FIM Chapter 03 Structure of Interest Rates

1/29/2023
Lesson Outline
2
Chapter 03
o Why Debt Security Yields Vary
o Estimating the Appropriate Yield

Structure of Interest Rates o Theories of Term Structure
o Use of the Term Structure
Md. Kaysher Hamid
Md. Kaysher Hamid © MKH BUP 2023
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Why Debt Security Yields Vary Why Debt Security Yields Vary
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 The yields on debt securities are affected:  Credit (Default) Risk
o Credit (default) risk o Securities with a higher degree of default risk offer higher yields.
o Liquidity o Rating Agencies - Rating agencies charge the issuers of debt securities a
o Tax status fee for assessing default risk.
o Term to maturity
Md. Kaysher Hamid © MKH BUP 2023 Md. Kaysher Hamid © MKH BUP 2023
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 Credit (Default) Risk  Credit (Default) Risk

National Credit Ratings Ltd. o National Credit Ratings Ltd.
(http://www.ncrbd.com/services.php?nId=9&pId=14&nName=Services)
o Credit Rating Agency of Bangladesh Ltd. (https://crab.com.bd/credit-

rating-scales-and-definitions/)
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 Liquidity  Tax Status
o Debt securities with a short-term maturity or an active secondary o Investors are more concerned with after-tax income
market have greater liquidity o Taxable securities must offer a higher before-tax yield
o The lower a security’s liquidity, the higher the yield preferred by an o The extra compensation required on taxable securities depends on
investor. the tax rates of individual and institutional investors.
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 Tax Status  Exercise 01
o Consider a taxable security that offers a before-tax yield of 8 percent.. If You need to choose between investing in a one-year municipal bond with
the tax rate of the investor is 20 percent, then what is the after-tax yield? a 7 percent yield and a one-year corporate bond with an 11 percent yield.
o Suppose that a firm in the 20 percent tax bracket is aware of a tax- If your marginal federal income tax rate is 30 percent and no other
exempt security that is paying a yield of 8 percent. To match this after- differences exist between these two securities, which would you invest in?
tax yield, taxable securities must offer a before-tax yield of ………….
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 Exercise 02  Term to Maturity
You need to choose between investing in a 10-year corporate bond with a 13.5 o Maturity dates will differ between debt securities
percent yield and a 10-year corporate bond with a 12 percent yield. If your o The term structure of interest rates defines the relationship between term
marginal governmental income tax rate is 15 percent and no other differences
to maturity and the annualized yield
exist between these two securities, which would you invest in? Why?
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Estimating the Appropriate Yield Estimating the Appropriate Yield

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Yn = Rf,n + DP + LP + TA Suppose that the three-month T-bill’s annualized rate is 8 percent and
where: that Elizabeth Company plans to issue 90-day commercial paper.
Yn = yield of an n-day debt security Assume Elizabeth Company believes that a 0.7 percent default risk
premium, a 0.2 percent liquidity premium, and a 0.3 percent tax
Rf,n = yield of an n-day Treasury (risk-free) security
adjustment are necessary to sell its commercial paper to investors.
DP = default premium to compensate for credit risk
Calculate the appropriate yield to be offered on the commercial paper?
LP = liquidity premium to compensate for less liquidity
Yn = Rf,n + DP + LP + TA
TA = adjustment due to difference in tax status
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Estimating the Appropriate Yield Theories of Term Structure

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 Exercise 03 o Pure Expectations Theory

a) A corporation is planning to sell its 90-day commercial paper to o Liquidity Premium Theory
investors by offering an 8.4 percent yield. If the three-month T-
bill’s annualized rate is 7 percent, the default risk premium is o Segmented Markets Theory
estimated to be 0.6 percent, and there is a 0.4 percent tax
adjustment, then what is the appropriate liquidity premium?
b) Suppose that, because of unexpected changes in the economy, the
default risk premium increases to 0.8 percent. Assuming that no
other changes occur, what is the appropriate yield to be offered
on the commercial paper?
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Theories of Term Structure Theories of Term Structure

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 Pure Expectations Theory  Pure Expectations Theory
o Term structure reflected in the shape of the yield curve is determined

solely by the expectations of interest rates.
o An expected increase in rates leads to an upward sloping yield curve
o An expected decrease in rates leads to a downward sloping yield curve.
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 Pure Expectations Theory  Pure Expectations Theory
o If investors were indifferent to maturities, the return of any security

should equal the compounded yield of consecutive investments in
shorter-term securities. That is, a two-year security should offer a
return that is similar to the anticipated return from investing in two
consecutive one-year securities and so on.
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 Pure Expectations Theory  Liquidity Premium Theory
o If the term structure of interest rates is solely influenced by o Investors prefer short-term liquid securities but will be willing to
expectations of future interest rates, the following relationships hold: invest in long-term securities if compensated with a premium for
lower liquidity.
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 Liquidity Premium Theory  Exercise 04

