...Different Interest Rates In this paper, I will discuss why bonds with different maturities can have different interest rates. I will do so by explaining the importance of understanding the term structure, as well as the three theories that support the term structure; the expectations theory, the segmented markets theory, and the liquidity premium theory. Term Structure According to Hubbard and O’Brien, the term structure “is the relationship among the interest rates on bonds that are otherwise similar but have different maturities.” Term structure is most commonly analyzed by looking at the Treasury yield curve, which is the relationship of interest rates on Treasury bonds with different maturities on a particular day. Yields generally tend to move in line with maturity, producing an upward sloping yield curve or a “normal yield curve.” Rarely, however, the yields on the long-term treasuries fall below the yields of short-term treasuries. This creates an inverted yield curve. According to a class lecture, six times when the yield curve became inverted, there was an economic recession. Wheelock and Wohar believe that term structure plays an important role in an economy because it “has been found useful for forecasting such variables as output growth, inflation, industrial production, consumption, and recessions.” The Expectations Theory According to Hubbard and O’Brien, the expectations theory “holds that the interest rate on a long-term bond is an average of the interest rates...
Words: 891 - Pages: 4
...storage systems which is believed to be the future of our business. These changes have sparked an interest in our management to overhaul the current financial policies. Therefore, this financial team was created and asked to help Bob Knight analyze three working capital policies: aggressive, conservative, and moderate. A decision must be made to determine which policy will be the most beneficial for the future of Office Mates. Each policy has its own unique pros and cons, and changes that come with estimating different economic outlooks. * Aggressive policy * Minimizing the amount of cash and inventories * Use only short-term debt * Would result in the smallest investment in net working capital * Minimize accounts receivables * Moderate policy * Falls between the aggressive and conservative policies * Conservative policy * Holding large amounts of cash and inventories * Use only long-term debt * Maximize accounts receivables After analyzing each policy and comparing them with the needs of Office Mates, it has been concluded that Office Mates should use the conservative policy. This will put Office Mates in the working capital structure with the highest ROE at the lowest risk. We also have come to the conclusion that with the potential change in short term interest rates, the conservative working capital structure will not be affected. Summary of Facts Office Mates is a medium-sized manufacturer of metal...
Words: 2758 - Pages: 12
...Running head: DIVIDENDS, CAPITAL STRUCTURES DECISIONS Dividends, Capital Structures Decisions Ma. Cesarlita G. Josol MBA - Acquisitions Strayer University 1 DIVIDENDS, CAPITAL STRUCTURES DECISIONS 2 Use the following information for Questions 1 through 3: Boehm Corporation has had stable earnings growth of 8% a year for the past 10 years and in 2013 Boehm paid dividends of $2.6 million on net income of $9.8 million. However, in 2014 earnings are expected to jump to $12.6 million, and Boehm plans to invest $7.3 million in a plant expansion. This one- time unusual earnings growth won’t be maintained, though, and after 2014 Boehm will return to its previous 8% earnings growth rate. Its target debt ratio is 35%. Calculate Boehm’s total dividends for 2014 under each of the following policies: Growth rate Net Income Dividend Dividend/Net Income Ratio Dividend/Net Income % 8% 2013 $9.8 $2.6 0.265306 26.5306% 2014 $10.584 $2.808 2014 $12.600 $3.34 QUESTION #1: Calculate Boehm’s total dividends for 2014 if its 2014 dividend payment is set to force dividends to grow at the long-run growth rate in earnings. Step 1: Find the dividend / net income ratio for 2013 Dividend/ Net Income Ratio = Dividend 2013 / Net Income2013 = $2.6 million / $9.8 million = 0.265306 Dividend/Net Income Ratio = 26.5306 % **The dividend/net income ratio will be used as the rate for the projection of dividends Step 2: Calculate the 2014 projected net income...
Words: 3433 - Pages: 14
... S Structure, Par+cipants, Instruments Interest Rates and Valua+on of Bonds DEBT MARKETS: FM2014 5-‐6. Debt Markets: Structure, Par+cipants, Instruments, Interest Rates and Valua+on of Bonds 1 FM: Objec+ves A?er successfully comple+ng this topic, you will be able to: § Apply basic pricing models to evaluate stocks and bonds § Describe the theoreIcal determinants of the level and term structure of interest rates § Explain the concept of “yield” and its rela+on to “interest rate” § Determine the price of coupon and discount bonds § Compute the dura+on and convexity of a bond § Differen+ate between Macaulay and modified dura+on § Understand the rela+onship between dura+on and convexity and bond price vola+lity FM2014 5-‐6. Debt Markets: Structure, Par+cipants, Instruments, Interest Rates and Valua+on...
