Fall 2013 ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

LectureNo. No 06 TermStructureofInterest
Hammad HassanMirza AssistantProfessor(Finance) DepartmentofBusinessAdministration UniversityofSargodha

InterestRates
Aninterestrate isthepricepaidbyaborrowertoa lenderfortheuseofresourcesthatwillbeused duringsometimeperiodthenreturned.
Realrate Riskfreerate Shorttermrate

TheoriesofInterestRates

Fishers Fi h Classical Cl i lApproach A h LoanableFundsTheory KeynesLiquidityPreferenceTheory

Fishers Fisher sClassicalApproach

SupplyofSavings
Marginalrateoftimepreference Income Rewardforsaving

DemandforBorrowedResources
Marginal M i lproductivity d ti it of fcapital it l Rateofinterest

EquilibriumRateofInterest

Fishers Fisher sLaw

NominalRateofInterest(i) RealRateofInterest(r) PremiumforExpected p Inflation(p) FishersLaw (1+i)=(1+r)(1+p) or i=r+p

TheLoanableFundsTheory
DemandforandSupplyofFundsbyFirms, Firms Governments,andHouseholds
Changesinthemoneysupply Governmentdeficits Changesinpreferencesbyhouseholds Newinvestmentopportunitiesforfirms

EquilibriumRateofInterest

TheLiquidityPreferenceTheory
DemandforMoneyBalances
Transactionsdemand Precautionarydemand Speculativedemand

SupplyofMoney Equilibrium ilib i Rate R of fInterest

ChangesintheDemandfor Money andInterestRates

LiquidityEffect
Ifincreasing,causestheinterestratetorise.

IncomeEffect
Ifincreasing,causestheinterestratetorise.

PriceExpectationsEffect
Ifincreasing,causestheinterestratetorise.

NetEffect:
Th Thei interest t trate t mayrise, i fall, f ll orremain i unchangeddependingontheneteffectofchanges indesiredliquidity,income,andpriceexpectations.

FeaturesofaBond

TimetoMaturity PrincipalorParValue Coupon p Interest YieldtoMaturity(YTM) IfYTM=couponrate,marketprice=parvalue IfYTM>couponrate,marketprice<parvalue IfYTM<couponrate,marketprice>parvalue

Determinants oftheStructureof InterestRates

TheBaseInterestRate RiskPremiumsAreDeterminedBy:
IssuerType Creditrisk Termtomaturity Embeddedoptions p Taxabilityofinterest Liquidity

TypesofIssuers
TreasuryMarketSector CorporateMarketSector
Utilities Industrials Finance B k Banks

IntermarketandintramarketSector

DefaultorCreditRisk
RatingCompanies
Moodys,S&P,Fitch

CreditRatings g
Investmentgrade Noninvestmentgrade

Credit C di Spread S d

TermtoMaturity
Thevolatilityofabond bonds spriceisinfluencedbyits maturity. Thelongerthematurityofabond,thegreaterits pricesensitivitytoachangeinmarketyields. Maturityspreadoryieldcurvespread

EmbeddedOptions
Calloption
benefitsissuer increasesrequiredreturnonTreasuries

Conversionoption
benefitsbondholder reduces d required dreturnonbonds b d

Prepaymentoption
Benefitsissuer Increasesrequiredreturnonmortgagebacked securities

TaxTreatment

Yieldontaxablebond Aftertaxyield=Pretaxyieldx(1 Marginaltax rate) Equivalenttaxableyield Taxableyield=Taxexemptyield/(1 Marginaltax rate)

Liquidity
Thegreatertheexpectedliquidityofasecurityissue, issue thelowertherequiredyield. Thesizeoftheissueisanimportantfactorthat affectsitsliquidity.

Session II

TheYieldCurve
Relationshipbetweenyieldandmaturityforbondsof thesamecreditqualitybutdifferentmaturities. Yieldcurveshapes
Normal N l Inverted Flat Humped

 Any yfinancialassetcanbeviewedasapackage p g ofzero couponinstruments.

UsingtheYieldCurvetoPricea Bond

Maturityofaninstrumentisthecouponpaymentdateor maturitydate. date Valueoftheassetequalsthetotalvalueofthecomponent zerocouponinstruments.

SpotRate
Rateonzerocouponbond

TheoreticalSpotRateCurve
Theprocessofcreatingayieldcurvebasedon theoreticalspotratesiscalledbootstrapping. Thetheoreticalvalueofabondisequaltothepresent valueofitsperiodiccashflowsdiscountedatthe correspondingtheoreticalspotrateforeachperiod.

ForwardRates
Markets Market sConsensusPredictionofFutureInterest Rates
Theimpliedforwardrateiscalculatedfromeitherthe spotratesoryieldcurve. Theyieldcurvecanbeusedtocalculatetheimplied forwardrateforany yinvestmenthorizonorany ysub periodwithinthathorizon.

RelationshipBetweenSpotRatesandShort T Term F Forward dR Rates t

Therelationshipbetweenthespotrateonan instrumentmaturinginsixmonths(thecurrentsix month thspot trate), t ) and dthe th implied i li dmonthly thl forward f d ratesforthenextsixmonthsis:

zt = [(1 + z1 )(1 + f1 )(1 + f 2 )(1 + f 3 )...(1 + f t 1 )] 1

1/ t

ForwardRateasaHedgeable Rate
Forwardratesdonot predictfutureinterestrates. rates Forwardratesdoindicatehow aninvestors expectationsmustdifferfromthemarketconsensus inordertomakethecorrectdecision.

DeterminantsoftheShapeofthe TermStructure
(Pure)ExpectationsTheory LiquidityTheory PreferredHabitatTheory MarketSegmentationTheory

PureExpectationsTheory
Yieldsonbondswithdifferentmaturitiesarebased onlyonexpectationsoffutureshorttermrates. Termstructuremightbenormal,inverted,humped, orflat. flat Ignorespriceriskandreinvestmentrisk. Interpretations p includebroad,localandreturnto maturity.

LiquidityTheory
Yieldsonbondswithdifferentmaturitiesare basedonlyonexpectedfutureratesplusa liquiditypremiumthatincreaseswith maturity. Termstructuremightbenormalorflat. Presupposes P th that tall lll lenders d want tto t l lend d shorttermandallborrowerswanttoborrow long o gterm. Inreality,therearelendersforshortandlong termsandborrowersforshortandlong

PreferredHabitatTheory
Yieldsonbondswithdifferentmaturitiesare basedonlyondemandandsupplyateach maturity. Termstructuremightbenormal,inverted, humped,orflat. Issuers I and db buyersof fb bonds d h havematurity t it preferencesbutwillshifttoothermaturitiesif thep priceso oryields y areattractiveenough. o g Yieldsarecompletelyunrelatedto expectationsoffuturerates.

MarketSegmentationTheory
Yieldsonbondswithdifferentmaturitiesare basedonlyondemandandsupplyateach maturity. Termstructuremightbenormal,inverted, humped,orflat. Issuers I and db buyersof fb bonds d h havematurity t it preferencesandwillnotshifttoanother maturity ybecauseeachmaturity yisaseparate p market. Yieldsarecompletelyunrelatedto ff

ThankYou!