Money and Bankng

Money & Banking
Video 03—Interest Rates II
Understanding interest rates (Chapter 4)

The Behavior of Interest Rates (Chapter 5)
Interest Rate Determination (Chapter 6)
Hal W. Snarr
8/20/2015
Chapter 4
Understanding Interest Rates
Interest Rates
In Money & Banking, the discount rate is

• market rate of interest i on a loan: coupon bond
• called the Yield to Maturity
C C C C F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
P = price of bond when auctioned/issued

F = face value of bond
c = annual coupon rate (in percent)
C = dollar value of annual coupon payment = cF
n = years to maturity date
4-3 © 2013 Pearson Education, Inc. All rights reserved.

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P    . . .  
 i
1.0713  i )2
(1.0713  i )3
(1.0713 i )
(1.0713 n10
 i ) n10
(1.0713
c = 10%, n = 10, F = $1,000

=-PV(7.13%,10,100,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P    . . .  
 i
1.0848  i )2
(1.0848  i )3
(1.0848 i )
(1.0848 n10
 i ) n10
(1.0848
c = 10%, n = 10, F = $1,000

=-PV(8.48%,10,100,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P    . . .  
 i
1.1000  i )2
(1.1000  i )3
(1.1000 i )
(1.1000 n10
 i ) n10
(1.1000
c = 10%, n = 10, F = $1,000

=-PV(10%,10,100,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P    . . .  
 i
1.1175  i )2
(1.1175  i )3
(1.1175 i )
(1.1175 n10
 i ) n10
(1.1175
c = 10%, n = 10, F = $1,000

=-PV(11.75%,10,100,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P    . . .  
 i
1 .1381  i )2
(1.1381  i )3
(1.1381 i )
(1.1381 n10
 i ) n10
(1 .1381
c = 10%, n = 10, F = $1,000

=-PV(13.81%,10,100,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P 
1200   . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n10
(1  i ) n10
c = 10%, n = 10, F = $1,000

=rate(10,100,-1200,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P 
1100   . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n10
(1  i ) n10
c = 10%, n = 10, F = $1,000

=rate(10,100,-1100,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P 
1000   . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n10
(1  i ) n10
c = 10%, n = 10, F = $1,000

=rate(10,100,-1000,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P 
900   . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n10
(1  i ) n10
c = 10%, n = 10, F = $1,000

=rate(10,100,-900,1000,0)

Interest Rates

100
C 100
C 100
C 100
C 1000
F
P 
800   . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n10
(1  i ) n10
c = 10%, n = 10, F = $1,000

=rate(10,100,-800,1000,0)

Interest Rates

• market rate of interest i on a loan: fixed payment loan
C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
P = payment to borrower after loan is signed

F = 0
C = annual cash payment

Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
Example: You borrow $10,000 to buy a pickup. If you have to pay 60 monthly
payments of $200, what is the interest rate? What is the annual rate of interest?

Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
=rate(60,200,-10000,0,0)

Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
0.006183413

Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
0.006183413
i  (1  0.006183413)12  1

Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
0.006183413
i = 7.68%

Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
0.006183413
i = 12×0.006183413
Interest Rates

C C C C 0
F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n
0.006183413
i = 7.42%
Interest Rates

• market rate of interest i on a loan: perpetuity (or consol) bond
C C C C F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n

F = 0
C = dollar value of annual coupon payment
n = infinity

Interest Rates

C C C C F
P     . . .  
1 i (1  i ) 2 (1  i )3 (1  i ) n (1  i ) n

F = 0
n = infinity

Interest Rates

P
 1/(1  i )1  1/(1  i ) 2  1/(1  i )3 
C

F = 0
n = infinity

Interest Rates

P
 x1  x 2  x3 
C

F = 0
n = infinity

Interest Rates

P
 1  x 0  x1  x 2  x 3 
C

F = 0
n = infinity

Interest Rates

P 1
 1 
C 1 x

F = 0
n = infinity

Interest Rates

P x

C 1 x

F = 0
n = infinity

Interest Rates

P 1/(1  i )

C 1  1/(1  i )

F = 0
n = infinity

Interest Rates

P 1/(1  i )

C i /(1  i )

F = 0
n = infinity

Interest Rates

P 1

C ic

F = 0
n = infinity

Interest Rates

C
ic 
P

F = 0
n = infinity

Interest Rates

C
ic 
P
Example: A consol pays out $20 annually, and interest rates are 5%. Compute
the price of the consol.

