Chapter

9

Interest Rates

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives

It will be worth your time to increase your rate of interest in these topics:

1. Money market prices and rates.

2. Rates and yields on fixed-income securities.

3. Treasury STRIPS and the term structure of interest rates.

4. Nominal versus real interest rates.

9-2

Interest Rates

• Our goal in this chapter is to discuss the many different interest rates that are commonly reported in the financial press.

• We will also: – Find out how different interest rates are calculated and quoted, and – Discuss theories of what determines interest rates.

9-3

U.S. Interest Rate History, 1800-2007

9-4

Money Market Interest Rates

9-5

Money Market Rates, I.

• • • •

Prime rate

- The basic interest rate on short-term loans that the largest commercial banks charge to their most creditworthy corporate customers.

Discount rate

- The interest rate that the Fed offers to commercial banks for overnight reserve loans.

Federal funds rate

- Interest rate that banks charge each other for overnight loans of $1 million or more.

Banker’s acceptance

- A postdated check on which a bank has guaranteed payment. Commonly used to finance international trade transactions.

• •

Call money rate

from banks. This rate is used as the basis for customer rates on margin loans.

- The interest rate brokerage firms pay for call money loans

Commercial paper

corporations.

- Short-term, unsecured debt issued by the largest 9-6

Money Market Rates, II.

• • •

U.S. Treasury bill (T-bill)

- A short-term U.S. government debt instrument issued by the U.S. Treasury.

London Interbank Offered Rate (LIBOR)

- Interest rate that international banks charge one another for overnight Eurodollar loans.

Euro LIBOR

refers to deposits denominated in euros —the common currency of 12 European Union countries.

•

EURIBOR

is an interest rate that also refers to deposits denominated in euros. However, EURIBOR is based largely on interest rates from the interbank market for banks in the European Union.

•

HIBOR

is an interest rate based on Hong Kong dollars. Hibor is the interest rate among banks in the Hong Kong interbank market.

•

Eurodollars

States. - U.S. dollar denominated deposits in banks outside the United 9-7

Money Market Prices and Rates

• A

Pure Discount Security

is an interest-bearing asset: – It makes a

single payment

of face value

at maturity

.

– It makes

no payments before maturity

.

•

There are several different ways market participants quote interest rates.

– Bank Discount Basis – Bond Equivalent Yields (BEY) – Annual Percentage Rates (APR) – Effective Annual Rates (EAR) 9-8

The Bank Discount Basis

• The

Bank Discount Basis

is a method of quoting interest rates on money market instruments. – It is commonly used for T-bills and banker’s acceptances.

• The formula is: Current Price  Face Value x  1 Days to Maturity x Discount Yield 360 – Note that we use 360 days in a year in this (and many other) money market formula.

– The term “discount yield” here simply refers to the quoted interest rate.

9-9

Example: Calculating a Price Using a Bank Discount Rate • Suppose a banker’s acceptance that will be paid is 90 days has a face value of $1,000,000.

• If the discount yield is 5%, what is the current price of the banker’s acceptance?

Current Price  Face Value  1  Days to maturity 360  Discount yield  $1,000,000    1  90 360  0.05

 $1,000,000   1 0.0125

  $987,500.

9-10

Treasury Bill Quotes online at www.wsj.com

9-11

Treasury Bill Prices, September 21, 2007 • Figure 9.3 shows a T-bill that expires December 13, 2007.

– It has 83 days to maturity.

– The bid discount is 3.64 (you use this to calculate the bid price, i.e., the price you will receive for the T-bill).

– Prices are quoted for $1,000,000 face values.

Current T bill Price  Face Value    1  Days to maturity 360  Discount yield    $1,000,000    1  83 360  0.0364

   $1,000,000   1 0.00839222

  $991,607.7

8

Verify that the ask price is $991,630.83

9-12

Bond Equivalent Yields

• Bond Equivalent Yields (BEY) are another way to quote an interest rate.

• You can convert a bank discount yield to a bond equivalent yield using this formula: BEY  365 x discount 360  days to maturity x yield discount yield

Note that this formula is correct only for maturities of six months or less. Moreover, if February 29 occurs within the next 12 months, use 366 days.

9-13

Example I: Bond Equivalent Yield

• Figure 9.3 shows a T-bill that expires December 13, 2007.

– It has 83 days to maturity.

– The

bid

discount is 3.64.

– What is the Bond Equivalent (bid) Yield?

BEY  365 x Discount 360  Days to maturity x yield Discount yield BEY  365  0.0364

360  83  0.0364

 0.037218, or about 3.72%.

Remember to multiply before you subtract.

9-14

Example II: Calculating T-bill Prices Using Bond Equivalent Yield • We can calculate a Treasury bill asking price using the “asked” yield, which is a bond equivalent yield.

• Look at Figure 9.3 for the T-bill that expires on December 13, 2007.

– It has 83 days to maturity.

– The ask yield is 3.63.

Bill Ask Price  1  Bond Equivalend Face Value Yield  Days to Maturity / 365  1  $1,000,000 0.0371

 83/365  $1,000,000 1.00843644

 $991,634.1

4.