Words: 4045 - Pages: 17
...MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) Default risk is the risk that A) a bond issuer is unable to make interest payments. B) a bond issuer is unable to make a profit. C) a bond issuer is unable to pay the face value at maturity. D) all of the above. E) both A and C above. 2) The spread between the interest rates on default-free bonds and those with a positive default risk is called the A) junk premium. B) capitalized risk. C) default premium. D) risk premium. 3) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the _____ and the demand curve for Treasury bonds to the _____. A) left; left B) left; right C) right; right D) right; left 4) An increase in the riskiness of corporate bonds will _____ the yield on corporate bonds and _____ the yield on Treasury securities. A) increase; reduce B) reduce; reduce C) increase; not affect D) reduce; increase E) increase; increase 5) Bonds with relatively low risk of default are called A) investment grade bonds. C) zero coupon bonds. 6) Which of the following statements are true? A) A corporate bond's return becomes more uncertain as default risk increases. B) An increase in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds. C) As their relative riskiness increases, the expected return on corporate bonds decreases relative to the expected...
Words: 1256 - Pages: 6
... Chapter 4 The Risk and Term Structure of Interest Rates Two ques3ons about interest rates of bonds ¤ Why bonds with the same maturity have different yields/ interest rates? => Risk structure of interest rates ¤ Why bonds with iden3fied characteris3cs have different yields/ interest rates? => Term structure of interest rates FIGURE 1 Long-‐Term Bond Yields, 1919– 2008 Sources: Board of Governors of the Federal Reserve System, Banking and Monetary Sta4s4cs, 1941–1970; Federal Reserve: www.federalreserve.gov/releases/h15/data.htm. Risk Structure of Interest Rates ¤ Bonds with the same maturity have different interest rates due to they have different characteris3cs of: ¤ Default risk ¤ Liquidity ¤ Tax considera3ons/ tax status ¤ Special provisions Default risk ¤ Default (credit) risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face...
Words: 2352 - Pages: 10
...INTEREST RATE RISK MANAGEMENT: DEVELOPMENTS IN INTEREST RATE TERM STRUCTURE MODELING FOR RISK MANAGEMENT AND VALUATION OF INTEREST-RATE-DEPENDENT CASH FLOWS Andrew Ang* and Michael Sherris† ABSTRACT This paper surveys the main concepts and techniques of recent developments in the modeling of the term structure of interest rates that are used in the risk management and valuation of interest-rate-dependent cash flows. These developments extend the concepts of immunization and matching to a stochastic interest rate environment. Such cash flows include the cash flows on assets such as bonds and mortgage-backed securities as well as those for annuity products, life insurance products with interest-rate-sensitive withdrawals, accrued liabilities for definedbenefit pension funds, and property and casualty liability cash flows. 1. INTRODUCTION The aim of this paper is to discuss recent developments in interest rate term structure modeling and the application of these models to the interest rate risk management and valuation of cash flows that are dependent on future interest rates. Traditional approaches to risk management and valuation are based on the concepts of immunization and matching of cash flows. These ideas were pioneered in the actuarial profession by the British actuary Frank Redington (1952). Interest rates have long been recognized as important to the risk management of insurance liabilities. Recent developments have incorporated a stochastic approach to modeling interest...
Words: 18994 - Pages: 76
...Bond Yields Interest rates have a big part in determining the yield of a bond. If interest rates rise, the bond will be worth less and if they fall bonds will be worth more. The Yield to Maturity or YTM is the rate of return the lender or borrower will earn if the bond is not sold before its maturity. It can be also referred to as the bond`s yield. In order to be able to calculate the Yield to Maturity, some of the things you would need to know are the current price, the par value, the interest payments, and the maturity date for the bond. A coupon is the stated interest payment made on a bond. The market value will be less than par value if the required rate of return is above the coupon interest rate. Bond will be valued above pay value if the required rate of return is below the coupon interest rate. Also, the lower the coupon rate the greater the interest rate risk. Interest rate risk refers to the risk of fluctuating interest rates. In other words, bond values have an inverse relationship to interest rates. Long-term bonds will have a greater interest rate risk than short-term bonds. Interest rates have a greater impact on long-term bonds because it takes longer for them to mature. Typically, the more you can earn from a bond the more risk there is to it. However, the more risk there is to a bond the more likely either the borrower might default. Bonds have a rating system which gives them a rating based on the likelihood...
