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Interest rates
An interest rate is the price paid by a
borrower to a lender.
The amount borrowed is referred to as
the principal of a loan and the price
paid by the borrower is referred to as
interest, usually expressed as an
annualized percentage of principal.
The level of interest rate paid is
generally determined by supply and
demand in the marketplace.
Fishers Law
Its the real rate of interest
that we should care about,
not the nominal rate of
interest.
The nominal rate is the
observable market rate; the
interest rate we see quoted.
Because of inflation,
however, the real rate of
interest is different from the
nominal rate.
CFt
NPV INV
t
t 1 (1 k )
NPV net present va lue of project
INV initial investment
CFt cash flow in period t
k required rate of return on project
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DA = Dh + Db + Dg + Dm + Df
Dh = household demand for loanable funds
Db = business demand for loanable funds
Dg = federal government demand for loanable funds
Dm = municipal government demand for loanable funds
Df = foreign demand for loanable funds
SA = Sh + Sb + Sg + Sm + Sf
Sh = household supply for loanable funds
Sb = business supply for loanable funds
Sg = federal government supply for loanable funds
Sm = municipal government supply for loanable funds
Sf = foreign supply for loanable funds
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Credit risk.
Term to maturity.
Tax status of interest.
Liquidity.
Embedded options.
Credit risk
Credit risk, also known as default risk, refers to
the likelihood that the issuer may not be able to
make timely principal or interest payments.
Rating agencies offer opinions regarding this risk.
Moodys: Aaa (top rating); S & P: AAA; Fitch: AAA.
Term to maturity
The difference in yield between maturity
sectors is called a maturity spread or yield
curve spread.
U.S. Treasury yields are most commonly
used for this purpose, although any credit
rating may be used.
Example of how spreads are quoted: If a two
year Treasury yields 2.34% and a five year
Treasury yields 3.02%, they would be said to
be trading at a 68 basis point maturity spread.
Tax treatment
Unless exempted under federal tax
code, interest income from bonds is
taxable at the federal level. State and
local income taxes may apply as well.
Municipal bonds are securities issued
by state and local governments and
their authority. The vast majority pay
interest that is exempt from income
taxes.
Liquidity
The greater the expected liquidity of
a bond, the lower the required yield
(the higher the price).
The type and size of issues can affect
their liquidity.
Bonds trade primarily over-thecounter, where significant differences
in liquidity among issues can exist.
Embedded options
Call provision: Most common option embedded in
bonds. Allows issuer to retire the debt, partially or
in full, before the scheduled maturity date, at
designated dates and prices. (benefits issuer)
Put provision: Less common. Allows the bondholder
to sell bond back to the issuer at designated dates
and prices. (benefits bondholder)
Convertible provision: Grants the bondholder the
right to exchange the bond for a specific number of
shares of common stock. (may benefit both issuer &
bondholder)
And many others.
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Inverted
Liquidity theory
Yields on different maturities are based on
expected future rates plus a liquidity premium
that increases with maturity.
Yield curve would be normal or perhaps flat
under this theory.
One common interpretation
Long-term yields should be higher than short-term
yields because investors will not invest unless they
are compensated for locking up their money.
Does this make sense?
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