Interest Rates

20
.05 
P

Interest Rates

20
P 
.05

Interest Rates

P  400

Interest Rates

C
ic 
P
Example: A perpetuity that pays $150 annually is currently has a price of

$2500. Compute the current yield of the perpetuity.

Interest Rates

150
ic 
2500


Interest Rates

ic  .06


Interest Rates

ic  6%


Interest Rates

ic  6%

=rate(1000,150,-2500,0,0)

Interest Rates

ic  6%

6%

Interest Rates

• market rate of interest i on a loan: zero-coupon bond
C C C C F
P     . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n


Interest Rates

C0 0
C 0
C 0
C F
P     . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n

C = 0

Interest Rates

CF C C C F
P  n   . . .  
1 ii ) (1  i )2 (1  i )3
(1 (1  i ) n (1  i ) n


Interest Rates

1/ n
CF C C C F F 
P  n   . . .  i    1
1 ii ) (1  i )2 (1  i )3
(1 (1  i ) n (1  i )Pn 


Interest Rates

1/ n
CF C C C F F 
P  n   . . .  i    1
1 ii ) (1  i )2 (1  i )3
(1 (1  i ) n (1  i )Pn 
Example: Compute the interest rate on a $1000 bond that matures in nine years
and costs $850 today.

Interest Rates

1/ n
F
i   1
P

Interest Rates

1/ 9
 1000 
i   1
 850 

Interest Rates

i  .0182216842

Interest Rates

i  1.822%

Interest Rates

i  1.822%
=rate(9,0,-850,1000,0)

Interest Rates

i  1.822%
1.822%

Interest Rates

1/ n
CF C C C F F 
P  n   . . .  i    1
1 ii ) (1  i )2 (1  i )3
(1 (1  i ) n (1  i )Pn 
Example: If you require a minimum of 5% on safe investments, what price are

you willing to pay for a $1000 bond that matures in nine years?

Interest Rates

CF C C C F
P  n   . . .  
1 ii ) (1  i )2 (1  i )3
(1 (1  i ) n (1  i ) n


Interest Rates

1000 C
C C C F
P   9   . . .  
1 i.05)(1  i )2 (1  i )3
(1 (1  i ) n (1  i ) n


Interest Rates

C C C C F
P  $644.61
   . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n


Interest Rates

C C C C F
P  $644.61
   . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n

=-PV(5%,9,0,1000,0)

Interest Rates

C C C C F
P  $644.61
   . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n

$644.61

Interest Rates

• market rate of interest i on a loan: discount bond
CF C C C F
P  n   . . .  
1 ii ) (1  i )2 (1  i )3
(1 (1  i ) n (1  i ) n

n = 1 period

Interest Rates

CF C C C F
P  1   . . .  
1(1ii ) (1  i )2 (1  i )3 (1  i ) n (1  i ) n

n = 1 period

Interest Rates

CF C C C F
P     . . .  
11 ii (1  i )2 (1  i )3 (1  i ) n (1  i ) n

n = 1 period

Interest Rates

CF C C C F F
P    . . .   i  n 1
11 ii (1  i ) (1  i )
2 3
(1  i ) (1  i ) P
n

n = 1 period

Interest Rates

CF C C C F F
P    . . .   i  n 1
11 ii (1  i ) (1  i )
2 3
(1  i ) (1  i ) P
n
Example: Compute the interest rate on a $1000 bond that matures in one year

Interest Rates

F
i 1
P

Interest Rates

1000
i 1
850

Interest Rates

i  .1764705882

Interest Rates

i  17.647%

Interest Rates

i  17.647%
=rate(1,0,-850,1000,0)

Interest Rates

i  17.647%
17.647%

Interest Rates

i  17.647%
Example: What is the interest rate on a 10-year, $1000 bond that you purchased
for $850 nine years after it was issued by the Treasury Department?
17.647%

Interest Rates

CF C C C F F
P    . . .   i  n 1
11 ii (1  i ) (1  i )
2 3
(1  i ) (1  i ) P
n
Example: What price are you willing to pay for a $1000 bond that matures in
one year, if you require 5% interest?

