Power Point Slides for Financial Institutions Markets and

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Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell,

Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University Copyright© 2006 John Wiley & Sons, Inc. 1

CHAPTER 6 THE STRUCTURE OF INTEREST RATES Copyright© 2005 John Wiley & Sons, Inc

CHAPTER 6 THE STRUCTURE OF INTEREST RATES Copyright© 2005 John Wiley & Sons, Inc

Factors that Influence Interest Rate Differences Term to Maturity. Default Risk. Tax Treatment. Marketability.

Factors that Influence Interest Rate Differences Term to Maturity. Default Risk. Tax Treatment. Marketability. Copyright© 2006 John Wiley & Sons, Inc. 3

Term (Maturity) Structure May be studied visually by plotting a yield curve at a

Term (Maturity) Structure May be studied visually by plotting a yield curve at a point in time A yield curve is a smooth line, which shows the relationship between maturity and a security's yield at a point in time. The yield curve may be ascending (normal), flat, or descending (inverted). Several theories explain the shape of the yield curve. Copyright© 2006 John Wiley & Sons, Inc. 4

Yield Curves in the 2000 s - Exhibit 6. 1 Copyright© 2006 John Wiley

Yield Curves in the 2000 s - Exhibit 6. 1 Copyright© 2006 John Wiley & Sons, Inc. 5

Yield Curves and the Business Cycle Interest rates are directly related to the level

Yield Curves and the Business Cycle Interest rates are directly related to the level of economic activity. An ascending yield curve notes the market expectations of economic expansion and/or inflation. A descending yield curve forecasts lower rates possibly related to slower economic growth or lower inflation rates. Security markets respond to updated new information and expectations and reflect their reactions in security prices and yields. Copyright© 2006 John Wiley & Sons, Inc. 6

Yield-Curve Patterns Over the Business Cycle Copyright© 2006 John Wiley & Sons, Inc. 7

Yield-Curve Patterns Over the Business Cycle Copyright© 2006 John Wiley & Sons, Inc. 7

Uses of the Yield Curve At any point in time, the slope of the

Uses of the Yield Curve At any point in time, the slope of the yield curve can be used to assess the general expectations of borrowers and lenders about future interest rates! Investors can use the yield curve to identify underpriced securities for their portfolios. Issuers may use the yield curve to price their securities. Investors use the yield curve for a strategy known as riding the yield curve. Copyright© 2006 John Wiley & Sons, Inc. 8

Default Risk It is the probability of the borrower not honoring the security contract

Default Risk It is the probability of the borrower not honoring the security contract Losses may range from “interest a few days late” to a complete loss of principal. Risk averse investors want adequate compensation for expected default losses. Copyright© 2006 John Wiley & Sons, Inc. 9

Default Risk, cont. Investors charge a default risk premium (above riskless or less risky

Default Risk, cont. Investors charge a default risk premium (above riskless or less risky securities) for added risk assumed DRP = i - irf The default risk premium (DRP) is the difference between the promised or nominal rate and the yield on a comparable (same term) riskless security (Treasury security). Investors are satisfied if the default risk premium is equal to the expected default loss. Copyright© 2006 John Wiley & Sons, Inc. 10

Risk Premiums (May 2004) Copyright© 2006 John Wiley & Sons, Inc. 11

Risk Premiums (May 2004) Copyright© 2006 John Wiley & Sons, Inc. 11

Default Risk, cont. Default risk premiums increase (widen) in periods of recession and decrease

Default Risk, cont. Default risk premiums increase (widen) in periods of recession and decrease in economic expansion In good times, risky security prices are bid up; yields move nearer that of riskless securities. With increased economic pessimism, investors sell risky securities and buy “quality” widening the DRP. Copyright© 2006 John Wiley & Sons, Inc. 12

Default Risk, cont. Credit rating agencies measure and grade relative default risk security issuers

Default Risk, cont. Credit rating agencies measure and grade relative default risk security issuers Cash flow, level of debt, profitability, and variability of earnings are indicators of default riskiness. As conditions change, rating agencies alter rating of businesses and governmental debtors. Copyright© 2006 John Wiley & Sons, Inc. 13

Corporate Bond-Rating Systems, Exhibit 6. 7 Copyright© 2006 John Wiley & Sons, Inc. 14

Corporate Bond-Rating Systems, Exhibit 6. 7 Copyright© 2006 John Wiley & Sons, Inc. 14

Tax Effects on Yields The taxation of security gains and income affects the yield

Tax Effects on Yields The taxation of security gains and income affects the yield differences among securities The after-tax return, iat, is found by multiplying the pre-tax return by one minus the marginal tax rate. iat = ibt(1 -t) Municipal bond interest income is tax exempt. Coupon income and capital gains have been taxed differently in the past, but are now both taxed at the same rate as ordinary income for individuals. Copyright© 2006 John Wiley & Sons, Inc. 15

To Buy a Municipal or a Corporate Bond? Copyright© 2006 John Wiley & Sons,

To Buy a Municipal or a Corporate Bond? Copyright© 2006 John Wiley & Sons, Inc. 16

Impact of Marketability on Interest Yields Marketability -- The costs and rapidity with which

Impact of Marketability on Interest Yields Marketability -- The costs and rapidity with which investors can resell a security. Cost of trade. Physical transfer cost. Search costs. Information costs. Securities with good marketability have higher prices (in demand) and lower yields. Copyright© 2006 John Wiley & Sons, Inc. 17