Fe442 Slides Ch. 2

Front 1

Factors Affecting Nominal Interest Rates

Back 1

Inflation, Real Interest Rate, Default Risk, Liquidity Risk, Special Provisions, Term to Maturity

Front 2

Inflation (IP?)

Back 2

One of six factors affecting nominal interest rates...
continual increase in price of goods/services

Front 3

Real Interest Rate (RIR)

Back 3

One of six factors affecting nominal interest rates...
Nominal interest rate int he absence of inflation

Front 4

Default Risk

Back 4

One of six factors affecting nominal interest rates...
Risk that issuer will fail to make promised payment

Front 5

Liquidity Risk

Back 5

One of six factors affecting nominal interest rates..
Risk that a security can not be sold at a predictable price with low transaction cost on short notice

Front 6

Special Provisions

Back 6

One of six factors affecting nominal interest rates..
E.g., taxability, convertibility, callability, putability

Front 7

Term to Maturity

Back 7

One of six factors affecting nominal interest rates..
Just how long it is until the asset matures lalala

Front 8

Inflation and interest rates: Fisher Effect

Back 8

The interest rate should compensate an investor for both expected inflation and the opportunity cost of foregone consumption (the real rate component)

i=RIR + Expected (IP) or...
RIR = i - Expected (IP)

Front 9

Default Risk and Int. Rates

Back 9

The risk that a security's issuer will default on that security by being late on or missing an interest or principal payment

DRP>j = i>jt - i>Tt

I think those mean the Deafult premium is the rate on the asset minus the rate on a trasury asset we'll look into that further...

Front 10

Tax Effects: The tax exemption of interest on municipal bonds

Back 10

Interest Payments on municipal securities are exempt from federal taxes and possibly state and local taxes. Therefore, yields on "munis" are generally lower than on equivalent taxable bonds x (1-State Tax Rate - Fed. Tax Rate)

Interest on Muni = Interest on Corp

Front 11

Term to maturity and Interest Rates : Yield Curve

Back 11

Yield Curve can have positive slope (i.e. rates increase with time to maturity (most common), or no slope (no effect on rates o time to maturity), or negative slope (the more the time to maturity, the less the required rate) the previous two are rare and are generally anomalous in financial history

Front 12

Unbiased Expectations Theory

Back 12

at a given point in time, the yield curve reflects the market’s current expectations of future -short-term rates

-AKA Pure Expectations Hypothesis (PEH)

Front 13

Liquidity Premium Theory

Back 13

-investors will only hold long-term maturities if they are offered a premium to compensate for future uncertainty in a security's value

-AKA Liquidity Preference Hypothesis

Front 14

Market Segmentation Theory

Back 14

-Investors have specific maturity preferences and will generally demand a higher premium

-AKA Market Segmentation Hypothesis

Front 15

Pure Expectations Hypothesis

Back 15

Contends shape of yield curve depends on investor's expectations about future interest rates

If interest rates are expected to increase, LT rates will be higher than ST rates, and vice-versa. Thus, the yield curve can slope up, down, and even bow.

Front 16

Assumptions of the PEH

Back 16

1. The maturity risk premium for Treasury securities is zero
2. LT rates are an average of current and future ST rates
3. If E is correct, you can use the yield curve to "back out" expected future interest rates

Front 17

Forecasting Interest Rates Using the PEH

Back 17

Forward rate is an expected or "implied" rate on a security that is to be originated at some point in the future using the unbiased expectations theory (equation on slide 14 of these things chickity check it out biatch)