Interest Rates

CF C C C F
P     . . .  
11 ii (1  i )2 (1  i )3 (1  i ) n (1  i ) n

Interest Rates

1000
C C C C F
P     . . .  
11.05
i (1  i )2 (1  i )3 (1  i ) n (1  i ) n

Interest Rates

C C C C F
P  $952.38
   . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n

Interest Rates

C C C C F
P  $952.38
   . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n
=-PV(5%,1,0,1000,0)

Interest Rates

C C C C F
P  $952.38
   . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n
$952.38

Interest Rates

• market rate of interest i on a loan: simple loan
C
C C C C F C
P    . . .   i  n 1
 ii (1  i ) (1  i )
11 2 3
(1  i ) (1  i ) P
n

C = cash payoff of loan’s principal and interest
n = 1 period

Interest Rates

C
C C C C F C
P    . . .   i  n 1
 ii (1  i ) (1  i )
11 2 3
(1  i ) (1  i ) P
n
Example: If you borrow $200 and you agree to pay the lender $205 at the end of
the month, what is the monthly interest rate? What is the annual interest rate?

Interest Rates

C
i 1
P

Interest Rates

205
i 1
200

Interest Rates

i  2.5%

Interest Rates

i  2.5%
i  (1  .025)12  1

Interest Rates

i  2.5%
i  (1  .025)12  1

Interest Rates

i  2.5%
i  (1  .025)12  1

Interest Rates

i  2.5%
i  (1  .025)12  1

Interest Rates

i  2.5%
i  (1  .025)12  1

Interest Rates

i  2.5%
i  .3448888242

Interest Rates

i  2.5%
i  34.489%

Interest Rates

i  2.5%
i  34.489%

Bond Properties
1. The price of a bond falls as interest rates rise.
C C C C F
P     . . .  
1  i (1  i )2 (1  i )3 (1  i ) n (1  i ) n

Bond Properties

2. The rate of return (R) is the return on a bond held for a given period of time
• R = yield to maturity only if it is held for all n periods
C C C C F
P    . . .  
1  i (1  i ) (1  i )
2 3
(1  i ) (1  i ) n
n
no
Interest-
Rate Risk

Bond Properties

• R ≠ yield to maturity if the bond is held less than n periods
o If a coupon bond is purchased and held for its final year,
C F
P 
1  Ri 1  Ri

Bond Properties

CF
P
1 R

Bond Properties

CF
R 1 
P

Bond Properties

CF
R 1
P

Bond Properties

CF P
R
P

Bond Properties

C F P
R 
P P

Bond Properties

o If a zero-coupon bond is purchased and held for its final year,
0 F P
R 
P P

Bond Properties

o If a zero-coupon bond is purchased and held for its final year,
F P
R
P

Bond Properties

o If a coupon bond is purchased and held for its final year, and its
purchase price equals its face value,
C F FP
R 
P
F P
F

Bond Properties

o If a coupon bond is purchased and held for its final year, and its
purchase price equals its face value,
cF
R c
F
F

Bond Properties

o If a coupon bond is held for one year and sold before it matures,
C P F P
R  ic  gt+1 t
Pt Pt

Bond Properties

o If a zero-coupon bond is held for one year and sold before it matures,
C PF P
R  g  t+1 t
Pt Pt

Bond Properties

o If a coupon bond is held for one year, and sold before it matures for the
same price it was purchased,
C F P
R  ic 
P P

