BUS 320 Lecture Notes - Lecture 6: Yield Spread, Corporate Bond, United States Treasury Security

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3 Jun 2018
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Chapter 6 Study Guide: Interest Rates
What four factors affect the level of interest rates?
Production opportunities
Time preferences for consumption
Risk
Expected inflation
“Nominal” vs “Real” Rates
r = represents any nominal rate
r* = represents the “real” risk-free rate of interest.
o Like a T-bill rate, if there was no inflation.
o Typically ranges from 1% to 4% per year.
rRF = represents the rate of interest on Treasury securities.
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security
r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
Premiums Added to R* for Different Types of Debt
Yield Curve and the Term Structure of Interest Rates
Term structure: relationship between interest rates (or yields) and
maturities
The yield curve is a graph of the term structure
The March 2015 Treasury yield curve is shown at the right
Constructing the Yield Curve
Constructing the Yield Curve: Inflation
Step 1: Find the average expected inflation rate over Years 1 to N:
o
Assume inflation is expected to be 5% next year, 6% the following
year, and 8% thereafter
IP MRP DRP LP
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Document Summary

What four factors affect the level of interest rates: production opportunities, time preferences for consumption, risk, expected inflation. Determinants of interest rates r = r* + ip + drp + lp + mrp r = required return on a debt security r* = real risk-free rate of interest. Premiums added to r* for different types of debt. Constructing the yield curve: inflation: step 1: find the average expected inflation rate over years 1 to n: N: assume inflation is expected to be 5% next year, 6% the following year, and 8% thereafter. %75. 7: must earn these ips to break even vs. inflation; these ips would permit you to earn r* (before taxes) Constructing the yield curve: maturity risk: step 2: find the appropriate maturity risk premium (mrp), for this example, the following equation will be used to find a security"s appropriate maturity risk premium, mrpt = 0. 1% (t - 1)

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