Note: The bill’s ask price differs from a previous slide by about $4 due to rounding of the reported asked yield. It’s really 3.7115% (verify using the BEY formula)

9-15

More Ways to Quote Interest Rates

•

“Simple” interest basis

- Another method to quote interest rates. – Calculated just like

annual percentage rates (APRs).

– Used for CDs.

– The bond equivalent yield on a T-bill with less than six months to maturity is also an APR.

• An APR understates the

true

interest rate, which is usually called the

effective annual rate (EAR) .

9-16

Example: The BEY on a T-bill is Really Just an APR • Earlier, using the bid discount rate, we calculated a bid price for an 83-day T-bill to be $991,607.78.

– At maturity, this T-bill will be worth $1,000,000.

– You will earn $8,392.22 of interest on an investment of $991,607.78 over 83 days, a return of 0.846325%.

– In a 365-day year, there are 365/83 = 4.3976 periods of 83 days in length.

– 0.846325 times 4.3976 is 3.7218%. • This is the bond equivalent (bid) yield that we calculated before (that we rounded to 3.72%).

Note: The Wall Street Journal rounds ask yields 2 decimal places.

9-17

Converting APRs to EARs

• In general, if we let

m

be the number of periods in a year, an APR can be converted to an EAR as follows: 1  EAR  APR m m • EARs are sometimes called effective annual yields, effective yields, or annualized yields.

9-18

Example I: What is the EAR of this T bill’s BEY (aka APR)?

1  EAR   1 APR m m 1  EAR   1 0.037218

4.3976

4.3976

 1.00846325

4.3976

 1.037757

so, the EAR  3.7757%.

Note that when interest rates are low, the APR will be close to the EAR.

9-19

Example II: Converting Credit Card APRs to EARs • Some Credit Cards quote an APR of 18%.

– 18% is used because 18 = 12 times 1.50

– That is, the monthly rate is really 1.50%.

– What is the EAR?

1  EAR  APR m m 1  EAR     0.18

12 12  1.015

12  1.1956

so, the EAR  19.56%.

Ouch.

9-20

Using Excel to Calculate T-bill Prices and Yields

Treasury Bill Price and Yield Calculations

A Treasury bill traded on February 23, 2007 pays $100 on May 15, 2007. Assuming a discount rate of 3.55 percent, what are its price and bond equivalent yield?

Hint: Use the Excel functions TBILLPRICE and TBILLEQ.

$99.2013 =TBILLPRICE("2/23/2007","5/15/2007",0.0355) 3.628% =TBILLEQ("2/23/2007","5/15/2007",0.0355) What is the effective annual rate (EAR) on this T-bill?

Hint: Use the Excel function EFFECT.

3.689% =EFFECT(B10,12) 9-21

Rates and Yields on Fixed-Income Securities

• Fixed-income securities include

long-term

wide variety of issuers: debt contracts from a – The U.S. government, – Real estate purchases (mortgage debt), – Corporations, and – Municipal governments • When issued, fixed-income securities have a maturity of greater than one year.

• When issued, money market securities have a maturity of less than one year.

9-22

The Treasury Yield Curve

• The

Treasury yield curve

is a plot of Treasury yields against maturities.

• It is fundamental to bond market analysis, because it represents the interest rates for default-free lending across the maturity spectrum.

9-23

Example: The Treasury Yield Curve

9-24

The Term Structure of Interest Rates, I.

• The

term structure of interest rates

is the relationship between time to maturity and the interest rates for default-free,

pure discount

instruments.

• The term structure is sometimes called the “

zero-coupon yield curve

” to distinguish it from the Treasury yield curve, which is based on coupon bonds.

9-25

The Term Structure of Interest Rates, II.

• The term structure can be seen by examining yields on U.S. Treasury STRIPS.

• STRIPS are pure discount instruments created by “stripping” the coupons and principal payments of U.S. Treasury notes and bonds into separate parts,which are then sold separately.

• The term STRIPS stands for Separate Trading of Registered Interest and Principal of Securities.

9-26

U.S. Treasury STRIPS

• An asked yield for a U.S. Treasury STRIP is an APR, calculated as two times the true semiannual rate.

• Recall: Present value  Future  1  r value  N • Therefore, for STRIPS: STRIPS Price   1 Face  Value YTM 2  2M

M is the number of years to maturity.

9-27

U.S. Treasury STRIPS

9-28

Example: Pricing U.S. Treasury STRIPS, I.

• Let’s verify the price of the August 2017 Strip.

– The ask quote is 62.162, or $62.162.

– The ask YTM is 4.86%.

– Matures in about 10 years from the time of the quote.

STRIPS Price   1 Face  Value YTM 2  2M   1  100 0.0486

2  2  10   1  100 0.0486

2  2  10  100 1.61638

 $61.867.

– Close (considering the two-decimal rounding of the ask YTM).

9-29

Example: Pricing U.S. Treasury STRIPS, II.

• Let’s calculate the YTM from the quoted price.