Bond Properties
3. A rise in interest rates is associated with a fall in bond prices, resulting in a

capital loss if time to maturity is longer than the holding period
4. The more distant a bond’s maturity, the greater the size of the percentage
price change associated with an interest-rate change
5. The more distant a bond’s maturity, the lower the rate of return the occurs as a
result of an increase in the interest rate
6. Even if a bond has a substantial initial interest rate, its return can be negative
if interest rates rise

Bond Properties

c = 10%, n = 5, F = $1,000
100
C 100
C 100
C C
100 100
C 1000
F
P       5 = 1000
 i
1 .10  i ) (1 .10
(1 .10 2
 i ) (1 
3 4
 i ) (1 
.10i ) (1 .10 5
.10i )

Bond Properties

c = 10%, n = 5, F = $1,000
100
C 100
C 100
C C
100 100
C 1000
F
P       5 = 1000
741
 i
1 .20  i ) (1 .20
(1 .20 2
 i ) (1 
3 4
 i ) (1 
.20i ) (1 .20 5
.20i )
Pt = 741 Pt-1 -25.9% – 1)×100 ic = 10%

g = (741/1000
4-108 © 2013 Pearson Education, Inc. All rights reserved. R = -15.9%
Bond Properties

7. Prices and returns for long-term bonds are more volatile than those for
shorter-term bonds
Interest-
Rate Risk
Chapter 5
The Behavior of Interest Rates
Bond Demand
The quantity of bonds demanded increases as p falls.
P D
B
Bond Demand
Bond demand increases in

• Expected return relative to other assets
• Liquidity relative to other assets P D
• Wealth
B
Bond Demand
For 1-year discount
bonds held for 1 year,
Bond demand increases in R=i

• Expected return relative to other assets
• Liquidity relative to other assets P D
• Wealth
Bond demand decreases in

• Riskiness relative to other assets
• Expected inflation
• Expected interest rate
B
Bond Supply
The quantity of bonds supplied increases as p rises.
B
Bond Supply
The quantity of bonds supplied increases as p rises.

Bond supply increases in
• Expected profitability of investment opportunities
• Expected inflation
• Government budget deficits
P
B
Supply and Demand
Excess supply: the price suppliers are asking for is too high
P D
95
15 25 B
Supply and Demand
Excess supply: the price suppliers are asking for is too high
• For a zero-coupon $100 bond held for one year
P D i
F
100
95 5.3 i 1
P
95
15 25 B
Supply and Demand
Equilibrium: the quantities of bonds supplied and demanded equal

P D i
95 5.3
92
15 20 25 B
Supply and Demand

P D i
95 5.3
F
100
92 8.7 i 1
P
92
20 B
Supply and Demand
Excess demand: the price suppliers are asking for is low

P D i
95 5.3
92 8.7
90
S
15 25 B
Supply and Demand
Excess demand: the price suppliers are asking for is low

P D i
95 5.3
92 8.7
F
100
90 11.1 i 1
P
90
S
15 25 B
Supply and Demand

P D i
95 5.3
92 8.7
90 11.1
S
15 20 25 B
The Fisher Effect
Suppose expected inflation rise by 6 percentage-points.
D S
P i
95 5.3
20 B
The Fisher Effect
D S
P i
95 5.3
D
92 8.7
15 20 B
The Fisher Effect
D S
P i
95 5.3
D S
92 8.7
90 11.1
15 20 B
The nominal rate of interest rises by 5.8 pct. pts.

