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1、Money and Capital Markets7 7C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill / IrwinSlides by Yee-Tien (Ted) FuThe Impact of Inflation & Deflation, The Impact of Inflation & Deflation, Yield Curves, and Duration on Yield Curves, and Du
2、ration on Interest Rates and Asset PricesInterest Rates and Asset Prices 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 2Money and Capital Markets8 8C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill /
3、 IrwinSlides by Yee-Tien (Ted) FuMarketability, Default Risk, Call Marketability, Default Risk, Call Privileges, Prepayment Risk, Taxes, and Privileges, Prepayment Risk, Taxes, and Other Factors Affecting Interest RatesOther Factors Affecting Interest Rates 2003 by The McGraw-Hill Companies, Inc. Al
4、l rights reserved.McGraw Hill / Irwin7 - 3 Learning Objectives wTo see the effects of the marketability, default risk, liquidity, call privileges, prepayment risk, convertibility and taxability of various loans and securities upon their interest rates.wTo understand why there are so many different i
5、nterest rates within the global economy.wTo learn how the “structure of interest rates” is built and why it changes constantly. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 4 Learning Objectives wTo appreciate the difficulties of forecasting interest rates and f
6、inancial asset prices accurately. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 5IntroductionwIn the preceding chapter, we examined how expected inflation and security maturity affect interest rates.wIn this chapter, we will look at how some other factors influen
7、ce interest rates: marketability, default risk, call privileges, taxation of security income, prepayment risk, and convertibility. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 6Marketability and LiquiditywMarketability Can an asset be sold quickly?wMarketability
8、 is positively related to the size and reputation of the institution issuing the securities and to the number of similar securities outstanding. However, marketability is negatively related to yield.wLiquidity A liquid financial asset is readily marketable. Moreover, its price tends to be stable and
9、 reversible. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 7Default RiskwDefault risk The risk that a borrower will not make all the promised payments at the agreed-upon times. wPromised yield on a risky asset= risk-free interest rate + default risk premiumwExpec
10、ted yield on a risky asset = S piyipi = probability that the ith possible yield, yi, occurswAnticipated default loss on a risky asset= promised yield expected yield 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 8Default RiskSource: Economic Trends, Federal Reserv
11、e Bank of Cleveland, July 2001 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 9Default RiskFactors Influencing Default Risk PremiumswCredit ratings by rating companies such as Moodys and Standard & PoorsHighly-rated securities are perceived as having negligible de
12、fault risk.wFluctuations (cycles) in business activityThe yield spread between Aaa- and Baa-rated securities increases during economic recessions. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 10Default RiskAverage Yields (% per annum)Baa Corporate BondsAaa Corpo
13、rate Bonds10-year Treasury Bonds30-yearTreasuryBondsData Source: Board of Governors of the Federal Reserve System 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 11Default RiskwFor corporate securities, the period of time the firm has been in operation, variability
14、 in company earnings, and the amount of leverage employedwInflationDefault risk premiums tend to be higher and more volatile when inflation is high and volatile.Factors Influencing Default Risk Premiums 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 12Default Risk
15、The Junk-Bond Spread and the EconomywJunk bond spread =junk bond yields Aaa corporate bond yieldswA rise in the junk bond spread indicates a growing fear among bond market investors that marginal-quality corporate borrowers are more likely to default on their debts (i.e. a weakening economy). 2003 b
16、y The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 13Default RiskNew Ways of Dealing with Default RiskwCredit derivatives are financial contracts that seek to protect lenders against default risk by shifting that risk to someone else willing to accept it for a fee.wIn a cre
17、dit swap, two or more lenders agree to exchange a portion of their expected payments.wA credit option may enable the lender to be reimbursed if a credit asset begins to lose value. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 14Call PrivilegeswA call privilege o
18、n a bond contract grants the borrower the option to retire all or a portion of a bond issue by buying back the securities in advance of maturity at a specified call price.wA bond may be callable immediately, or the privilege may be deferred for a specified period of time. 2003 by The McGraw-Hill Com
19、panies, Inc. All rights reserved.McGraw Hill / Irwin7 - 15Call PrivilegesAdvantages and DisadvantageswThe call option is an advantage to the security issuer because it grants greater financial flexibility and the potential for reducing future interest costs.wHowever, it is a disadvantage to the secu
20、rity buyer. The holding-period yield may decline if the security is called, and the potential for capital gains is limited. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 16Call PrivilegesThe Call PremiumwIssuers of callable securities must pay a call premium in t
21、he form of a higher interest rate.wThe call premium is higher ifthe market expects interest rates to fall (such that the call risk is higher),the call deferment period is shorter, andthe call price is lower. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 17Prepaym