YTM  2        Face Value STRIPS Price 1   2M  1      2       100 62.162

1 2  10  1      2    1.6087

 0.05

 1   0.0481, or 4.81%.

• Close again (reported ask YTM was 4.86%--using the actual days to maturity. We used “about 10 years.”).

9-30

Nominal versus Real Interest Rates

•

Nominal interest rates

are interest rates as they are observed and quoted, with no adjustment for inflation.

•

Real interest rates

are adjusted for inflation effects.

Real interest rate = nominal interest rate – inflation rate

9-31

Real T-bill Rates

9-32

Nominal versus Real Interest Rates

• The

Fisher Hypothesis

asserts that the general level of nominal interest rates follows the general level of inflation.

• According to the Fisher hypothesis, interest rates are, on average, higher than the rate of inflation.

9-33

Inflation Rates and T-bill Rates

9-34

Inflation-Indexed Treasury Securities, I.

• Recently, the U.S. Treasury has issued securities that guarantee a fixed rate of return in excess of realized inflation rates. • These inflation-indexed Treasury securities: – pay a fixed coupon rate on their

current

principal –

adjust

their principal semiannually according to the most recent inflation rate • Example: Suppose an inflation-indexed note is issued with a coupon rate of 3.5% and an initial principal of $1,000. – Six months later, the note will pay a coupon of $1,000 × (3.5%/2) = $17.50. – Assuming 2 percent inflation over the six months since issuance, the note’s principal is then increased to $1,000 × 102% = $1,020. – Six months later, the note pays $1,020 × (3.5%/2) = $17.85

– Its principal is again adjusted to compensate for recent inflation.

9-35

Inflation-Indexed Treasury Securities, II.

9-36

Traditional Theories of the Term Structure

•

Expectations Theory :

The term structure of interest rates reflects financial market beliefs about future interest rates.

•

Market Segmentation Theory :

Debt markets are segmented by maturity, so interest rates for various maturities are determined separately in each segment.

•

Maturity Preference Theory :

Long-term interest rates contain a maturity premium necessary to induce lenders into making longer term loans.

9-37

Problems with Traditional Theories

•

Expectations Theory

– The term structure is almost always upward sloping, but interest rates have not always risen.

– It is often the case that the term structure turns down at very long maturities.

•

Maturity Preference Theory

– The U.S. government borrows much more heavily short-term than long-term.

– Many of the biggest buyers of fixed-income securities, such as pension funds, have a strong preference for long maturities.

9-38

Problems with Traditional Theories

•

Market Segmentation Theory

– The U.S. government borrows at all maturities.

– Many institutional investors, such as mutual funds, are more than willing to move maturities to obtain more favorable rates.

– There are bond trading operations that exist just to exploit perceived premiums, even very small ones.

9-39

Modern Term Structure Theory, I.

• Long-term bond prices are much more sensitive to interest rate changes than short-term bonds. This is called

interest rate risk

.

• So, the modern view of the term structure suggests that: NI = RI + IP + RP • In this equation: NI = Nominal interest rate RI = Real interest rate IP = Inflation premium RP = Interest rate risk premium 9-40

Modern Term Structure Theory, II.

9-41

Modern Term Structure Theory, III.

• The previous equation showed the component of interest rates on default-free bonds that trade in a liquid market.

• Not all bonds do.

• Therefore, a

liquidity premium (LP)

and a

default premium (DP)

must be added to the previous equation: NI = RI + IP + RP + LP + DP 9-42

Useful Internet Sites

• • • • • • • • • • www.money-rates.com

www.gmacfs.com

(for the latest money market rates) (the General Motors Acceptance Corp.) www.bba.org.uk

www.sifma.org

(learn more about LIBOR) (information on fixed income securities) www.bloomberg.com

(current U.S. Treasury rates) www.smartmoney.com/bonds (view a “living yield curve”) www.fanniemae.com

(one of three mortgage security websites) www.ginniemae.gov

(one of three mortgage security websites) www.freddiemac.com

(one of three mortgage security websites) www.publicdebt.treas.gov

(information on STRIPS; other U.S. debt) 9-43

Chapter Review, I.

• Interest Rate History and Money Market Rates – Interest Rate History – Money Market Rates • Money Market Prices and Rates – Bank Discount Rate Quotes – Treasury Bill Quotes – Bank Discount Yields versus Bond Equivalent Yields – Bond Equivalent Yields, APRs, and EARs 9-44

Chapter Review, II.

• Rates and Yields on Fixed-Income Securities – The Treasury Yield Curve – Rates on Other Fixed-Income Investments • The Term Structure of Interest Rates – Treasury STRIPS – Yields for U.S. Treasury STRIPS • Nominal versus Real Interest Rates – Real Interest Rates – The Fisher Hypothesis – Inflation-Indexed Treasury Securities 9-45

Chapter Review, III.

• Traditional Theories of the Term Structure – Expectations Theory – Maturity Preference Theory – Market Segmentation Theory • Determinants of Nominal Interest Rates: A Modern Perspective – Problems with Traditional Theories – Modern Term Structure Theory – Liquidity and Default Risk 9-46