The Fisher Effect
Source: Mishkin (1981) “The Real Interest Rate: An Empirical Investigation” Carnegie-Rochester
Conference Series on Public Policy 15: 151–200. These procedures involve estimating expected inflation
as a function of past interest rates, inflation, and time trends.
The Fisher Effect
Source: FRED
The Fisher Effect
1978-2007
18
16 i = 1.1pe + 1.7
R² = 0.47
14
12
10
0
0 2 4 6 8 10 12
Source: FRED
The Business Cycle and Interest Rates
Suppose economic growth is accelerating.
D S
P i
95 5.3
18 B
D S
P i
S
95 5.3
92 8.7
18 23 B
D D S
P i
S
95 5.3
93 7.5
92 8.7
18 23 23 B
The quantity and price of bonds both increase

Source: Federal Reserve: www.federalreserve.gov/releases/H15/data.htm.
The quantity and price of bonds both increase

Keynes’ liquidity preference framework
• holding money and buying bonds are the only stores of wealth
• the quantity of loanable funds people and firms supply = the value of bonds purchased
Total Wealth = Bs + Ms = Bd + Md
Loanable
Bond Market
funds Market
P LD i Bs – Bd =Ms – Md
BD
==0=0if0ifthe
ifloanable
bond
market
92 8.7 formarket
funds moneymarketin
is in
in
equilibrium
BS
LS
L 15 B
Loanable funds Market

LD i
i LD
8.7 8.7
LS LS
L 15 15 L
• The interest rate in these markets are the same
Loanable funds Market The market for money

i LD i
MD
8.7
LS
15 L M
The Liquidity Effect
• Money supply shifts to the right (increases) if

o The Fed injects money into the banking system with OMP
o Banking lending increases

i LD i
MD
8.7
7.5
LS
15 L M
The Price-level Effect
• A one time increase in MS permanently raises the price level by end of year: i = r + p
o bond demand falls because the return falls (the supply of loanable funds falls)
o bond supply rises because the cost of borrowing falls (demand for loanable funds rises)
o money demand increases
Bond Market Loanable funds Market The market for money

P i i
BD BS 8.7 8.7
95 5.3 5.3
92 LD MD
LS
L 15 B 15 L M
The Expected-Inflation Effect
• An increase in MS causes inflation expectations to rise, which may diminish over time.
o bond demand falls (the supply of loanable funds falls)
o bond supply rises (demand for loanable funds rises)

i i
8.7 8.7
5.3 5.3
LD MD
LS
15 L M
The Income Effect
• An increase in MS is an expansionary influence on the economy.

o demand for loanable funds rises

i i
7.1 7.1
5.3 5.3
LD MD
LS
15 L M
The Total Effect
4 5 6
2 9
5
a
6
4 7 7 8
1 3 8 9
2 a
3
b
1 b
Sources: Federal Reserve: www.federalreserve.gov/releases/h6/hist/h6hist1.txt.
Figure 12 Annual M2 Growth and 3-month T-bill (1950–2011)

Chapter 6
Interest Rate Determination
Nominal Rate (i) = Real Rate (r)

+ Expected Inflation (p e)
+ Default Risk Premium (d)
Risk structure + Illiquidity Risk Premium (l)
– Tax exemption discount (t)
Risk Structure
Default risk premium
• Default risk is the probability that the issuer of the bond is unable
or unwilling to make interest payments or pay off the face value
o U.S. Treasury bonds are considered default free
o Default risk premium (d) is the spread between the interest rates on bonds
with default risk and the interest rates on Treasury bonds, holding l, t, n,
lnt, and int – it equal
Risk Structure
TABLE 1
Risk Structure
P i P i
Sc St
950 5 950 5
Dt
Dc
Q Q
Corporate Bond U.S. Treasury Bond
Market Market
Risk Structure
P i P i
Sc St
950 5 950 5
925 6
Dt
Dc Dc
Q Q
Market Market
Risk Structure
P i P i
Sc St
975 4
950 5 950 5
925 6
Dt
Dt
Dc Dc
Q Q
Market Market
Risk Structure
P i P i
Sc St
975 4
925 6
Dt
Dt
Dc Dc
Q Q
Market Market
Risk Structure
Since the ic – it is illiquidity risk …
P i P i
Sc St
975 4
925 6
Dt
Dt
Dc Dc
Q Q
Market Market
Risk Structure
Since the ic – it is illiquidity risk …
P i P i
SAAA SBBB
975 4
925 6
DBBB
DBBB
DAAA DAAA
Q Q
Corporate Bond Corporate Bond
Market Market
AAA BBB
Risk Structure
You own a $1000, 10% GM bond that matures next year. The Obama
Administration abrogated 100 years of bankruptcy law when it stripped
primary bond holders of their first claim rights on corporate assets
during the GM bailout. Explain why corporate bond prices would be
lower in the post bailout era, holding all else equal. If the GM bond sold
for $1068 before the bailout but sells for $1023, compute the yields on
the bonds before and after the bailout.
Pre-bailout Post-bailout
N=1 N=1
I% = A I% = A
PV = -1068 PV = -1023
PMT = 100 PMT = 100
FV = 1000 FV = 1000
Risk Structure
You own a $1000, 10% GM bond that matures next year. The Obama
Administration abrogated 100 years of bankruptcy law when it stripped
primary bond holders of their first claim rights on corporate assets
during the GM bailout. Explain why corporate bond prices would be
lower in the post bailout era, holding all else equal. If the GM bond sold
for $1068 before the bailout but sells for $1023, compute the yields on
the bonds before and after the bailout.
Pre-bailout Post-bailout
N=1 N=1
I% = 2.996 I% = 7.527
PV = -1068 PV = -1023
PMT = 100 PMT = 100
FV = 1000 FV = 1000
Risk Structure
Illiquidity risk premium
• Liquidity is the relative ease with which an asset can be converted

