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Lesson Outline
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Chapter 03
o Why Debt Security Yields Vary

o Estimating the Appropriate Yield

Structure of Interest Rates o Theories of Term Structure

o Use of the Term Structure

Md. Kaysher Hamid

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Why Debt Security Yields Vary Why Debt Security Yields Vary
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 The yields on debt securities are affected:  Credit (Default) Risk

o Credit (default) risk o Securities with a higher degree of default risk offer higher yields.

o Liquidity o Rating Agencies - Rating agencies charge the issuers of debt securities a

o Tax status fee for assessing default risk.

o Term to maturity

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Why Debt Security Yields Vary Why Debt Security Yields Vary
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 Credit (Default) Risk  Credit (Default) Risk

National Credit Ratings Ltd. o National Credit Ratings Ltd.
(http://www.ncrbd.com/services.php?nId=9&pId=14&nName=Services)

o Credit Rating Agency of Bangladesh Ltd. (https://crab.com.bd/credit-

rating-scales-and-definitions/)

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Why Debt Security Yields Vary Why Debt Security Yields Vary
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 Liquidity  Tax Status

o Debt securities with a short-term maturity or an active secondary o Investors are more concerned with after-tax income
market have greater liquidity o Taxable securities must offer a higher before-tax yield
o The lower a security’s liquidity, the higher the yield preferred by an o The extra compensation required on taxable securities depends on
investor. the tax rates of individual and institutional investors.

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Why Debt Security Yields Vary Why Debt Security Yields Vary
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 Tax Status  Exercise 01

o Consider a taxable security that offers a before-tax yield of 8 percent.. If You need to choose between investing in a one-year municipal bond with
the tax rate of the investor is 20 percent, then what is the after-tax yield? a 7 percent yield and a one-year corporate bond with an 11 percent yield.
o Suppose that a firm in the 20 percent tax bracket is aware of a tax- If your marginal federal income tax rate is 30 percent and no other
exempt security that is paying a yield of 8 percent. To match this after- differences exist between these two securities, which would you invest in?
tax yield, taxable securities must offer a before-tax yield of ………….

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Why Debt Security Yields Vary Estimating the Appropriate Yield

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 Term to Maturity Yn = Rf,n + DP + LP + TA

o Maturity dates will differ between debt securities where:
o The term structure of interest rates defines the relationship between term
Yn = yield of an n-day debt security
to maturity and the annualized yield
Rf,n = yield of an n-day Treasury (risk-free) security

DP = default premium to compensate for credit risk

LP = liquidity premium to compensate for less liquidity

TA = adjustment due to difference in tax status

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Estimating the Appropriate Yield Estimating the Appropriate Yield

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Suppose that the three-month T-bill’s annualized rate is 8 percent and  Exercise 02

that Elizabeth Company plans to issue 90-day commercial paper. a) A corporation is planning to sell its 90-day commercial paper to
investors by offering an 8.4 percent yield. If the three-month T-
Assume Elizabeth Company believes that a 0.7 percent default risk
bill’s annualized rate is 7 percent, the default risk premium is
premium, a 0.2 percent liquidity premium, and a 0.3 percent tax estimated to be 0.6 percent, and there is a 0.4 percent tax
adjustment are necessary to sell its commercial paper to investors. adjustment, then what is the appropriate liquidity premium?
Calculate the appropriate yield to be offered on the commercial paper? b) Suppose that, because of unexpected changes in the economy, the
default risk premium increases to 0.8 percent. Assuming that no
Yn = Rf,n + DP + LP + TA other changes occur, what is the appropriate yield to be offered
on the commercial paper?

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Theories of Term Structure Theories of Term Structure

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o Pure Expectations Theory  Pure Expectations Theory

o Liquidity Premium Theory o Term structure reflected in the shape of the yield curve is determined
solely by the expectations of interest rates.
o Segmented Markets Theory
o An expected increase in rates leads to an upward sloping yield curve

o An expected decrease in rates leads to a downward sloping yield curve.