22、ent Risk on Loan-Backed SecuritieswPrepayment risk is the risk that the purchaser may receive higher-than-expected repayments of principal early in the life of loan-backed securities.wPrepayment risk is especially valid for the investors in securities that are backed by home mortgage loans, as many
23、home loans will be retired early due to loan refinancing and home-owner turnover. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 18Prepayment Risk on Loan-Backed SecuritieswSince prepayments may lower the investors return, loan-backed securities with greater prepa
24、yment risks are priced lower. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 19Taxation of Security ReturnswTaxes imposed by the federal, state, and local governments can have a profound effect on the returns earned by investors on financial assets.wThus, governme
25、nts can use their taxing power to encourage the investment in certain financial assets, thereby redirecting the flow of savings and investment toward areas of critical social need. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 20Taxation of Security ReturnswIn pa
26、rticular, governments mayvary the income brackets and tax ratestie the applicable tax rates to the length of time that securities were heldgrant certain amounts of tax exemptions for various categoriesenable the deduction of capital losses (up to specified limits)change the permissible annual contri
27、butions to educational or retirement accounts 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 21Taxation of Security ReturnsA Brief History of Marginal Income Tax RatesSource: Economic Trends, Federal Reserve Bank of Cleveland, January 2002 2003 by The McGraw-Hill
28、Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 22Taxation of Security ReturnswTax-exempt securities represent a subsidy to induce investors to support local governments.wThe exemption privilege shifts the burden of federal taxation from buyers of municipal bonds to other taxpayers.wHowev
29、er, the privilege lowers the interest rates at which municipals can be sold in the open market relative to comparable taxable bonds. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 23Taxation of Security ReturnswAfter-tax yield = (1 t ) Before-tax yieldwhere t is t
30、he investors marginal tax ratewAn investor will be indifferent between taxable and tax-exempt securities whenTax-exempt yield = (1 t ) Taxable yieldwTo make valid comparisons between taxable and tax-exempt issues, the taxed investor should convert all expected yields to an after-tax basis. 2003 by T
31、he McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 24Convertible SecuritieswConvertible (or hybrid) securities are special issues of corporate bonds or preferred stock that can be exchanged for a specific number of shares of the issuing firms common stock.wConvertibles offer t
32、he investor the prospect of a stable interest or dividend income, as well as capital gains on common stock on conversion.wHence, investors are generally willing to pay a premium for convertibles. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 25Convertible Securit
33、ieswNote that the issuer may call in the securities early, forcing conversion. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 26The Structure of Interest RateswThe risk-free interest rate underlies all interest rates and is a component of all rates.wAll other inte
34、rest rates are scaled upward by varying degrees from the risk-free rate, depending on such factors as inflation, the term (maturity) of a loan, the risk of borrower default, the risk of prepayment, and the marketability, liquidity, convertibility, and tax status of the securities to which those rate
35、s apply. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 27The Structure of Interest RatesAn ExampleDuring the month of January 2002 The long-term U.S. Treasury bond rate averaged 5.75%The corporate Baa bond rate averaged 7.60%while+ 1.85% =Real risk-free rate+3.00
36、%Expected inflation+2.00%Liquidity premium +0.75% Total= 5.75%Premiums for: marketability+0.35%Call risk +0.25%Default risk+1.25% Total= 1.85% 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 28Money and Capital Markets in CyberspacewThe world wide web addresses a n
37、umber of the foregoing issues at a variety of websites:http:/www.gac.edu/elvis/EM42/Chapter7http:/www.taxpolicycenter.org/ http:/www.federalreserve.gov/releases/http:/www.clev.frb.org/research/ 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 29Chapter ReviewwIntrod
38、uctionwMarketability and LiquiditywDefault RiskThe Premium for Default RiskThe Expected Rate of Return on a Risky AssetAnticipated Default LossFactors Influencing Default Risk PremiumsThe Junk-Bond Spread and the EconomyNew Ways of Dealing with Default Risk 2003 by The McGraw-Hill Companies, Inc. Al
39、l rights reserved.McGraw Hill / Irwin7 - 30Chapter ReviewwCall PrivilegesAdvantages and DisadvantagesThe Call PremiumwPrepayment Risk on Loan-Backed SecuritieswTaxation of Security ReturnsComparing Taxable and Tax-Exempt SecuritieswConvertible SecuritieswThe Structure of Interest Rates 2003 by The M
40、cGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 31 Learning Objectives wTo learn what inflation is and how it can impact interest rates and asset prices.wTo understand the greater concern today over deflation and how deflation may affect the economy and financial system.wTo see
41、 how yield curves arise and explore the ideas about what determines the shape of the yield curve at any point in time. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 32 Learning Objectives wTo discover how yield curves can be a useful tool for those interested in
42、investing their money and in tracking the health of the economy.wTo look at the concept of duration and see how it can assist in the making of investment choices and in protecting against the risk of changing interest rates. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / I
