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Module - 2 - Interest Rates

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12 views15 pages

Module - 2 - Interest Rates

Uploaded by

eminencebhatia
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Interest Rates

Types of Rates
• Fixed vs Floating
• Short vs Long Term
• Secured vs Unsecured

• Treasury rate
• LIBOR
• Fed funds rate (Call Money rate)
• Repo rate
• Swap rate
• OIS rate
Treasury Rate
• Rate on instrument issued by a government in its own currency
LIBOR
• LIBOR is the rate of interest at which a AA
bank can borrow money on an unsecured
basis from another bank
• For 5 currencies and 7 maturities ranging it is
calculated daily by the submissions from a
number of major banks
• There have been some suggestions that
banks manipulated LIBOR during certain
periods. Why would they do this?
The U.S. Fed Funds Rate
• Unsecured interbank overnight rate of interest
• Allows banks to adjust the cash (i.e., reserves) on deposit with the Federal
Reserve at the end of each day
• The effective fed funds rate is the average rate on brokered transactions
• The central bank may intervene with its own transactions to raise or lower
the rate
• Similar arrangements in other countries
Repo Rate
• Repurchase agreement is an agreement where a financial institution
that owns securities agrees to sell them for X and buy them bank in
the future (usually the next day) for a slightly higher price, Y
• The financial institution obtains a loan.
• The rate of interest is calculated from the difference between X and Y
and is known as the repo rate
LIBOR swaps
• The most common swap is where LIBOR is exchanged for a fixed rate
(Plain vanilla interest rate swap)
• The swap rate where the 3-month LIBOR is exchanged for fixed has
the same risk as a series of continually refreshed 3-month loans to
AA-rated banks
OIS rate
• An overnight indexed swap is swap where a fixed rate
for a period (e.g. 3 months) is exchanged for the
geometric average of overnight rates.
• For maturities up to one year there is a single
exchange
• For maturities beyond one year there are periodic
exchanges, e.g. every quarter
• The OIS rate is a continually refreshed overnight rate
The Risk-Free Rate
• The Treasury rate is considered to be artificially low
because
• Banks are not required to keep capital for Treasury
instruments
• Treasury instruments are given favorable tax treatment in
the US
• OIS rates are now used as a proxy for risk-free rates in
derivatives valuation
What is the “term structure of interest rates”?
What is a “yield curve”?

• Term structure: the relationship between


interest rates (or yields) and maturities.
• A graph of the term structure is called the yield
curve.
Treasury Yield Curve

Interest 1 yr 6.3%
Rate (%) 5 yr 6.7%
15
10 yr 6.5%
30 yr 6.2%
10 Yield Curve
(May 2024)

0 Years to Maturity
10 20 30
Hypothetical Treasury Yield Curve

Interest
Rate (%) 1 yr 8.0%
15 Maturity risk premium 10 yr 11.4%
20 yr 12.65%
10 Inflation premium

Real risk-free rate


0 Years to Maturity
1 10 20
What factors can explain the shape of this
yield curve?

• This constructed yield curve is upward sloping.


• This is due to increasing expected inflation and
an increasing maturity risk premium.
What kind of relationship exists between the Treasury
yield curve and the yield curves for corporate issues?

• Corporate yield curves are higher than that of the


Treasury bond. However, corporate yield curves are
not neces-sarily parallel to the Treasury curve.
• The spread between a corporate yield curve and the
Treasury curve widens as the corporate bond rating
decreases.
Hypothetical Treasury and
Corporate Yield Curves
Interest
Rate (%)
15

BB-Rated
10
AAA-Rated
Treasury
6.0%
5 5.9% yield curve
5.2%

Years to
0
maturity
0 1 5 10 15 20

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