RAINIER B.

OCAMPO
FM 11-7 (MONDAY & WEDNESDAY 5:30 - 7:00 P.M.)
PROF. SHELLA GARLITOS
PAGE 13
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This is not necessarily true because investors demand a greater return as the maturity increases.
The maturity premium results from the fact that more uncertainty exists for longer term maturity.
Other factors causing the yield curve to be upward-sloping include liquidity considerations and
supply and demand concerns. For example, if investors wanted fewer longer term bonds than
were currently being supplied, then this would drive up the yield on longer term bonds.
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There are various theories that can account for any slope that the yield curve might take. First,
there is the pure expectations theory where the forward rates exclusively represent the expected
future rates. ince these rates can either increase or decrease for any time period, the yield curve
can be sloped upward or downward for that time period.
econd, there is the liquidity preference theory which asserts that investors do not like uncertainty
and so much be offered a higher rate of return for longer term maturities. Thus, the forward rate
will not only reflect expectations about future interest rates but also a !liquidity" premium that will
be higher for longer term securities. #eteris paribus, an increasing liquidity premium implies that
the yield curve will be upward sloping.
The preferred habitat theory also adopts the view that the term structure reflects the expectation
of the future path of interest rates as well as a risk premium. $owever, the preferred habitat
theory re%ects the assertion that the risk premium must rise uniformly with maturity. The preferred
habitat theory asserts that to the extent that the demand and supply of funds in a given maturity
range do not match, some lenders and borrowers will be induced to shift to maturities showing
the opposite imbalances. $owever, they will need to be compensated by an appropriate risk
premium whose magnitude will reflect the extent of aversion to either price or reinvestment risk.
Thus this theory proposes that the shape of the yield curve is determined by both expectations of
future interest rates and a risk premium, positive or negative, to induce market participants to shift
out of their preferred habitat. Thus, according to this theory, yield curves sloping up, down, flat, or
humped are all possible.
The market segmentation theory also recogni&es that investors have preferred habitats dictated
by the nature of their liabilities. This theory also proposes that the ma%or reason for the shape of
the yield curve lies in asset-liability management constraints 'either regulatory or self-imposed(
and)or creditors 'borrowers( restricting their lending 'financing( to specific maturity sectors.
$owever, the market segmentation theory differs from the preferred habitat theory in that it
assumes that neither investors nor borrowers are willing to shift from one maturity sector to
another to take advantage of opportunities arising from differences between expectations and
forward rates. Thus for the segmentation theory, the shape of the yield curve is determined by
supply of and demand for securities within each maturity sector.
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* future 'expected( interest rate that can be computed from either the spot rates or the yield curve
is called a forward rate. From the yield curve we can extrapolate the theoretical spot rates. +n
addition, we can extrapolate what some market participants refer to as the market,s consensus of
future interest rates. The market prices its expectations of future interest rates into the rates
offered on investments with different maturities.
* natural question about forward rates is how well they do at predicting future interest rates.
tudies have demonstrated that forward rates do not do a good %ob in predicting future interest
rates. $owever, from an investor-s point of view, forward rates indicate how their expectations
must differ from the market,s consensus in order to make the correct decision. For this reason,
some market participants prefer not to talk about forward rates as being market consensus rates.
+nstead, they refer to forward rates as being hedgeable rates.
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:!(1-%?"'-#*%(, :#+'+):
*ll the securities maturing from ../ years on are selling at par. The 0-month and .-year securities
are &ero-coupon instruments.
(#) C#*)"*#,% ,0% .'++'(6 +3!, $#,%+.
Y%#$ YTM (@) S3!, R#,%
1./ 1.1/2/ 1.1/2/
..1 1.1// 1.1//
../ 1.1/3/ 1.1/30
2.1 1.10 0.0A0B
2./ 1.102/ 0.0AB>
4.1 1.10/ 0.0A55
4./ 1.103/ 0.070C
5.1 1.13 0.071
5./ 1.132/ 0.07
/.1 1.13/ 0.077
First, we compute the spot rate for year 2 by following the seven step procedure given below.
tep One. Take the semiannual yield to maturity 'coupon rate( for year two times 6.11 to get
the cash flow for periods one through three. 7e have8 '1.1011 ) 2(6.11 9 64.11 for t 9 ., 2,
and 4.
tep Two. :et the appropriate semiannual discount rate that will be used to get the present
value of each cash flow in tep One. These rates are the spot rates given spot rate column
divided by two. 7e get8 1.1/2/ ) 2 9 1.1202/ for t 9 ., 1.1//1 ) 2 9 1.123/1 for t 9 2, and
1.1/3/; ) 2 9 1.12<3;< for t 9 4.
tep Three. #ompute the sum of the present values of all of the cash flows in tep One using
the appropriate discount rates from tep Two. 7e get cash flows of 62.;2420 = 62.<5./0 =
62.3//10 9 6<./.;<;.
tep Four. ubtract the sum of the present values of the cash flows in tep Three from 6.11.
