Download - 342 Chapter 11
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Chapter 11.
The Level & Structure of InterestRates
Loanable funds market
Risk Structure of Interest Rates
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I. Loanable Funds Market
determine equilibrium interest rate
overall level of interest rates
but still many different interestrates
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Demand for LF
behavior of issuers & borrowers
interest rate is cost of borrowing
it is the price of loanable funds demand is downward sloping
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LF
i
DLF
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what shifts demand?
tax rules
favorable tax treatment for interest
payments increase demand mortgage interest deductible
bond interest deductible for issuer
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expected profitability
increases will encourageinvestment & borrowing
-- increase demand
increases w/ economic expansion,
decreases w/ recession
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government borrowing
deficits increase demand surpluses decrease demand
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Supply of LF
behavior of savers, lenders, bondbuyers
interest rate is reward for saving postpone present consumption
supply curve is upward sloping
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LF
i
SLF
DLF
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income & wealth increases will increase amount
and % of saving
rate of time preference people more/less willing to
postpone consumption
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FOMC policy
if Fed buys Treasuries, increase
supply of LF
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Example
Fed sell Treasuries
decrease SLF
Federal govt runs a deficit increase DLF
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LF
i
SLF
DLF
interest raterises
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What is i?
benchmark interest rate or base interest rate
minimum rate acceptable to lenders
all other rates compared tobenchmark
Treasury yield-- default-free, highly liquid
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III. Risk Structure of Interest Rates
different interest rates on assetswith same maturity
why? assets have different
characteristics
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measurement
difference between two interest rates
spread
measured in percentage points
basis points
1 percentage pt. = 100 basis pts.
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example 1
3 mo. Tbill .95%
3 mo. Commercial paper 1.02 %
spread.07 percentage pts.
7 basis pts.
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example 2
10 yr Tnote 3.85%
10 BAA corporate 5.02%
spread 1.07 percentage pts.
107 basis pts.
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3/5/2004
3 mo Tbill .95%
3 mo Commerical Paper 1.02%
10 yr. Tnote 3.85%
10 yr. AAA corporate 4.31%
10 yr. BAA corporate 5.02%
10 yr. AAA muni 3.47% 30 yr. mortgage 5.36%
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Patterns
Baa always the highest yield
Municipals always the lowest (1940)
Baa > AAA > U.S. > municipal size of the spread varies
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Risk premium
base interest rate + risk premium
= interest rate on corporate
debt
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size of risk premium
issuer
default/credit risk
liquidity maturity (chapter 12)
options
tax treatment
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Issuer
spreads exist among differentissuers
but usually a function of otherfactors
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Default risk/ credit risk
risk of not receiving timely paymentof principal and interest
depends on creditworthiness of issuer
structure of bond
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U.S. government debt
zero default risk
backed by full faith and credit
of U.S. government why?
power to tax largest economy
power to issue stable currency
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Other issuers
private
foreign
municipal all have some default risk
rated for default risk
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Bond ratings
bond issuer pays rating agency
Moodys, S&P
high credit rating low default risk
bond ratings may change over time
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default risk & yield
investors are risk averse
higherdefault
risk
lowercredit
rating
higheryield
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so default risk explains
Treasury
yields
AAA
Corp
yields
BAA
Corp
yields