, the other is a tax-free municipal, and both have an 8% coupon rate. If the bonds have a current yield of 3.5%, and you intend to hold them for their final year, compute the price you would be willing to pay assuming a federal income tax rate of 50%.
Risk Structure Tax exemption risk discount
Tax-free municipal
N = 1I% = 3.5PV = -1043.48PMT = 80FV = 1000
Corporate
N = 1I% = 3.5PV = -1004.83PMT = 40FV = 1000
![Page 61: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/61.jpg)
Figure 1—Long-Term Bond Yields, 1919–2011
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, 1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
Risk Structure
![Page 62: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/62.jpg)
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
![Page 63: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/63.jpg)
Interest Rate Determination
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
Risk structure
Term structure
![Page 64: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/64.jpg)
Term Structure
• Time to maturity affects interest rates because– Time increases exposure to risk, causing investors to
demand higher yields on securities with longer maturities.
• The term structure of interest rates refers to difference in the yields on instruments that are identical except for term to maturity.
• Term structure is represented graphically by a yield curve.– Yield curves consider only the relationship between
maturity or term of a security and its yield at a moment in time, otrs.
![Page 65: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/65.jpg)
Facts that the theory must explain:1. Interest rates on bonds of different maturities move together over time
Term Structure
![Page 66: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/66.jpg)
Figure 4—Interest rate movements on Treasuries with different maturities
Sources: Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
Term Structure
![Page 67: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/67.jpg)
Facts that the theory must explain:1. Interest rates on bonds of different maturities move together over time
2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
3. Yield curves almost always slope upward
Term Structure
![Page 68: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/68.jpg)
68February 4, 2005
Term Structure
![Page 69: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/69.jpg)
Figure 7 Yield Curves for U.S. Government Bonds
Term Structure
![Page 70: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/70.jpg)
Figure 6
Term Structure
![Page 71: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/71.jpg)
Facts that the theory must explain:1. Interest rates on bonds of different maturities move together over time
2. When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted
3. Yield curves almost always slope upward
Term Structure
Three Theories that explain these facts1. Segmented markets theory explains fact three but not the first two
2. Expectations theory explains the first two facts but not the third
3. Liquidity premium theory combines the two theories to explain all three facts
![Page 72: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/72.jpg)
Term Structurematurity premium
• Expectations theory says the yield on a long-term bond equals the average of the short-term interest rates people expect to occur over its life
– Maturity Premium is the spread between the interest rates on bonds with n years and 1 year to maturity, holding d, l, t, and lnt equal.
int – it
– Buyers of bonds o do not prefer bonds of one maturity over anothero do not hold any quantity of a bond if its expected return is less
than that of another bond with a different maturity o consider bonds with different maturities to be perfect
substitute
1 2 ( 1)...e e et t t t n
nt
i i i ii
n
![Page 73: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/73.jpg)
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
i 1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
nt
Term Structurematurity premium
![Page 74: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/74.jpg)
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
nt
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1ti
Term Structurematurity premium
![Page 75: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/75.jpg)
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
2ti
Term Structurematurity premium
![Page 76: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/76.jpg)
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
3ti
Term Structurematurity premium
![Page 77: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/77.jpg)
4t
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
i
Term Structurematurity premium
![Page 78: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/78.jpg)
5t
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
i
Term Structurematurity premium
![Page 79: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/79.jpg)
6t
The table below shows current and expected future one-year interest rates, as well as current interest rates on multiyear bonds. Use the table to calculate the liquidity premium for each multiyear bond.
1 2 3 4 5e e e e e
t t t t t ti i i i i i
n
i
Term Structurematurity premium
![Page 80: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/80.jpg)
Graph the maturity adjusted yields over maturity
Term Structurematurity premium
i
n
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 61.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
![Page 81: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/81.jpg)
Graph the maturity adjusted yields over maturity
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
i
n
maturity premium for a 1-year bond0%
![Page 82: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/82.jpg)
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 2-year bond0.325%
![Page 83: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/83.jpg)
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 3-year bond0.57%
![Page 84: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/84.jpg)
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 4-year bond0.7675%
![Page 85: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/85.jpg)
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 5-year bond0.93%
![Page 86: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/86.jpg)
Term Structurematurity premium
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
Graph the maturity adjusted yields over maturity
i
n
maturity premium for a 6-year bond1.06%
![Page 87: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/87.jpg)
Term StructureExpectations Theory
1.00
1.20
1.40
1.60
1.80
2.00
2.20
1 2 3 4 5 6
i
n
Yield Curve
![Page 88: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/88.jpg)
Term Structureliquidity premium
• The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond
• Bonds of different maturities are partial (not perfect) substitutes– Liquidity premium is the spread between the interest
rates on bonds with n and one years to maturity, holding d, l, t, and int – it equal
lnt
![Page 89: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/89.jpg)
Suppose the liquidity premium is linear in maturity:
lnt = 0.08n
Term Structureliquidity premium
![Page 90: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/90.jpg)
1 2 ( 1)...e e et t t t
n tt nni i i
nl
ii
Term StructureExpectations Theory
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 6
Yield Curve
![Page 91: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/91.jpg)
Term StructureLiquidity Premium Theory
1.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 61.00
1.25
1.50
1.75
2.00
2.25
2.50
2.75
1 2 3 4 5 6
1 2 ( 1)...e e et t t t
n tt nni i i
nl
ii
Yield Curve
![Page 92: Money & Banking Video 04—Interest Rates II The Behavior of Interest Rates (Chapter 5) Interest Rate Determination (Chapter 6) Hal W. Snarr 8/20/2015](https://reader037.vdocuments.site/reader037/viewer/2022110101/56649ee05503460f94bf0094/html5/thumbnails/92.jpg)
Nominal Rate (i) = Real Rate (r) + Expected Inflation (p e)
+ Default Risk Premium (d)+ Illiquidity Risk Premium (l)– Tax exemption discount (t)+ Maturity Premium (int – it)+ Liquidity Premium (lnt)
Interest Rate Determination
Risk structure
Term structure