CH 9: Interest Rates

Money Market Rates and Products

Prime rate: The basic interest on short-term loans that the largest commercial banks charge to their most creditworthy customers.

Bank rate: The interest rate that Bank of Canada offers to commercial banks for overnight reserve loans.

Call money rate: The interest rate that Bank of Canada offers to commercial banks for overnight reserve loans.

Commercial paper: Short-term, unsecured debt issued by the largest corporations

CDs: The interest rate on certificates of deposit, which are large denomination deposits of $100,000 or more at commercial banks

Bankers acceptance: A postdated check on which a bank has guaranteed payment. Commonly used to finance international trade transactions.

Treasury bills (T-bills): Short-term government debt issues that represent risk-free rate.

Money Market Prices and Rates

A pure discount security is an interest-bearing asset

• Sold at a discount

• Makes a single payment of face value at maturity

• Makes no payments before maturity

Market participants quote interest rates:

Bank discount yield (Bankers’ acceptance & Commercial paper)

Bond Equivalent Yields (T-bills)

Annual Percentage Rates (simple annual rate)

Effective Annual Rates (Considers the effect of compounding interest)

The Bank Discount Basis is a method of quoting interest rates on money market instruments, such as bankers acceptances.

Simple interest basis: Another method to quote interest rates.

• Calculated just like APR

• Used for CDs

• The bond equivalent yield on a T-bill with less than 6 months to maturity is also an APR

An APR understates the true interest rate, which is usually called the effective annual rate EAR.

Nominal interest rates are interest rates as they are observed and quoted, with no adjustment for inflation.

Real interest rates are adjusted for inflation effects.

The Fisher Hypothesis asserts that the general level of nominal interest rates follows the general level of inflation. Interest rates are, on average, higher than the rate of inflation.

Expectation Theory

The term structure of interest rates reflects financial market beliefs about future interest rates.

• an upward-sloping yield curve predicts an increase in interest rates.

• Downard sloping yield curve predicts decrease in interest rates.

• A flat yield curve means interest rates are not likely to change in the near future.

Expectation Theory is closely related the Fisher hypothesis in that:

• If expected future inflation is higher than current inflation, then it will be an upward-sloping term structure.

• If expected future inflation is lower than current inflation, then it will be a downward-sloping term structure.

Traditional Theories of the Term Structure

Matuirty Preference Theory: Long-term interest rates contain a maturity premium necessary to induce lenders into making longer term loans. Borrowers have to pay higher rates to borrow longer term.

Market Segmentation Theory: Debt markets are segmented by maturity, so interest rates for various maturities are determined separately in each segment. Interest rates corresponding to each maturity are determined by supply and demand conditions in each segment.

Modern Term Structure Theory

Long term bond prices are much more sensitive to interest rate changes than short term bonds. This is called interest rate risk.