CHAPTER The Structure of Interest Rates Copyright 1999

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CHAPTER The Structure of Interest Rates Copyright © 1999 Addison Wesley Longman 1 4

CHAPTER The Structure of Interest Rates Copyright © 1999 Addison Wesley Longman 1 4

2 Chapter 4: The Structure of Interest Rates Objectives 1. The Importance of Interest

2 Chapter 4: The Structure of Interest Rates Objectives 1. The Importance of Interest Rates 2. Factors that affect Interest Rates 3. How Interest Rates affect Stocks Copyright © 1999 Addison Wesley Longman

3 Chapter 4: The Structure of Interest Rates Interest rates: The rental price of

3 Chapter 4: The Structure of Interest Rates Interest rates: The rental price of money. The price changes over time as the demand supply changes. Factors that impact interest rates u Technology Changes u Business Environment u Federal Reserve u Time Preference of Consumption Changes Copyright © 1999 Addison Wesley Longman

4 Chapter 4: The Structure of Interest Rates FIGURE 4. 1 Monthly T-Bill Returns

4 Chapter 4: The Structure of Interest Rates FIGURE 4. 1 Monthly T-Bill Returns over Time Copyright © 1999 Addison Wesley Longman

5 Chapter 4: The Structure of Interest Rates Other Factors that determine the level

5 Chapter 4: The Structure of Interest Rates Other Factors that determine the level of IR N = r + INF + LP + DRP + MRP N = Nominal Rate r = Real Rate INF = expected inflation LP = liquidity premium DRP = default risk premium MRP = maturity risk premium Copyright © 1999 Addison Wesley Longman

6 Chapter 4: The Structure of Interest Rates Inflation FIGURE 4. 2 3 -Month

6 Chapter 4: The Structure of Interest Rates Inflation FIGURE 4. 2 3 -Month T-Bill Returns and Inflation Rates Copyright © 1999 Addison Wesley Longman

7 Chapter 4: The Structure of Interest Rates Default Risk Ratings by Standard and

7 Chapter 4: The Structure of Interest Rates Default Risk Ratings by Standard and Poor’s AAA CCC AA CC A C BBB CI BB D B NR Copyright © 1999 Addison Wesley Longman

8 Chapter 4: The Structure of Interest Rates Term Structure of Interest Rates FIGURE

8 Chapter 4: The Structure of Interest Rates Term Structure of Interest Rates FIGURE 4. 3 Treasury Yield Curve for July 30, 1997 and July 30, 1980 Copyright © 1999 Addison Wesley Longman

9 Chapter 4: The Structure of Interest Rates Pure Expectation Theory 2 year rate

9 Chapter 4: The Structure of Interest Rates Pure Expectation Theory 2 year rate = average of the one year rates Copyright © 1999 Addison Wesley Longman

10 Chapter 4: The Structure of Interest Rates Liquidity Preference Theory u Borrowers pay

10 Chapter 4: The Structure of Interest Rates Liquidity Preference Theory u Borrowers pay a premium to induce lender to make long-term loans. Copyright © 1999 Addison Wesley Longman

11 Chapter 4: The Structure of Interest Rates Market Segmentation Theory FIGURE 4. 4

11 Chapter 4: The Structure of Interest Rates Market Segmentation Theory FIGURE 4. 4 Equilibrium with Market Segmentation Copyright © 1999 Addison Wesley Longman

12 Chapter 4: The Structure of Interest Rates Reconciling the Theories u u u

12 Chapter 4: The Structure of Interest Rates Reconciling the Theories u u u They are all probably relevant Expectations and Liquidity Preference explain long term Segmentation explains short term Copyright © 1999 Addison Wesley Longman

13 Chapter 4: The Structure of Interest Rates Taxes and IR’s u u Municipal

13 Chapter 4: The Structure of Interest Rates Taxes and IR’s u u Municipal Bonds: Federal Income tax exempt Rat = Rbt (1 – Tr) Copyright © 1999 Addison Wesley Longman

14 Chapter 4: The Structure of Interest Rates When IR increase, corporate profits decline

14 Chapter 4: The Structure of Interest Rates When IR increase, corporate profits decline because of: Increased interest expense u Reduced expansion u Slower economy As a result, stock prices tend to fall as IR increase. u Copyright © 1999 Addison Wesley Longman