into cash
o Cost of selling a bond
o Number of buyers/sellers in a bond market
o Illiquidity risk premium (l) is the spread between the interest rate on a
bond that is illiquid and the interest rate on Treasury bonds, holding d, t, n,
lnt, and int – it equal.
o E.g., assume an investor is looking at buying two corporate bonds that have
the same coupon rates and maturities, but only one is traded on a public
exchange. The investor is not be willing to pay as much for the non-public
bond. The difference in yields the investor is willing to pay for each bond is
the liquidity premium.
Risk Structure
P i P i
Sc St
950 5 950 5
Dt
Dc
Q Q
Market Market
Risk Structure
P i P i
Sc St
950 5 950 5
925 6
Dt
Dc Dc
Q Q
Market Market
Risk Structure
P i P i
Sc St
975 4
950 5 950 5
925 6
Dt
Dt
Dc Dc
Q Q
Market Market
Risk Structure
P i P i
Sc St
975 4
925 6
Dt
Dt
Dc Dc
Q Q
Market Market
Risk Structure
You are considering owning two $1000 bonds that mature next
year. One is a corporate bond, the other is a Treasury, and both
have an 8% coupon rate. Why is the price of Treasuries higher than
corporate bonds with the same attributes? If the price of treasuries
is $1058 and the price of a similar corporate bond with the same
bond rating is $1001, compute the yields on the two bonds.
Treasury Corporate
N=1 N=1
I% = A I% = A
PV = -1058 PV = 1001
PMT = 80 PMT = 80
FV = 1000 FV = 1000
Risk Structure
year. One is a corporate bond, the other is a Treasury, and both
have an 8% coupon rate. Why is the price of Treasuries higher than
corporate bonds with the same attributes? If the price of treasuries
is $1058 and the price of a similar corporate bond with the same
bond rating is $1001, compute the yields on the two bonds.
Treasury Corporate
N=1 N=1
I% = 2.079 I% = 7.892
PV = -1058 PV = 1001
PMT = 80 PMT = 80
FV = 1000 FV = 1000
Risk Structure
Tax exemption discount
• Income tax considerations

