Chapter-03 - Structure of Interest Rates
Chapter-03 - Structure of Interest Rates
Chapter-03 - Structure of Interest Rates
Structure of Interest
Rates
Chapter Objectives
2. Liquidity:
The Liquidity of a security affects the
yield/price of the security
A liquid investment is easily converted to cash
at minimum transactions cost
Investors pay more (lower yield) for liquid
investment
Factors Affecting Security Yields
3. Tax status
Tax status of income or gain on security
impacts the security yield
Investor concerned with after-tax return or
yield
Investors require higher yields for higher taxed
securities
Factors Affecting Security Yields
Yat = Ybt(1 – T)
Where:
Yat = after-tax yield
Ybt = before-tax yield
T = investor’s marginal tax rate
Factors Affecting Security Yields
4. Term to Maturity
Interest rates typically vary by maturity.
The term structure of interest rates defines the
relationship between maturity and yield.
The Yield Curve is the plot of current interest yields
versus time to maturity.
Exhibit: 3.3
Exhibit 3.3
Example of Relationship between Maturity and Yield of Treasury
Securities (as of March 2014).
Yield Curve
The slope of the yield curve can predict future interest rate
changes and economic activity.
Yield
%
Time to Maturity
Special Provisions
Call Feature: enables borrower to buy back the
bonds before maturity at a specified price
Call features are exercised when interest rates have
declined
Investors demand higher yield on callable bonds,
especially when rates are expected to fall in the future
Special provisions
Convertible bonds
Convertibility feature allows investors to convert the
bond into a specified number of common stock shares
Investors will accept a lower yield for convertible bonds
because investor returns include expected return on
equity participation
Estimating the Appropriate Yield
Downward-
Upward-
Sloping
Sloping
Yield Curve
Yield Curve
7
Minus Three-Month Rate)
6
5
4
3
2
1
0
–1
–2
–3
–4
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2001
Year
*The general shape of the yield curve is measured as the differential between annualized 10-year and three-month inte
Recessionary periods are shaded.
International Structure of Interest Rates