Tài chính doanh nghiệp - Chapter 3: Structure of interest rates

Chapter 3Structure of Interest RatesFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineCharacteristics of debt securities that cause their yields to varyExplaining actual yield differentialsEstimating the appropriate yieldA closer look at the term structureInternational structure of interest rates2Characteristics of Debt SecuritiesCredit (default) riskSecurities with a higher degree of risk have to offer higher yields to be chosenCredit risk is especially relevant for longer-term securitiesInvestors must consider the creditworthiness of the security issuerCan use bond ratings of rating agenciesThe higher the rating, the lower the perceived credit riskRatings can change over time as economic conditions changeRatings for different bond issues by the same issuer can vary3Characteristics of Debt Securities (cont’d)Credit (default) risk (cont’d)Rating agenciesMoody’s Investor Service and Standard and Poor’s Corporation are the most popularAgencies use different methods to assess the creditworthiness of firms and state governmentsA particular bond issue could have different ratings from each agency, but differences are usually smallFinancial institutions may be required to invest only in investment-grade bonds rated Baa or better by Moody’s and BBB or better by Standard and Poor’s4Characteristics of Debt Securities (cont’d) Ratings Assigned by:Description of SecurityMoody’sStandard and Poor’sHighest qualityAaaAAAHigh qualityAaAAHigh-medium qualityAAMedium qualityBaaBBBMedium-low qualityBaBBLow quality (speculative)BBPoor qualityCaaCCCVery poor qualityCaCCLowest quality (in default)CDDD, D5Characteristics of Debt Securities (cont’d)Credit (default) risk (cont’d)Shifts in credit risk premiumsThe risk premium corresponding to a particular bond rating can chance over timeAccuracy of credit ratingsIn general, credit ratings have served as reasonable indicators of the likelihood of defaultCredit rating agencies do not always detect financial problems of firms6Characteristics of Debt Securities (cont’d)LiquidityLiquid securities can be easily converted to cash without a loss in valueShort-maturity securities with an active secondary market are liquidSecurities with lower liquidity have to offer a higher yield to be preferred7Characteristics of Debt Securities (cont’d)Tax statusInvestors are more concerned with after-tax income than before-tax incomeTaxable securities have to offer a higher before-tax yield to be preferredThe after-tax yield is equal to:8Characteristics of Debt Securities (cont’d)Tax statusComputing the equivalent before-tax yieldThe before-tax yield necessary to match the after-tax yield on a tax-exempt security is:State taxes should be considered along with federal taxes9Computing the Equivalent Before-Tax Yield Assume a firm in the 30 percent tax bracket is aware of a tax-exempt security that pays a yield of 9 percent. To match this after-tax yield, taxable securities (with similar maturity and risk) must offer a before-tax yield of:10Characteristics of Debt Securities (cont’d)Term to maturityThe term structure of interest rates defines the relationship between maturity and annualized yieldSpecial provisionsA call feature allows the issuer of bonds to buy the bonds back before maturityThe yield on callable bonds should be higher than on noncallable bondsA convertibility clause allows investors to convert the bond into a specified number of common stock sharesThe yield on convertible bonds is lower than on nonconvertible bonds 11Explaining Actual Yield DifferentialsYield differentials are often measured in basis points 100 basis points equal 1 percentYield differentials of money market securitiesCommercial paper rates are higher than T-bill ratesEurodollar deposit rates are higher than yields on other money market securitiesMarket forces cause the yields of all securities to move in the same direction12Explaining Actual Yield Differentials (cont’d)Yield differentials of capital market securitiesMunicipal bonds have the lowest before-tax yieldAfter-tax yield is higher than that of Treasury bondsTreasury bonds have the lowest yield No default riskVery liquidInvestors prefer municipal or corporate bonds over Treasury bonds only if the after-tax yield compensates for default risk and lower liquidity13Estimating the Appropriate YieldThe yield on a debt security is based on the risk-free rate with adjustments to capture various characteristics:Maturity is controlled for by matching the maturity of the risk-free security to that of the security of concern14Computing the Appropriate Yield A company wants to issue 180-day commercial paper. Six-month T-bills currently have a yield of 7 percent. Assume that a default risk premium of 0.8 percent, a liquidity premium of 0.1 percent, and a 0.2 percent tax adjustment are necessary to sell the commercial paper to investors. What is the appropriate yield the company should offer on its commercial paper?15A Closer Look at the Term StructurePure expectations theoryPure expectations theory suggests that the shape of the yield curve is determined solely by expectations of future interest ratesAssuming an initially flat yield curve:The yield curve will become upward sloping if interest rates are expected to riseThe yield curve will become downward sloping if interest rates are expected to decline16Sudden Expectation of Higher Interest RatesS1D1i1D2i2S2Market for short-term risk-free debtS2D2i2D1i1S1Market for long-term risk-free debt17Sudden Expectation of Higher Interest Rates (cont’d)Yield CurveYC1YC218Sudden Expectation of Lower Interest RatesS1D1i1D2i2S2Market for long-term risk-free debtS2D2i2D1i1S1Market for short-term risk-free debt19Sudden Expectation of Lower Interest Rates (cont’d)Yield CurveYC1YC220A Closer Look at the Term Structure (cont’d)Pure expectations theory (cont’d)Algebraic presentationThe relationship between interest rates on two-year and one-year securities is:The one-year interest rate in one year (the forward rate) can then be estimated:21Computing the Forward Rate Assume that the annualized two-year interest rate today is 8 percent. Furthermore, one-year securities currently offer an interest rate of 5 percent. What is an estimate of the forward rate?22A Closer Look at the Term Structure (cont’d)Pure expectations theory (cont’d)Algebraic presentation (cont’d)The one-year interest rate in two years (the forward rate) can also be estimated:23Computing the One-Year Interest Rate Two Years from Now Continuing with the previous