Ch 2 Determinants of Interest Rates

FINC 310 markets and institutions

Inflation

the continual increase in the price level of a basket of goods and services

Real Risk Free Rate

nominal risk-free rate that would exist on a security is no inflation were expected.

Default Risk

risk that a security issuer will default on the security by missing an interest or principal payment.

Liquidity Risk

risk that a security cannot be sold at a predictable price with low transaction costs at a short notice.

Term to Maturity

length of time a security has until maturity.

Special Provisions

provisions that impact the security holder beneficially or adversely and as such are reflected in the interest rates on securities that contain such provisions.

What measures U.S. inflation?

Consumer Price Index (CPI)

The Fisher Effect

the relationship among the RFR, the expected rate of inflation and the nominal interest rate. 

The higher society’s preference to consume today…

the higher the real risk free rate.

Default Risk Premium

difference between a quoted interest rate on a security and a Treasury security with similar maturity, liquidity, tax, and other features (such as callability or convertibility).

The higher the default risk…

the higher the interest rate that will be demanded by the buyer of the security to compensate him/her for this default (or credit) risk exposure. 

Liquid Asset

one that can be sold at a predictable price with low transaction costs, and thus can be converted into its full market value at short notice.

Special provisions provide..

benefits to the security holder and are associated with low interest rates.

Taxability 

depends on the type of security, how long you hold it, and your income level. 

Convertibility

describes the ability to exchange one type of security for another.

Callability

refers to the right of the issuer to redeem (buy back) the security from the investor before its scheduled maturity.

Maturity Premium

change in required interest rates as the maturity of a security changes.

Term Structure of Interest Rates

the relationship between a security’s interest rate and its remaining term to maturity.

Unbiased Expectations Theory

at a given point in time, the yield curve reflects the market’s current expectations of future short-term rates.

Forward Rate 

an expected (quoted today) rate on a security that originates at some point in the future. 

Liquidity Premium Theory

based on the idea that investors will hold long-term maturities only if they are offered at a premium to compensate for future uncertainty in a securities value, which increases with an asset’s maturity.

Market Segmentation Theory

argues that individual investors and FI’s have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate maturity premium).

Time Value of Money 

the basic notion that a dollar received today is worth more than a dollar received at some future date. 

Value of a Lump Sum

a lump sum payment is a single cash payment received at the beginning or end of some investment horizon.

Value of Annuity Payments

annuity payments are a series of equal cash flows received at fixed intervals over the entire investment horizon.