a) Assume that, as of today, the annualized two-year interest rate is
13 percent and the one year interest rate is 12 percent. Use this
information to estimate the one-year forward rate.
where LP2 is the liquidity premium on the 2 year security b) Assume that the liquidity premium on a two-year security is 0.3
percent. Use this information to estimate the one-year forward rate.
The relationship between the liquidity premium and term to maturity
can be expressed as follows:
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 Segmented Markets Theory  Segmented Markets Theory
o Investors choose securities with maturities that satisfy their forecasted o Limitations of the theory
cash needs.  Some borrowers and savers have the flexibility to choose among various
maturities
o If investors and borrowers participate only in the maturity market that
o Implications: Preferred Habitat Theory
satisfies their particular needs, then markets are segmented. That is,
investors (or borrowers) will shift from the long-term market to the  Although investors and borrowers may normally concentrate on a particular
maturity market, certain events may cause them to wander from their “natural”
short-term market, or vice versa, only if the timing of their cash needs
or preferred market.
changes.
 Preferred habitat theory acknowledges that natural maturity markets may
o The choice of long-term versus short-term maturities is determined more
influence the yield curve, but it also recognizes that interest rate expectations
by investors’ needs than by their expectations of future interest rates.
could entice market participants to stray from their natural, preferred markets.
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Integrating the Theories of the Term Structure Use of the Term Structure
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 If we assume the following conditions:  Forecasting Interest Rates
o Investors and borrowers who select o The shape of the yield curve can be used to assess the general
security maturities based on anticipated expectations of investors and borrowers about future interest rates.
interest rate movements currently o The curve’s shape should provide a reasonable indication (especially
expect interest rates to rise. once the liquidity premium effect is accounted for) of the market’s
o Most borrowers are in need of long- expectations about future interest rates.
term funds, while most investors have
 Forecasting Recessions
only short-term funds to invest Then all three conditions place
upward pressure on long-term yields
o Some analysts believe that flat or inverted yield curves indicate a
o Investors prefer more liquidity to less. relative to short term yields leading to recession in the near future.
upward sloping yield curve.
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Use of the Term Structure Exercises

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5. a. Determine the forward rate for various one-year interest rate scenarios
 Making Investment Decisions
if the two-year interest rate is 8 percent, assuming no liquidity premium. Explain
o If the yield curve is upward sloping, some investors may attempt to the relationship between the one-year interest rate and the one-year forward rate
while holding the two-year interest rate constant.
benefit from the higher yields on longer-term securities even though b. Determine the one-year forward rate for the same one-year interest rate
they have funds to invest for only a short period of time. scenarios described in question (a) while assuming a liquidity premium of 0.4
percent. Does the relationship between the one-year interest rate and the forward
 Making Decisions about Financing rate change when the liquidity premium is considered?
c. Determine how the one-year forward rate would be affected if the
o Firms can estimate the rates to be paid on bonds with different quoted two-year interest rate rises; hold constant the quoted one-year interest rate as
well as the liquidity premium. Explain the logic of this relationship.
maturities. This may enable them to determine the maturity of the
d. Determine how the one-year forward rate would be affected if the
bonds they issue. liquidity premium rises and if the quoted one-year interest rate is held constant.
What if the quoted two-year interest rate is held constant? Explain the logic of this
relationship.
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Exercises
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6. If ti1 > ti2, what is the market consensus forecast about the one-year
forward rate one year from now? Is this rate above or below today’s one-
year interest rate? Explain.
7. Determine how the after-tax yield from investing in a corporate bond is

affected by higher tax rates, holding the before-tax yield constant. Explain
the logic of this relationship.
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FIM Chapter 03 Structure of Interest Rates

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1/29/2023

o Estimating the Appropriate Yield

o Use of the Term Structure

Md. Kaysher Hamid

Md. Kaysher Hamid © MKH BUP 2023

 The yields on debt securities are affected:  Credit (Default) Risk

o Tax status fee for assessing default risk.

 Credit (Default) Risk  Credit (Default) Risk

o Credit Rating Agency of Bangladesh Ltd. (https://crab.com.bd/credit-

 Liquidity  Tax Status

 Tax Status  Exercise 01

 Exercise 02  Term to Maturity

Estimating the Appropriate Yield Estimating the Appropriate Yield

where: that Elizabeth Company plans to issue 90-day commercial paper.

Estimating the Appropriate Yield Theories of Term Structure

 Exercise 03 o Pure Expectations Theory

Theories of Term Structure Theories of Term Structure

 Pure Expectations Theory  Pure Expectations Theory

o Term structure reflected in the shape of the yield curve is determined

o An expected increase in rates leads to an upward sloping yield curve

o An expected decrease in rates leads to a downward sloping yield curve.

Theories of Term Structure Theories of Term Structure

 Pure Expectations Theory  Pure Expectations Theory

o If investors were indifferent to maturities, the return of any security

Theories of Term Structure Theories of Term Structure

 Pure Expectations Theory  Liquidity Premium Theory

Theories of Term Structure Theories of Term Structure

 Liquidity Premium Theory  Exercise 04

Theories of Term Structure Theories of Term Structure

 Segmented Markets Theory  Segmented Markets Theory

 If we assume the following conditions:  Forecasting Interest Rates

Use of the Term Structure Exercises

7. Determine how the after-tax yield from investing in a corporate bond is

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