7e get8 6.11.11 > 6<./.;<; 9 6;..5<1...
tep Five. #ompute the cash flow in period 5 which is the 64.11 coupon payment plus the par
value of 6.11 and divide this by the cash flow computed in tep Four. 7e get 6.14.11 )
6;..5<1.. 9 ...2/;2<.
tep ix. Take the value in tep Five to the one-fourth power and subtract one. The power is
determined by dividing one by the period for which we are computing the spot rate which is
period four. 7e get8 1.1411;0.
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Following the process in part 'a(, we get respective spot rates for years /./ and 0.1 of
3.;0<5? and <.2351?. These are more accurate than those given and can be used when
computing the price of a 0? six-year Treasury security because we have to discount the cash
flows for periods eleven and twelve by the appropriate discount rate 'which are the theoretical
spot rates for those two periods(. 7ith the twelve spot rates known, we can proceed to
compute the price of the 0? six-year Treasury security. The price of this security is the
present value of its cash flows. @er 6.11 par value, the semiannual coupon payment is
6.11'1.10 ) 2( 9 64.11. There will be twelve payments of 64.11 plus the payment of the par
value of 6.11 received at the end of period twelve. *s noted above, the appropriate discount
rate for each of the twelve cash flows are the twelve spot rates that correspond to each of the
twelve periods when cash flows are received. The present value of the twelve respective
cash flows is8 62.;244, 62.<5.2, 62.3//1, 62.005/, 62./312, 62.5320, 62.4324, 62.20;0,
62..0/1, 62.1/;1, 6..;/21, and 6..<55. These total 62<.<<;5. The present value of the 6.11
par value discounted at the theoretical spot rate of 5..431? is 60..5<1<. Thus, the price of a
0? six-year Treasury security should be 6;1.4312 or about 6;1.43.
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The six-month forward rate for period twelve can be computed by knowing the spot rates for
periods twelve and thirteen. The 0-year spot rate at the beginning of year six 'or period
twelve( is <.23?. The semiannual rate is 5..4/?. The 0./-year 'or period-.4( spot rate is
<./;? with a semiannual rate of 5.2;/?. The six-month forward rate at the start of the sixth
year or twelfth period 'f.2( is the rate that will satisfy the following equation8
PAGE 31
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The higher bid means a lower price. o the dealer is willing to pay less than would be paid for the
lower ask price. 7e illustrate this below.
:iven the yield on a bank discount basis 'Ad(, the price of a Treasury bill is found by first solving
the formula for the dollar discount 'B(, as follows8
B 9 Ad'F( . The price is then price 9 F > B.
For the .11-day Treasury bill with a face value 'F( of 6.11,111, if the yield on a bank discount
basis 'Ad( is quoted as /.;.?, B is equal to8
B 9 Ad'F( 9 1.1/;.'6.11,111(9 6.,05..03.
Therefore, price 9 6.11,111 > 6.,05..03 9 6;<,4/<.44.
For the .11-day Treasury bill with a face value 'F( of 6.11,111, if the yield on a bank discount
basis 'Ad( is quoted as /.<;?, B is equal to8
B 9 Ad'F( 9 1.1/<;'6.11,1119 6.,040....
Therefore, price is8 @ 9 F > B 9 6.11,111 > 6.,040... 9 6;<,404.<;.
Thus, the higher bid quote of /.;.? 'compared to lower ask quote /.<;?( gives a lower selling
price of 6;<,4/<.44 'compared to 6;<,404.<;(. The 1.12? higher yield translates into a selling
price that is 6/./0 lower.
+n general, the quoted yield on a bank discount basis is not a meaningful measure of the return
from holding a Treasury bill, for two reasons. First, the measure is based on a face-value
investment rather than on the actual dollar amount invested.
econd, the yield is annuali&ed according to a 401-day rather than a 40/-day year, making it
difficult to compare Treasury bill yields with Treasury notes and bonds, which pay interest on a
40/-day basis. The use of 401 days for a year is a money market convention for some money
market instruments, however. Bespite its shortcomings as a measure of return, this is the method
that dealers have adopted to quote Treasury bills. Cany dealer quote sheets, and some reporting
services, provide two other yield measures that attempt to make the quoted yield comparable to
that for a coupon bond and other money market instruments.