Words: 1045 - Pages: 5
...Capital Structure Suppose the Schoof Company has this book value balance sheet: Current Assets: $30 million Fixed Assets: $50 million Total Assets: $80 million Current Liabilities: $10 million Long-Term Debt: $30 million Common Equity: Common Stock (1 million shares): $1 million Retained Earnings: $39 million Total claims: $80 million The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10%, the same as the rate on new bank loans. The long-term debt consists of 30,000 bonds, each of which has a par value of $1,000, carries an annual coupon interest rate of 6%, and matures in 20 years. The going rate of interest on new long-term debt, rd, is 10%, and this is the present yield to maturity on the bonds. The common stock sells at a price of $60 per share. Calculate the firm's market value capital structure. Suppose the Schoof Company has this book value balance sheet: Current Assets: $30 million Fixed Assets: $50 million Total Assets: $80 million Current Liabilities: $10 million Long-Term Debt: $30 million Common Equity: Common Stock (1 million shares): $1 million Retained Earnings: $39 million Total claims: $80 million The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10%, the same as the rate on new bank loans. The long-term debt consists of 30,000 bonds, each of which has a par value of $1,000, carries an annual coupon interest rate of 6%, and...
Words: 466 - Pages: 2
...Question: 1. Locate the annual balance sheets for General Motors (GM), Merk (MRK), and Kellogg (K). For each company calculate the long term debt-equity ratio for the prior two years. Why would these companies use such different capitals structures? 2. Look up a company and download the annual income statements. For the most recent year, calculate the average tax rate and EBIT, and find the total interest expense. From the annual balance sheets calculate the total long-term debts (including the portion due within one year). Using the interest expense and total long term debts, calculate the average cost of debt. Next, find the estimated beta for the company on the S&P Stock Report. Use this reported beta, a current T-bill rate, and the historical average market risk premium found in a previous chapter to calculate the levered cost of equity. Now calculate the unleveraged cost of equity, then the unlevered EBIT. What is the unlevered value of the company? What is the value of the interest tax shield and the value of the levered company. Answer: |Company name/Year |Debt-equity ratio 2010 |Debt-equity ratio 2011 | |General Motors (GM) |0.28 |0.31 | |Merck (MRK) |0.28 |0.28 ...
Words: 2212 - Pages: 9
...Chapter 6 Rate The Risk and Term Structure of Interest In the previous section, we have generalized our discussion of the influence of various factors on the behavior in interest rate by examining only a particular type of bonds: namely, the 1-year zero coupon bond. However, there are many types of bonds: bonds with different maturity, bonds issued by different parties (i.e. government vs. corporate), etc. As a result, there is a different interest rate for each type of bond. We will look at the behavior of interest rates of two groups of bonds: (1) Bonds with the same features but are issued by different agency. In other words, we want to look at the risk structure of interest rates. (2) Bonds issued by the same agency but have different term to maturity (i.e. life of the bond). In other words, we want to look at the term structure of interest rates. 1. Risk structure of interest rate As we have discussed in the previous section, the (relative) risk level of an asset affects its demands according to the theory of asset demand. The higher the relative risk level, the lower the demand of that asset. According to the theory of asset demand, this leads to an increase in interest rate. In other words, investors need to be compensated with a higher return (in the form of higher interest rate) in order to induce them to hold the assets. There are a number of factors that affect the risk level of a bond. In this section, we will focus on only 3 of them: default risk, liquidity, and tax...
Words: 3232 - Pages: 13
...FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES Macro-Finance Models of Interest Rates and the Economy Glenn D. Rudebusch Federal Reserve Bank of San Francisco January 2010 Working Paper 2010-01 http://www.frbsf.org/publications/economics/papers/2010/wp10-01bk.pdf The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Macro-Finance Models of Interest Rates and the Economy Glenn D. Rudebusch∗ Federal Reserve Bank of San Francisco Abstract During the past decade, much new research has combined elements of finance, monetary economics, and macroeconomics in order to study the relationship between the term structure of interest rates and the economy. In this survey, I describe three different strands of such interdisciplinary macro-finance term structure research. The first adds macroeconomic variables and structure to a canonical arbitrage-free finance representation of the yield curve. The second examines bond pricing and bond risk premiums in a canonical macroeconomic dynamic stochastic general equilibrium model. The third develops a new class of arbitrage-free term structure models that are empirically tractable and well suited to macro-finance investigations. This article is based on a keynote lecture to the 41st annual conference of the Money, Macro, and Finance Research Group...
