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Chapter 8Chapter 8The Structure of The Structure of
Interest RatesInterest Rates
©2000 South-Western College Publishing
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TheThe S Structure of tructure of Interest RatesInterest Rates
The pattern or spread among interest rates determined by the term to maturity, credit risk, and tax treatment
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Treasury NotesTreasury Notes
Securities issued by the U.S. Government with an original maturity of one to ten years
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Yield CurveYield Curve
A graphical representation of the relationship between interest rates (yields) on particular securities and their terms to maturity
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January 16, 1981 January 29, 1993 July 17, 1998
Maturity Interest Maturity Interest Maturity Interest
3 months 15.19% 3 months 2.92% 3 months 5.01%
1 year 13.91% 1 year 3.41% 1 year 5.36%
2 years 13.15% 2 years 4.24% 2 years 5.46%
5 years 12.69% 5 years 6.08% 5 years 5.47%
10 years 12.53% 10 years 6.46% 10 years 5.49%
Exhibit 8.1
Interest Rates on Treasury Securities
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Inte
rest
Rat
e (p
erce
nt)
0
5
10
15
20
January 16, 1981 January 29, 1993 July 17, 1998
Term to Maturity 10 years
Term to Maturity 3 months
Term to Maturity 1 year
Term to Maturity 2 yearsTerm to Maturity 5 years
Exhibit 8.2
Yield Curves
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Expectations TheoryExpectations Theory
A theory holding that the long-term interest rate is the geometric average of the present short-term rate and the short-term rates expected to prevail over the term to maturity of the long-term security
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Geometric AverageGeometric Average
An average that takes into account the effects of compounding used to calculate the long-term rate from the short-term rate and the short-term rates expected to prevail over the term to maturity of the long-term security
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12
34
56
1 2
5.99
Term to Maturity (years)
Yie
ld t
o M
atu
rity
(p
erce
nt)
Exhibit 8.3
Hypothetical Yield Curve
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1 2
12
34
56
78
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Exhibit 8.4
New Hypothetical Yield Curve
Yie
ld t
o M
atu
rity
(p
erce
nt)
New Curve1 year rate = 5%2 year rate = 6.98%Expected future 1 year rate = 9%
Term to Maturity (years)
Original Curve1 year rate = 5%2 year rate = 5.99%Expected future 1 year rate = 7%
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Term to Maturity
Yie
ld t
o M
atu
rity
Term to Maturity
Yie
ld t
o M
atu
rity
Term to MaturityY
ield
to
Mat
uri
ty
a. A Rise Expected in Interest Rates
b. No Change Expected in Interest Rates
c. A Decline Expected in Interest Rates
Exhibit 8.5
Alternative Yield Curve Shapes
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Preferred HabitatsPreferred Habitats
An expectations theory modification hypothesizing that many borrowers and lenders have preferred maturities which creates a degree of market segmentation between the short-term and the long-term markets
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Liquidity PremiumLiquidity Premium
The extra return required to induce lenders to send long-term rather than short-term
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1 2 3 4 5 6 7 8 9 10
12
34
56
78
910
Exhibit 8.6
The Role of
Liquidity Premiums
Yie
ld t
o M
atu
rity
(p
erce
nt)
Term to Maturity (years)
Observed Yield Curve = Expectations + Liquidity Premiums (C=A+B)
Yield Curve Based on Expectations (A)
Liquidity Premium (B)
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Credit Risk is...Credit Risk is...
The probability of a debtor not paying the principal and/or the interest due on an outstanding debt
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Standard & Poor’s Standard & Poor’s and and Moody’s Moody’s Investor ServicesInvestor Services
The two major credit-rating agencies that evaluate a borrower’s probability of default and assign the borrower to a particular risk class
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Aaa •Best quality AAAAa •High quality AAA •Higher medium grade ABaa •Medium grade BBB Ba •Lower medium grade BB
having speculative elements B •Lacks characteristics of B
desirable investmentCaa •Poor standing BCa •Highly speculative BC •Lowest grade (in default) D
Moody’s Standard & Poor’s General DescriptionGeneral Description
Exhibit 8.7
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Risk PremiumRisk Premium
The extra return or interest that a lender is compensated with for accepting more risk
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14%
12%
10%
6%
4%
2%
8%
959065
Exhibit 8.8
1960 70 75 80 85
Baa-Rated Municipal Bonds
Aaa-Rated Municipal Bonds
Recessions
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Marginal Tax RateMarginal Tax Rate
The tax rate that is paid on the last dollar of
income that the taxpayer earns
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Average Marginal Average Marginal Tax RateTax Rate
The average of the marginal tax rates of
all taxpayers