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#ommercial paper is an alternative to short-term bank borrowing for a corporation because it
gives them another way of borrowing or acquiring funds needed in the immediate future. For
companies able to issue commercial paper, the rate is often below the rate that banks require.
Core details are given below.
#ommercial paper is a short-term unsecured promissory note that is issued in the open market
and that represents the obligation of the issuing corporation. The primary purpose of commercial
paper was to provide short-term funds for seasonal and working capital needs. $owever,
corporations now use commercial paper for other purposes such as bridge financing. For
example, suppose that a corporation needs long-term funds to build a plant or acquire equipment.
Dather than raising long-term funds immediately, the corporation may elect to postpone the
offering until more favorable capital market conditions prevail. The funds raised by issuing
commercial paper are used until longer-term securities are sold.
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#ommercial paper is classified as either direct paper or dealer-placed paper. Birectly placed
paper is sold by the issuing firm directly to investors without the help of an agent or an
intermediary. '*n issuer may set up its own dealer firm to handle sales.( * large ma%ority of the
issuers of direct paper are financial companies. These entities require continuous funds in order
to provide loans to customers. *s a result, they find it cost-effective to establish a sales force to
sell their commercial paper directly to investors. Bealer-placed paper requires the services of an
agent to sell an issuer-s paper. The agent distributes the paper on a best efforts underwriting
basis by commercial banks and securities houses.
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.#,"$',/ $%&*%),4
+n brief, the yield spread between commercial paper and Treasury bills of the same maturity
reflects differences in credit risk, taxability, and liquidity. Core details are included below.
Eike Treasury bills, commercial paper is a discount instrument. That is, it is sold at a price that is
less than its maturity value. The difference between the maturity value and the price paid is the
interest earned by the investor, although there is some commercial paper that is issued as an
interest-bearing instrument. For commercial paper, a year is treated as having 401 days.
The yield offered on commercial paper tracks that of other money market instruments. The
commercial paper rate is higher than that on Treasury bills for the same maturity. There are three
reasons for this. First, the investor in commercial paper is exposed to credit risk. econd, interest
earned from investing in Treasury bills is exempt from state and local income taxes. *s a result,
commercial paper has to offer a higher yield to offset this tax advantage. Finally, commercial
paper is less liquid than Treasury bills. The liquidity premium demanded is probably small,
however, because investors typically follow a buy-and-hold strategy with commercial paper and
so are less concerned with liquidity.
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Fankers *cceptance is a short-term debt instrument issued by a firm that is guaranteed by a
commercial bank. These are issued by firms as part of a commercial transaction. These
instruments are similar to T-Fills and are frequently used in money market funds. Fanker,s
acceptances are traded at a discount from face value on the secondary market, which can be an
advantage because the banker,s acceptance does not need to be held until maturity. Fanker,s
acceptances are regularly used financial instruments in international trade.
+n other words, bankers- acceptance is a time draft, that is, an order to pay a specified amount of
money to the holder of the acceptance on a specified date. * bankers- acceptance is created
when a bank agrees to !accept," or guarantee, a future payment between two firms.
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+n G.., the Federal Deserve stopped using bankers- acceptances as an instrument of monetary
policy in .;<5, and now very rarely discounts a bankers- acceptance. Fut the eligibility criteria
remain important to banks, for three reasons8
First, bankers- acceptances that are eligible for discounting by Federal Deserve Fanks are
exempt from both reserve requirements and lending limits.
econd, dealers for bankers- acceptances in the secondary market have adopted the Federal
Deserve-s purchase rules for their own protection, and generally will not discount acceptances
that do not comply with them.
*nd third, eligibility for discounting by Federal Deserve banks provides banks that accept drafts
some protection against the possibility of an extraordinary loss of liquidity in the secondary
market for acceptances.
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# :!(14
For the buyer, a repo is an opportunity to invest cash for a customi&ed period of time 'other
investments typically limit tenures(. +t is short-term and safer as a secured investment since the
investor receives collateral. Carket liquidity for repos is good, and rates are competitive for
investors. Coney Funds are large buyers of Depurchase *greements.
For traders in trading firms, repos are used to finance long positions, obtain access to cheaper
funding costs of other speculative investments, and cover short positions in securities.