Words: 13245 - Pages: 53
...G-Sec Market: How the Term Structure Reacts to Monetary Polic Introduction Behavior of term structure is a major source of interest rate risk and influences the decision making process of the participants in money market and government securities (G-Sec) market regarding holding and trading. Monetary policy is a major determining factor of term structure. The first quarter of the current financial year found hikes in monetary policy rates in India to be followed by upward shifts in the domestic term structure, which adversely affected the G-Sec portfolios of the market participants. This paper wants to find out how term structure responds to monetary policy actions in India. Literature Review There are a number of studies in USA on how term structure responds to the expectations about the central bank’s monetary policy actions. Cook et al (1989) found that changes in the federal funds target rate (FFTR) in the 1970s caused large movements in short term interest rates, moderate movements in medium term rates, and small movements in long term rates. Kuttner (2001) estimated that the bond rate’s response to expected changes in monetary policy is negligible, while their response to unexpected changes is significant. Faust et al (2002), as reported by Goukasian et al (2006), using prices from federal funds futures contracts derived the unexpected component of Federal Reserve policy decisions and assessed their impact on the future trajectory of interest rates. 1 Goukasian...
Words: 6357 - Pages: 26
...Question 1 Are interest rate changes predictable? Interest rates are not entirely predictable but can be inferred from present interest rate prices. For example, when current interest rates are exceptionally low, future interest rates can be expected to rise and vice versa. Question 2 Consider a two year coupon bond which pays an annual coupon of 5% with a principal value of $100. Using the zero coupon bonds B(0, 1) and B(0, 2): 1. What is the strategy to replicate the coupon bond? 2. What is the strategy to hedge the coupon bond? PV of 2 year coupon bond = 5 B(0,1) + 105 B(0,2) 1. To replicate the bond, I should buy 5 units of B(0, 1) bonds and 105 units of B(0, 2) bonds. 2. To hedge the bond, I should do the opposite and sell 5 units B(0, 1) bonds and 105 units B(0, 2) bonds. Question 3 Consider three zero coupon bonds; B(0, 1)=0.95, B(0, 2)=0.90, and B(0, 3)=0.85: 1. What is the zero rate term structure? B(0,T) = e-rT/365 r(0,T) = -ln( B(0,T))365/T r(0,1) = -ln 0.95 = 0.0513 r(0,2) = -(ln 0.90)/2 = 0.0527 r(0,3) = -(ln 0.85)/3 = 0.0542 2. What is the forward rate term structure at one year intervals? In other words, f(0, 1, 2) and f(0, 2, 3). f(0,1,2) = B(0,1) / B(0,2) – 1 = 0.95/0.9 – 1 = 0.05556 f(0,2,3) = B(0,2) / B(0,3) – 1 = 0.90/0.85 – 1 = 0.05882 3. Name two other possible term structures that can be inferred. The other term structures are discount rate and simple interest rate structures. Question 4 The current date is January...
Words: 727 - Pages: 3
...Assignment Package 1 Total Marks 60 Each short answer-question carries 3 marks (You can use more space than provided under short-answer questions) Q1 Describe the role of interest rates in economic decision making. How does expected inflation matter in people's borrowing and investment decisions(See Ch 1, pages 5-6) The real interest rate is the most important variable when it comes to determining their investment decisions. The expected inflation matter in people’s borrowing and investment decisions, because this is the expected rate of change of prices. Both interest rate and expected inflation are needed for investment/borrowing decisions. Q2 How financial market determine prices of securities? List some of the factors that may cause shift in the demand and supply of securities. (Ch 2 pages 21-23) The financial market determines prices of securities by supply and demand. Factors that may cause shift in the demand and supply of securities * The supply curve of securities shifts right when the business believes their demand for their product will increase, which leads to borrowing more than before by increasing their supply securities * Investors who wants to buy more securities – demand will increase Q3. Make a distinction between inside money and outside money. (See Ch 3, pages 4 1-44) Outside money is money created by the government or by nature, not by groups of institutions in the private sector. Inside money is...
Words: 1464 - Pages: 6