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STRUCTURE OF INTEREST RATES
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The yields on debt securities are afected:
Credit (deault! ris"
#i$uidityTa% status
Ter& to &aturity
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Credit (Default) Risk ' securities ith a hi)herde)ree o deault
ris" ofer hi)her yields*
a.Rating Agencies + Ratin) a)encies char)e the issuerso debt
securities a ee or assessin) deault ris"*(E%hibit ,*1!*
b.Accuracy of Credit Ratings + The ratin)s issued bythe a)encies
are useul indicators o deault ris" butthey are o-inions. not
)uarantees*
c.Oversight of Credit Rating Agencies + The Financial
Reor& Act o /010 established an Oce o CreditRatin)s ithin
the Securities and E%chan)eCo&&ission in order to re)ulate
credit ratin) a)encies*Ratin) a)encies &ust establish internal
controls*
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eault Ris" (chance o not )ettin) your 3 bac" at&aturity!
Financial stren)th o the issuer
4usiness stren)ths o the issuer
Industry outloo"
Ter& to &aturity
Credit A)ency Ratin)
i$uidity (ho easy is it to buy or sell at intrinsic5alues6! Si7e
o the issue (8oat!
9eneral &ar"et conditions
Characteristics o the secondary &ar"et in bonds
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Co&-utin) the E$ui5alent 4eore+Ta% ;ield:
< ater+ta% yield
< beore+ta% yield
< In5estor=s &ar)inal ta% rate
Co&-utin) the E$ui5alent 4eore+Ta% ;ield:
6
)1( T
at
bt
=
)1( Tbtat =
at
bt
T
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Yn= Rf,n+ DP + LP + TA
here:
Yn < yield o an n+day debt security
Rf,n< yield o an n+day Treasury (ris"+ree! security
DP< deault -re&iu& to co&-ensate or credit
ris"
LP < li$uidity -re&iu& to co&-ensate or less
li$uidity
TA < ad>ust&ent due to diference in ta% status
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?ure E%-ectations Theory In5estor @ borroer e%-ectations and
-reerred &aturities Co&-utin) the forward rate(see -a)e
!
#i$uidity ?re&iu& Theory S+T securities ty-ically
&ore marketable that #+T Increase in &ar"etability. ceteris
-aribus. should result in
loer ;TBS
e)&ented Bar"ets Theory In5estor -reerences or certain
&aturities in5est&ent
hori7on Nature o assets and liabilities (&atchin)
-rinci-le!
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Al)ebraic ?resentation:
9
1timeofasdanticipateisthatrateinterestyear-one
at timesecurityyear-oneaofrateinterestannualizedknown
at timesecurityyear-twoaofrateinterestannualizedknown
)1)(1()1(
11
1
2
111
2
2
+=
=
=
++=+
+
+
tF
ti
ti
Fii
t
t
t
ttt
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o&-rehensi5e E%-lanation or Ter&Structure and Sha-e o
the ;ield Cur5eThe yield cur5e has &uch to do ith
in5estore%-ectations about the econo&y*
#enders -reer less ris" and &ore li$uidity*
4orroers -reer lon)er ter&s*
I&-lications o 8at and in5erted yield cur5es
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Nov 14, 2000
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4rie8y describethe implicationso the olloin) theoriesD ?ure
E%-ectations Theory
#i$uidity ?re&iu& Theory
Se)&ented Bar"ets Theory
hat actors doe consider hen in5estin) in bonds6
hy is the nor&alsha-e o the ;ield Cur5e u-ard slo-in) to the
ri)ht6
hat do e &eanby a before-tax equivalent ield and hy is it
i&-ortant6
hat actorsin8uence interest rates6
hat is a forwardrate and hy is it i&-ortant6
o do econo&icconditions afect the ris" -re&iu&6
GHA: 1. . . . 1JInter-retin): a. b. c*
1,