+n addition to using repo as a funding vehicle, repo traders Hmake marketsH. These traders have
been traditionally known as Hmatched-book repo tradersH. The concept of a matched-book trade
follows closely to that of a broker who takes both sides of an active trade, essentially having no
market risk, only credit risk. Ilementary matched-book traders engage in both the repo and a
reverse repo within a short period of time, capturing the profits from the bid)ask spread between
the reverse repo and repo rates. @resently, matched-book repo traders employ other profit
strategies, such as non-matched maturities, collateral swaps, and liquidity management.
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7hen dealers enter into a repo trade they agree the terms of the deal. These include the
collateral involved, the maturity of the trade, 'normally these trades are short term from . day to 4
months in maturity(, the cash amount and the repo rate.
Buring the life of the transaction the market risk and the credit risk of the collateral remain with
the seller. 'Fecause he has agreed to repurchase the asset for an agreed sum of money at
maturity(. @rovided the trade is correctly documented if the collateral has a coupon payment
during the life of the repo the buyer is obliged to pay this to the seller.
Buring the life of the trade the buyer can use the collateral for delivery or repo purposes. *nd if
the seller fails to return the cash the buyer can look to the collateral for repayment.
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'()$%#+% !$ 1%)$%#+%4
*n increase in expected future short selling drives up the current price of a Treasury bond
because future repo dividends are capitali&ed while the expected return on the security is
unchanged.
The repo rate normally trades closely to money market rates. This is sometimes referred to as the
general collateral rate. Fut sometimes a particular security is in demand for borrowing purposes.
This is because there are many dealers who have gone short of that security.
+n this situation the cost of borrowing the security increases and depending on supply and
demand conditions the repo rate can fall significantly. +t can end up several percentage points
beneath the prevailing money market rates. *nd in extreme situations a negative repo rate can
occur.
7hen the repo rate for a specific security falls like this the repo rate is called a special rate.
pecial repo rates mean that the individual security is expensive to borrow for dealers who are
short. Fut for those who are long there is a windfall gain. They can borrow cash at rates well
below money market rates and make a simple profit by redepositing it at the prevailing money
market rates.
1>. I( # $%3! ,$#(+#),'!(= 20#, '+ .%#(, :/ # 50#'$)",94
$aircut, in repurchase transaction, means the difference between prices at which a market maker
can buy and sell a security. +t is also the percentage by which an asset,s market value is reduced
for the purpose of calculating capital requirement, margin and collateral levels.
The term haircut comes from the fact that market makers can trade at such a thin spread. 7hen
they are used as collateral, securities will generally be devalued since a cushion is required by
the lending parties in case the market value falls.
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Federal funds market is the market for loans that the Federal Deserve makes to member banks.
The fed funds market is an indicator of the direction in which the Federal Deserve is trying to
push the broader economy.
+n general, if the Federal Deserve has a low interest rate range in the fed funds market, this
indicates that it is trying to promote growth by making liquidity easily availableJ a high interest rate
shows that the Fed is concerned about inflationary pressures on the economy and is trying to
reduce the amount of money in the economy. *long with the sale of Treasury securities and
determining the discount rate, influencing the federal funds market is one of the primary ways the
Federal Deserve sets the monetary policy of the Gnited tates.
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* repurchase agreement is a sale of a security coupled with an agreement to repurchase the
security at a specified price at a later date. +t is economically similar to a collaterali&ed loan,
where the lender of cash receives securities as collateral, and the borrower pays the lender
interest on the overnight loan the following day. From the perspective of the borrower of cash, the
transaction is called a !repo," and from the perspective of the lender of cash, it is a !reverse repo."
+f the rate on a repurchase agreement is low relative to other market rates, it indicates that the
underlying collateral is in demand and relatively dear, and as a result, the borrower does not have
to pay much interest for using the funds overnight.
Fy contrast, if the rate on a repurchase agreement is relatively high, it signals a relative
abundance of collateral, and the borrower has to pay a higher interest rate in order to obtain
funds.
Fed funds are unsecured loans of reserve balances at Federal Deserve Fanks between
depository institutions. Fanks keep reserve balances at the Federal Deserve Fanks to meet their
reserve requirements and to clear financial transactions. Transactions in the fed funds market
enable depository institutions with reserve balances in excess of reserve requirements to lend
them, or !sell" as it is called by market participants, to institutions with reserve deficiencies. Fed
funds transactions neither increase nor decrease total bank reserves. +nstead, they redistribute
bank reserves and enable otherwise idle funds to yield a return.