o Interest payments on municipal bonds are exempt from federal income
taxes.
o Tax exemption risk discount (t) is the spread between the interest rate on
a tax exempt municipal bond and the interest rate on Treasury bonds,
holding d, l, n, lnt, and int – it equal.
o The discount shrinks if
o federal income taxes are lowered or there is talk of doing so
o politicians seriously consider ending the exemption
o the exemption is repealed.
Risk Structure
P i P i
Sm St
950 5 950 5
Dm
Dt
Q Q
Municipal Bond U.S. Treasury Bond
Market Market
Risk Structure
P i P i
Sm St
950 5 950 5
925 6
Dm
Dt Dt
Q Q
Market Market
Risk Structure
P i P i
Sm St
975 4
950 5 950 5
925 6
Dm
Dm
Dt Dt
Q Q
Market Market
Risk Structure
P i P i
Sm St
975 4
-2
925 6
Dm
Dm
Dt Dt
Q Q
Market Market
Risk Structure
year. One is a corporate bond, the other is a tax-free municipal, and
both have an 8% coupon rate. If the bonds have a current yield of
3.5%, and you intend to hold them for their final year, compute the
price you would be willing to pay assuming a federal income tax
rate of 50%.
Tax-free municipal Corporate
N=1 N=1
I% = 3.5 I% = 3.5
PV = A PV = A
PMT = 80 PMT = 40
FV = 1000 FV = 1000
Risk Structure
year. One is a corporate bond, the other is a tax-free municipal, and
both have an 8% coupon rate. If the bonds have a current yield of
3.5%, and you intend to hold them for their final year, compute the
price you would be willing to pay assuming a federal income tax
rate of 50%.
Tax-free municipal Corporate
N=1 N=1
I% = 3.5 I% = 3.5
PV = -1043.48 PV = -1004.83
PMT = 80 PMT = 40
FV = 1000 FV = 1000
Risk Structure
Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Statistics,
1941–1970; Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
Figure 1—Long-Term Bond Yields, 1919–2011


+ Maturity Premium (int – it)
Term structure
+ Liquidity Premium (lnt)
Term Structure
• Time to maturity affects interest rates because

– Time increases exposure to risk, causing investors to demand
higher yields on securities with longer maturities.
• The term structure of interest rates refers to difference in

the yields on instruments that are identical except for term
to maturity.
• Term structure is represented graphically by a yield curve.

– Yield curves consider only the relationship between maturity or
term of a security and its yield at a moment in time
Term Structure
Facts that the theory must explain:

1. Interest rates on bonds of different maturities move together over time
Term Structure
Sources: Federal Reserve; www.federalreserve.gov/releases/h15/data.htm.
Figure 4—Interest rate movements on Treasuries with different maturities

Term Structure

2. When short-term interest rates are low, yield curves are more likely to have
an upward slope; when short-term rates are high, yield curves are more
likely to slope downward and be inverted
3. Yield curves almost always slope upward
Term Structure
February 4, 2005
Term Structure
Figure 7 Yield Curves for U.S. Government Bonds

Term Structure
Figure 6
Term Structure
Term Structure
Term Structure

2. When short-term interest rates are low, yield curves are more likely to have
an upward slope; when short-term rates are high, yield curves are more
likely to slope downward and be inverted
3. Yield curves almost always slope upward
Three Theories that explain these facts

1. Segmented markets theory explains fact three but not the first two
2. Expectations theory explains the first two facts but not the third
3. Liquidity premium theory combines the two theories to explain all three facts
Term Structure
maturity premium
• Expectations theory says the yield on a long-term bond equals the average of
the short-term interest rates people expect to occur over its life
it  ite1  ite 2  ...  ite ( n 1)

int 
n
– Maturity Premium is the spread between the interest rates on bonds with
n years and 1 year to maturity, holding d, l, t, and lnt equal.
int – it
– Buyers of bonds
o do not prefer bonds of one maturity over another
o do not hold any quantity of a bond if its expected return is less than that of
another bond with a different maturity
o consider bonds with different maturities to be perfect substitute
Term Structure
maturity premium
The table below shows current and expected future one-year interest rates,
as well as current interest rates on multiyear bonds. Use the table to
calculate the liquidity premium for each multiyear bond.
e
e
e
e
e
i  i e
 i e
 i e
 i e

i nt  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
e
e
e
e
e
i  i e
 i e
 i e
 i e

i nt1t  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
e
e
e
e
e
i  i e
 i e
 i e
 i e

i2t  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
e
e
e
e
e
i  i e
 i e
 i e
 i e

