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Chapter 11.

The Level & Structure of InterestRates

Loanable funds market

Risk Structure of Interest Rates

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I. Loanable Funds Market

determine equilibrium interest rate

overall level of interest rates

but still many different interestrates

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Demand for LF

behavior of issuers & borrowers

interest rate is cost of borrowing

it is the price of loanable funds demand is downward sloping

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LF

i

DLF

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what shifts demand?

tax rules

favorable tax treatment for interest

payments increase demand mortgage interest deductible

bond interest deductible for issuer

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expected profitability

increases will encourageinvestment & borrowing

-- increase demand

increases w/ economic expansion,

decreases w/ recession

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government borrowing

deficits increase demand surpluses decrease demand

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Supply of LF

behavior of savers, lenders, bondbuyers

interest rate is reward for saving postpone present consumption

supply curve is upward sloping

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LF

i

SLF

DLF

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income & wealth increases will increase amount

and % of saving

rate of time preference people more/less willing to

postpone consumption

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FOMC policy

if Fed buys Treasuries, increase

supply of LF

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Example

Fed sell Treasuries

decrease SLF

Federal govt runs a deficit increase DLF

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LF

i

SLF

DLF

interest raterises

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What is i?

benchmark interest rate or base interest rate

minimum rate acceptable to lenders

all other rates compared tobenchmark

Treasury yield-- default-free, highly liquid

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III. Risk Structure of Interest Rates

different interest rates on assetswith same maturity

why? assets have different

characteristics

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measurement

difference between two interest rates

spread

measured in percentage points

basis points

1 percentage pt. = 100 basis pts.

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example 1

3 mo. Tbill .95%

3 mo. Commercial paper 1.02 %

spread.07 percentage pts.

7 basis pts.

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example 2

10 yr Tnote 3.85%

10 BAA corporate 5.02%

spread 1.07 percentage pts.

107 basis pts.

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3/5/2004

3 mo Tbill .95%

3 mo Commerical Paper 1.02%

10 yr. Tnote 3.85%

10 yr. AAA corporate 4.31%

10 yr. BAA corporate 5.02%

10 yr. AAA muni 3.47% 30 yr. mortgage 5.36%

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Patterns

Baa always the highest yield

Municipals always the lowest (1940)

Baa > AAA > U.S. > municipal size of the spread varies

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Risk premium

base interest rate + risk premium

= interest rate on corporate

debt

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size of risk premium

issuer

default/credit risk

liquidity maturity (chapter 12)

options

tax treatment

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Issuer

spreads exist among differentissuers

but usually a function of otherfactors

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Default risk/ credit risk

risk of not receiving timely paymentof principal and interest

depends on creditworthiness of issuer

structure of bond

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U.S. government debt

zero default risk

backed by full faith and credit

of U.S. government why?

power to tax largest economy

power to issue stable currency

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Other issuers

private

foreign

municipal all have some default risk

rated for default risk

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Bond ratings

bond issuer pays rating agency

Moodys, S&P

high credit rating low default risk

bond ratings may change over time

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default risk & yield

investors are risk averse

higherdefault

risk

lowercredit

rating

higheryield

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so default risk explains

Treasury

yields

AAA

Corp

yields

BAA

Corp

yields