Interest rates

Bonds and their valuation

BUSINESS FINANCE
Nominal Interest Rate
Term Structure Of Interest Rates
• The term structure of interest rates describes the
relationship between long and short-term rates. It basically
shows the relationship between bond yields and
maturities.
• The graph that shows the relationship between bond yields
and maturities is called - Yield Curve.
Shapes of Yield Curve
• Normal yield curve is a yield curve in
which short-term debt instruments have a
lower yield than long-term
debt instruments of the same credit quality.
This gives the yield curve an upward slope.
• An inverted yield curve represents a
situation in which long-term debt
instruments have lower yields than short-
term debt instruments of the same credit
quality. It is downward sloping yield curve.
• A humped yield curve is a relatively rare
type of yield curve that results when the
interest rates on medium-term maturities
are higher than the rates of both long and
short-term maturities.
 WHAT DETERMINES THE SHAPE OF THE YIELD CURVE?
• other things were held constant, long-term bonds would always have
higher interest rates than short-term bonds.
• However, market interest rates also depend on expected inflation,
default risk, and liquidity, each of which can vary with maturity.
• Expected inflation has an especially important effect on the yield
curve’s shape.
• Treasury securities have essentially no default or liquidity risk, so the
yield on a Treasury bond that matures in t years can be expressed as
follows:
• T-bond yield = rt* + IPt + MRPt (Maturity risk preminum)
• r* May vary with economic or demographic factors.
• Inflation is expected to increase,
long-term bonds have higher yields
for two reasons: (1) Inflation is
expected to be higher in the future,
and (2) there is a positive maturity
risk premium.
• Weaker economic conditions
generally lead to declining inflation,
which, in turn, results in lower long-
term rates.
• Corporate bonds include a default risk premium (DRP) and a liquidity
premium (LP).
• Therefore, the yield on a corporate bond that matures in t years can
be expressed
• as follows:
• Corporate bond yield = rt* + IPt + MRPt +DRPt + LPt
• Corporate Bond Yield Spread = Corporate bond yield - Treasury bond
yield
= DRPt + LPt
• Longer-term corporate bonds also tend to be less liquid than shorter-
term bonds. Since short-term debt has less default risk, someone can
buy a short-term bond without doing as much credit checking as
would be necessary for a long-term bond.
 USING THE YIELD CURVE TO ESTIMATE
FUTURE INTEREST RATES
• Yield curve depends primarily on (1) expectations about future inflation
and (2) effects of maturity on bonds’ risk.
• Pure expectations theory: A theory that states that the shape of the
yield curve depends on investors’ expectations about future interest
rates.
• The expectations theory assumes that bond traders establish bond
prices and interest rates strictly on the basis of expectations for future
interest rates and that they are indifferent to maturity because they do
not view long-term bonds as being riskier than short-term bonds.
• If this were true, the maturity risk premium (MRP) would be zero and
long-term interest rates would simply be a weighted average of current
and expected future short-term interest rates.
 Factors that influence Interest Rate Levels
• Federal reserve policy: Federal reserve board controls the money supply. If fed
wants to lower the interest rate it increases money supply. A larger money
supply lowers market interest rates, making it less expensive for consumers to
borrow. Conversely, smaller money supplies tend to raise market interest rates,
making it pricier for consumers to take out a loan.
• Federal budget Deficits or surpluses: If government spends more than it takes
as taxes, it runs a deficit; and that deficit is either covered by borrowing or by
printing money. If government borrows, this increase the demand for funds and
thus increase the interest rates and if gov. prints money the result will be
increased inflation , which will increase interest rates.
• In case of surplus, An increase in government spending (expansionary fiscal
policy) would lead to an increase in output (through the multiplier effect)
however it would also increase interest rates as because incomes have
increased so consumers demand more money.
• International Factors
• Businesses and individuals in Pakistan buy from and sell to people and
firms all around the globe. If they buy more than they sell (that is, if
there are more imports than exports), they are said to be running a
foreign trade deficit.
• When trade deficits occur, they must be financed; and this generally
means borrowing from nations with export surpluses. Thus, if the
Pakistan imported $200 billion of goods but exported only $100 billion,
it would run a trade deficit of $100 billion while other countries would
have a $100 billion trade surplus. The Pakistan would probably borrow
the $100 billion from the surplus nations. At any rate, the larger the
trade deficit, the higher the tendency to borrow. Note that
• foreigners will hold Pakistan debt if and only if the rates on Pakistan
securities are competitive with rates in other countries. This causes
Pakistan interest rates to be highly dependent on rates in other parts of
the world.
• Business Activity

• Interest Rates and Business Decisions