i 3t  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
e
e
e
e
e
i  i e
 i e
 i e
 i e

i4t  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
e
e
e
e
e
i  i e
 i e
 i e
 i e

i 5t  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
e
e
e
e
e
i  i e
 i e
 i e
 i e

i 6t  t t 1 t  2 t 3 t  4 t 5i e
n
Term Structure
maturity premium
Graph the maturity adjusted yields over maturity
2.20
2.00
i 1.80
1.60
1.40
1.20
1.00
1 2 3 4 5 6
n
Term Structure
maturity premium
2.20
2.00
i 1.80
1.60
1.40 maturity premium

for a 1-year bond
1.20 0%
1.00
1 2 3 4 5 6
n
Term Structure
maturity premium
2.20
2.00
i 1.80
1.60
maturity premium
1.40
for a 2-year bond
0.325%
1.20
1.00
1 2 3 4 5 6
n
Term Structure
maturity premium
2.20
2.00
i 1.80
maturity premium
1.60
for a 3-year bond
0.57%
1.40
1.20
1.00
1 2 3 4 5 6
n
Term Structure
maturity premium
2.20
2.00
i 1.80
maturity premium
for a 4-year bond
1.60
0.7675%
1.40
1.20
1.00
1 2 3 4 5 6
n
Term Structure
maturity premium
2.20
2.00
i 1.80 maturity premium

for a 5-year bond
1.60 0.93%
1.40
1.20
1.00
1 2 3 4 5 6
n
Term Structure
maturity premium
2.20
2.00
maturity premium
i 1.80 for a 6-year bond
1.06%
1.60
1.40
1.20
1.00
1 2 3 4 5 6
n
Term Structure
Expectations Theory
Yield Curve
2.20
2.00
i 1.80
1.60
1.40
1.20
1.00
1 2 3 4 5 6
n
Term Structure
liquidity premium
• The interest rate on a long-term bond will equal an average of

short-term interest rates expected to occur over the life of the
long-term bond plus a liquidity premium that responds to supply
and demand conditions for that bond
• Bonds of different maturities are partial (not perfect) substitutes
– Liquidity premium is the spread between the interest rates on bonds with
n and one years to maturity, holding d, l, t, and int – it equal
lnt
Term Structure
liquidity premium
Suppose the liquidity premium is linear in maturity:
lnt = 0.08n
e
e
e
e
e
Term Structure
Expectations Theory
Yield Curve
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
1 2 3 4 5 6
it  ite1  ite 2  ...  ite ( n 1)

int   lnt
n
Term Structure
Liquidity Premium Theory
Yield Curve
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
1 2 3 4 5 6
it  ite1  ite 2  ...  ite ( n 1)

int   lnt
n

Term structure + Maturity Premium (int – it)
+ Liquidity Premium (lnt)

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Money & Banking

Video 03—Interest Rates II

Understanding interest rates (Chapter 4)

In Money & Banking, the discount rate is

P = price of bond when auctioned/issued

4-3 © 2013 Pearson Education, Inc. All rights reserved.

In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

4-8 © 2013 Pearson Education, Inc. All rights reserved.

In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

c = 10%, n = 10, F = $1,000

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In Money & Banking, the discount rate is

P = payment to borrower after loan is signed

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In Money & Banking, the discount rate is

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In Money & Banking, the discount rate is

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In Money & Banking, the discount rate is

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In Money & Banking, the discount rate is

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In Money & Banking, the discount rate is

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In Money & Banking, the discount rate is

In Money & Banking, the discount rate is

In Money & Banking, the discount rate is

P = price of bond when auctioned/issued

4-22 © 2013 Pearson Education, Inc. All rights reserved.

In Money & Banking, the discount rate is

P = price of bond when auctioned/issued

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In Money & Banking, the discount rate is

P = price of bond when auctioned/issued

4-24 © 2013 Pearson Education, Inc. All rights reserved.

In Money & Banking, the discount rate is

P = price of bond when auctioned/issued

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