David M. Harrison, Ph.D. Real Estate Finance Texas Tech University Interest Rates Base Interest Rate...

David M. Harrison, Ph.D.Real Estate FinanceTexas Tech University

Interest Rates Base Interest Rate

Minimum interest rate

Risk Premium

Spread Measures: Raw Spread Relative yield spread Yield ratio

Examples: Security A: 10 year, fixed-rate residential mortgage yielding 6.25% Security B: 10 year, Treasury note yielding 4.50%


Risks of Mortgage Investing


Term Structure of Interest Rates

Term Structure Defined

Yield Curve

Pricing caveat:

Spot vs. Forward Rates Spot rate Forward rate

Empirical Evidence:


Shape of the Yield Curve

Observed patterns in the yield curve


Pure Expectations Theory

Description -

Implications:

Major Limitations:


Forward Rates

Assume the prevailing current or “spot” rates are as follows: r1=6.0%

r2=6.3%

r3=6.8%

r4=7.1% Calculate the following forward rates:

Caveats & Trading Rules:


Forward Rates

1F1

2F1

2F2

3F1

1F3

1F2


Forward Rate Formulas

kkjj

jkj

kj Frr 111

jj

kjkjk

kjr

rF

1

11

11

1

kj

j

kjkj

kjr

rF


Alternative Term StructureTheories Liquidity Preference Theory

Idea – Implications –

Preferred Habitat Theory Idea – Implications –

Market Segmentation Theory Idea – Implications -


Alternative Term StructureTheories, cont. Money-substitute Theory

Idea – Implications –

Others Idea(s) – Implications –

Combination Theory Idea – Implications -

David M. Harrison, Ph.D. Real Estate Finance Texas Tech University Interest Rates Base Interest Rate...

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