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Theories of Term Structure Theories of Term Structure

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 Pure Expectations Theory  Pure Expectations Theory

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Theories of Term Structure Theories of Term Structure

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 Pure Expectations Theory  Pure Expectations Theory

o If investors were indifferent to maturities, the return of any security o If the term structure of interest rates is solely influenced by
should equal the compounded yield of consecutive investments in expectations of future interest rates, the following relationships hold:
shorter-term securities. That is, a two-year security should offer a
return that is similar to the anticipated return from investing in two
consecutive one-year securities and so on.

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Theories of Term Structure Theories of Term Structure

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 Liquidity Premium Theory  Liquidity Premium Theory

o Investors prefer short-term liquid securities but will be willing to

invest in long-term securities if compensated with a premium for
lower liquidity. where LP2 is the liquidity premium on the 2 year security

The relationship between the liquidity premium and term to maturity

can be expressed as follows:

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Theories of Term Structure Theories of Term Structure

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 Exercise 03  Segmented Markets Theory

a) Assume that, as of today, the annualized two-year interest rate is o Investors choose securities with maturities that satisfy their forecasted
13 percent and the one year interest rate is 12 percent. Use this cash needs.
information to estimate the one-year forward rate.
o If investors and borrowers participate only in the maturity market that
b) Assume that the liquidity premium on a two-year security is 0.3
percent. Use this information to estimate the one-year forward rate. satisfies their particular needs, then markets are segmented. That is,
investors (or borrowers) will shift from the long-term market to the
short-term market, or vice versa, only if the timing of their cash needs
changes.
o The choice of long-term versus short-term maturities is determined more
by investors’ needs than by their expectations of future interest rates.

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Theories of Term Structure Integrating the Theories of the Term Structure

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 Segmented Markets Theory  If we assume the following conditions:

o Limitations of the theory
o Investors and borrowers who select
 Some borrowers and savers have the flexibility to choose among various
security maturities based on anticipated
maturities
interest rate movements currently
o Implications: Preferred Habitat Theory
expect interest rates to rise.
 Although investors and borrowers may normally concentrate on a particular
maturity market, certain events may cause them to wander from their “natural”
o Most borrowers are in need of long-

or preferred market. term funds, while most investors have

 Preferred habitat theory acknowledges that natural maturity markets may only short-term funds to invest Then all three conditions place
upward pressure on long-term yields
influence the yield curve, but it also recognizes that interest rate expectations o Investors prefer more liquidity to less. relative to short term yields leading to
could entice market participants to stray from their natural, preferred markets. upward sloping yield curve.

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Use of the Term Structure Use of the Term Structure

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 Forecasting Interest Rates  Making Investment Decisions

o The shape of the yield curve can be used to assess the general o If the yield curve is upward sloping, some investors may attempt to
expectations of investors and borrowers about future interest rates. benefit from the higher yields on longer-term securities even though

o The curve’s shape should provide a reasonable indication (especially they have funds to invest for only a short period of time.

once the liquidity premium effect is accounted for) of the market’s  Making Decisions about Financing
expectations about future interest rates.
o Firms can estimate the rates to be paid on bonds with different
 Forecasting Recessions maturities. This may enable them to determine the maturity of the

o Some analysts believe that flat or inverted yield curves indicate a bonds they issue.

recession in the near future.

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Exercises Exercises
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4. a. Determine the forward rate for various one-year interest rate scenarios
5. If ti1 > ti2, what is the market consensus forecast about the one-year
if the two-year interest rate is 8 percent, assuming no liquidity premium. Explain
the relationship between the one-year interest rate and the one-year forward rate forward rate one year from now? Is this rate above or below today’s one-
while holding the two-year interest rate constant.
year interest rate? Explain.
b. Determine the one-year forward rate for the same one-year interest rate
scenarios described in question (a) while assuming a liquidity premium of 0.4
6. Determine how the after-tax yield from investing in a corporate bond is
percent. Does the relationship between the one-year interest rate and the forward
rate change when the liquidity premium is considered? affected by higher tax rates, holding the before-tax yield constant. Explain
c. Determine how the one-year forward rate would be affected if the
the logic of this relationship.
quoted two-year interest rate rises; hold constant the quoted one-year interest rate as
well as the liquidity premium. Explain the logic of this relationship.
d. Determine how the one-year forward rate would be affected if the
liquidity premium rises and if the quoted one-year interest rate is held constant.
What if the quoted two-year interest rate is held constant? Explain the logic of this
relationship.

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