43、rwin7 - 33Inflation and Interest RateswInflation refers to the rise in the average level of prices for all goods and services.7 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 34Inflation and Interest RateswIn recent years, the U.S. inflation and interest rates app
44、ear to be fairly strongly correlated.19601.7%1.4%3.2%19705.75.36.5198013.59.211.419905.43.97.520003.42.35.920012.82.23.3YearRate of Inflation (% D D)CPI GDP Deflator6-month T-bill Rate(secondary market) 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 35Inflation an
45、d Interest RatesNominal and Real Interest RateswIn general, lenders will attempt to charge nominal rates of interest that give them their desired real rates of return on their loanable funds based upon their expectations regarding inflation.nominal rate = published or quoted ratereal rate = rate mea
46、sured in terms of the actual purchasing power 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 36Inflation and Interest RatesThe Fisher EffectwIn a 1896 classic article, economist Irving Fisher argued thatexpected nominal interest rate = expected real rate + inflati
47、on premium + (expected real rate inflation premium) expected real rate + inflation premiumThe inflation premium measures the rate of inflation expected by investors in the marketplace during the life of a particular financial instrument. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.Mc
48、Graw Hill / Irwin7 - 37Inflation and Interest RatesThe Harrod-Keynes Effect of InflationwBuilding upon the Keynesian liquidity preference theory, Harrod argued that unless inflation affects money demand or supply, the expected nominal interest rate must be the same regardless of inflationary expecta
49、tions.wSo, a rise in inflationary expectations will lower the real rate of interest. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 38Inflation and Interest RateswThe simple Fisher effect was the majority view for decades until problems began to surface:Partial an
50、ticipation of inflationInflation-caused wealth effectInflation-caused income effectInflation-caused depreciation effectInflation-caused income tax effect 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 39Inflation and Interest RateswThe bulk of recent research sugg
51、ests that nominal rates rise by less than any given increase in the expected inflation rate and decline by less than any given decrease in the expected inflation rate.wHowever, note that the topic of inflation and interest rates is plagued by numerous measurement problems. 2003 by The McGraw-Hill Co
52、mpanies, Inc. All rights reserved.McGraw Hill / Irwin7 - 40Inflation and Interest RatesImpact of Price DeflationwThere is growing concern that deflation a fall in the average level of prices may soon replace inflation as one of the key problems that nations may face in the future.wPast experiences i
53、ndicate that price deflation can result in lower output (production) of goods and services, and force real interest rates upward. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 41Inflation and Interest RatesInflation and Stock PriceswCommon stock is widely viewed
54、as a hedge against inflation.wHowever, research evidence seem to support the view that the impact of inflation on stock prices varies from firm to firm and from industry to industry depending on the actual rate of inflation and the terms of existing nominal contracts. 2003 by The McGraw-Hill Compani
55、es, Inc. All rights reserved.McGraw Hill / Irwin7 - 42Inflation-Adjusted SecuritieswThe U.S. Treasury offers TIPS (Treasury Inflation Protected Securities) and “I bonds” for investors who want some protection against inflation.wAnnual nominal interest payment from a TIPS = inflation-adjusted promise
56、d nominal value coupon ratewWhen the public expects higher inflation, inflation-adjusted securities rise in value. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 43Inflation-Adjusted SecuritiesSource: Economic Trends, Federal Reserve Bank of Cleveland, June & July
57、 2001 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 44The Maturity of a LoanwOne important factor causing interest rates to differ from one another is differences in the maturity (or term) of securities and loans.wThe relationship between the rates of return on f
58、inancial instruments and their maturity is called the term structure of interest rates.wThis term structure may be represented visually by drawing a yield curve for all securities having the same credit quality. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 45Sou
59、rce: Economic Trends, Federal Reserve Bank of Cleveland, June 2001The Maturity of a LoanwYield curves may be upward sloping, downward sloping, or horizontal (flat). 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 46The Maturity of a LoanwThe unbiased expectations h
60、ypothesis argues that investor expectations regarding future changes in short-term interest rates determine the shape of the curve.wThus, changes in the relative amounts of long-term and short-term securities will not affect the shape of the yield curve unless investor expectations are also affected
61、. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 47The Maturity of a LoanwThe liquidity premium view of the yield curve suggests that there is a bias toward positively-sloped yield curves.wLonger-term securities tend to have more volatile market prices and hence,
62、greater risk of capital loss.wSo, investors must be paid an interest rate premium (the liquidity premium) to encourage them to purchase long-term securities. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 48The Maturity of a LoanwThe market segmentation argument o