example, assume that three-year securities currently offer an interest rate of 10 percent. What is an estimate of the one-year interest rate that will prevail two years from now?24A Closer Look at the Term Structure (cont’d)Pure expectations theory (cont’d)Algebraic presentation (cont’d)Future annualized interest rates for periods other than one year can also be computed using the yield curveA one-year investment followed by a two-year investment should offer the same yield as a three-year security:25Computing the Two-Year Interest Rate One Year from Now Continuing with the previous example, what is an estimate of the two-year interest rate that will prevail in one year? 26A Closer Look at the Term Structure (cont’d)Pure expectations theory (cont’d)The theory assumes that forward rates are unbiased estimators of future interest ratesIf forward rates are biased, investors should attempt to capitalize on the discrepancy27A Closer Look at the Term Structure (cont’d)Liquidity premium theoryAccording to the liquidity premium theory, the yield curve changes as the liquidity premium changes over time due to investor preferencesInvestors who prefer short-term securities will hold long-term securities only if compensated with a premiumShort-term securities are typically more liquid than long-term securitiesThe preference for short-term securities places upward pressure on the slope of the yield curve28A Closer Look at the Term Structure (cont’d)Liquidity premium theory (cont’d)Estimation of the forward rate based on a liquidity premiumThe yield on a security will not necessarily be equal to the yield from consecutive investments in shorter-term securities:The relationship between the liquidity premium and the term to maturity is:29A Closer Look at the Term Structure (cont’d)Liquidity premium theory (cont’d)Estimation of the forward rate based on a liquidity premium (cont’d)The one-year forward rate can be derived as:A positive liquidity premium means that the forward rate overestimates the market’s expectations of the future interest rateA flat yield curve means the market is expecting a slight decrease in interest ratesA slight upward slope means no expected change in interest rates30Computing the Forward Rate With A Liquidity Premium Assume that one-year interest rates are currently 10 percent. Further assume that two year interest rates are equal to 8 percent. The liquidity premium on a two-year security is 0.7 percent. What is an estimate of the one-year forward rate?31A Closer Look at the Term Structure (cont’d)Segmented market theoryAccording to segmented markets theory, investors and borrowers choose securities with maturities that satisfy their forecasted cash needsPension funds and life insurance companies prefer long-term investmentsCommercial banks prefer short-term investmentsShifting by investors or borrowers between maturity markets only occurs if the timing of their cash needs change32Impact of Different Scenarios – Segmented Markets TheoryInvestors Have Mostly Short-Term Funds Available; Borrowers Want Long-Term FundsInvestors Have Mostly Long-Term Funds Available; Borrowers Want Short-Term FundsSupply of short-term funds provided by investorsUpward pressureDownward pressureDemand for short-term funds by borrowersDownward pressureUpward pressureYield on new short-term securitiesDownward pressureUpward pressureSupply of long-term funds provided by investorsDownward pressureUpward pressureDemand for long-term funds issued by borrowersUpward pressureDownward pressureYield on long-term securitiesUpward pressureDownward pressureShape of yield curveUpward slopeDownward slope33A Closer Look at the Term Structure (cont’d)Segmented market theory (cont’d)Limitations of the theorySome borrowers and savers have the flexibility to choose among various maturity marketse.g., Corporations may initially obtain short term funds if they expect long-term interest rates to declineIf markets were segmented, an adjustment in the interest rate in one market would have no impact on other markets, but evidence shows this is not true34A Closer Look at the Term Structure (cont’d)Segmented market theory (cont’d)ImplicationsThe preference for particular maturities can affect the prices and yields of securities with different maturities and therefore the shape of the yield curveThe preferred habitat theory is a more flexible perspectiveInvestors and borrowers may wander from their markets given certain events35A Closer Look at the Term Structure (cont’d)Research on term structure theoriesInterest rate expectations have a strong influence on the term structureThe forward rate from the yield curve does not accurately predict future interest ratesVariation in the yield-maturity relationship cannot be explained by interest rate expectations or liquidityGeneral research implicationsSome evidence for pure expectations, liquidity premium, and segmented markets theory36A Closer Look at the Term Structure (cont’d)Uses of the term structureForecast interest ratesPure expectations and liquidity premium theories can be usedForecast recessionsA flat or inverted yield curve may indicate a recession in the near future since lower interest rates are expected37A Closer Look at the Term Structure (cont’d)Uses of the term structure (cont’d)Investment decisionsRiding the yield curve involves investment in higher-yielding long-term securities with short-term fundsFinancial institutions whose liability maturities are different from their asset maturities monitor the yield curveFinancing decisionsAssessing prevailing rates on securities for various maturities allows firms to estimate the rates to be paid on bonds with different maturities38A Closer Look at the Term Structure (cont’d)Impact of debt management on term structureIf the Treasury uses a relatively large proportion of long-term debt, this places upward pressure on long-term yieldsIf the Treasury uses short-term debt, long-term interest rates may be relatively lowHistorical review of the term structureEarly 1980s: downward sloping yield curve1982 to 2001: an upward sloping yield curve generally persistedSeptember 11, 2001: investors shifted funds into short-term securities and the Fed provided funds to the banking system, causing the yield curve to become steeper39International Structure of Interest RatesYield curves vary among countriesInterest rate movements across countries tend to be positively correlatedInterest rates may vary across countries at any particular point in timeSupply and demand conditions across countries cause differences40