63、f the yield curve separates the financial markets into several distinct markets according to the maturity preferences of the investors.wThe implication is that governments can alter the shape of the yield curve by shifting the available supplies of securities relative to the demand for those securit
64、ies in each distinct market. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 49The Maturity of a LoanwThe preferred habitat or composite theory of the yield curve argues that investors seek out their preferred habitat they choose securities that match their risk pr
65、eferences, tax exposure, liquidity needs, regulatory requirements, and planned holding periods.wAn investor will not normally stray from his or her preferred habitat unless the rates of return on some other securities are high enough to overcome his or her preferences. 2003 by The McGraw-Hill Compan
66、ies, Inc. All rights reserved.McGraw Hill / Irwin7 - 50The Maturity of a LoanwEmpirical studies on the various yield curve theories have produced mixed results.wAs such, the traditional models are giving way today to newer models that are being created in response to recent theoretical developments
67、in particular, the Black-Scholes option pricing formula and the rational expectations theory. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 51The Maturity of a LoanwThe yield curve is a useful tool for forecasting interest rates a downward-sloping yield curve sug
68、gests near-term declines in ratesidentifying portfolio management strategies a rising yield curve favors short-term borrowing and long-term lendingdetecting overpriced and underpriced securitiesindicating trade-offs between maturity and yield“riding” the yield curve active investors may gain by time
69、ly portfolio switching 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 52Duration: A Different Approach to MaturitywA popular measure of how responsive a debt securitys price is to changes in interest rates is its price elasticity (E).wGreater price elasticity mean
70、s that an asset goes through a greater price change for a given change in market rates of interest.% D D in a securitys priceover time% D D in a securitys yieldover time 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 53Duration: A Different Approach to MaturitywLo
71、nger-term debt securities generally have a larger price elasticity than shorter-term securities.wDebt securities with lower coupon rates also tend to have a larger price elasticity than those with higher coupon rates, since a greater proportion of the lower-coupon securitys total return lies in the
72、final payment at maturity. This is called the coupon effect. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 54Duration: A Different Approach to MaturitywTo enable financial analysts to construct a linear relationship between maturity and security price elasticity,
73、 regardless of differing coupon rates, a maturity measure called duration (D) was introduced. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 55Duration: A Different Approach to MaturitywDuration is thus a weighted average of the time required for the investor to r
74、eceive the promised payments. The weights are the present values of those payments.Ct= the expected principal/interest payment in time period ty = the securitys yield to maturity, with maturity reached at theend of n periods 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / I
75、rwin7 - 56Duration: A Different Approach to MaturitywThe relationship between an assets change in market price and its change in yield or interest rate is called convexity.wResearch shows that convexity increases with an assets duration.wMoreover, an assets change in price is greater at lower market
76、 interest rates than it is at higher market interest rates in general. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 57Duration: A Different Approach to MaturityUses of DurationwEstimating asset price changes % D in asset price wPortfolio immunization against int
77、erest rate changes This can be achieved by acquiring a portfolio of assets whose average duration equals the length of the investors desired holding period. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 58Duration: A Different Approach to MaturityLimitations of D
78、urationwIn practice, it is often difficult to find a group of assets with a certain average duration.wAs time passes, constant adjustments are also needed to ensure that the average duration decreases at the same pace.wThere is some risk associated with the use of conventional measures of duration d
79、ue to uncertain future interest rate movements. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 59Money and Capital Markets in CyberspacewWebsites that discuss the impact of inflation on interest rates include:http:/ more on yield curves, visit:http:/www.mathematic
80、al- 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 60Chapter ReviewwInflation and Interest RatesCorrelation between Inflation and Interest RatesNominal and Real Interest RatesThe Fisher EffectThe Harrod-Keynes Effect of InflationAlternative Views on Inflation and
81、Interest RatesImpact of Price DeflationInflation and Stock PriceswInflation-Adjusted Securities 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 61Chapter ReviewwThe Maturity of a LoanThe Yield Curve and the Term Structure of Interest RatesTypes of Yield CurvesThe U
82、nbiased Expectations HypothesisThe Liquidity Premium View of the Yield CurveThe Segmented-Markets ArgumentThe Preferred Habitat or Composite TheoryResearch Evidence on Yield-Curve TheoriesUses of the Yield Curve 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin7 - 62Chapter ReviewwDuration: A Different Approach to MaturityThe Price Elasticity of a Debt SecurityThe Impact of Varying Coupon RatesAn Alternative Maturity Index for a Security: DurationThe Convexity FactorUses of DurationLimitations of Duration
