Chapter 8: The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and Other Rate-Determining Factors Learning Objectives - The effect of several different features of financial assets—in the first power point below—on their interest rates and prices. - Influences on the ―structure of interest rates‖ - Lastly, a brief statement on the difficulty to accurately forecast interest rates and financial asset prices. - Peruse text for own knowledge, but understand the outline below. IntroductionPrior chapter examines how expected inflation and security maturity affect interest rates.This chapter examines other factors Marketability Liquidity Default risk  Call privileges Taxation of security income Prepayment risk Convertibility8-4 Features: Marketability: - The capacity to be sold readily of a security involves the issue of whether a market exists for those assets he or she would like to acquire. - Positively related to the size and reputation of the institution issuing the securities. - A negative relationship between marketability and yield. - Marketable generally carry lower expected returns than less marketable assets.Liquidity: - Reversibility: the holder of the asset can usually recover her funds upon resale with little risk of loss. - Tends lower their risk. - Liquid assets carry lower interest rates than illiquid assets. Investors strongly interested in maximum profitability try to minimize their holdings of liquid assets. Default risk: - Probability that the issuer of a debt security will not be able to make all payments promised at the times agreed upon. - (Influential factors: the variability of company earnings, the debt-to-equity ratio, etc. External factors: state of the economy, product demand, etc.) - Default-risk premiums: heavily influenced by the credit rating assigned by various credit rating agencies. - Junk bonds: Junk bonds: known as speculative-grade bonds. Junk bonds are issued by companies who have serious financial problems and, consequently, a low credit rating. - Credit derivatives are the financial contracts designed to offset at least a portion of any default losses that may occur from owning troubled loans or other credit assets. Credit derivatives transfer risk (but not credit assets themselves) from a lender to another individual or institution willing to bear that risk in return for a fee. - Note the ratings and agencies on page 238, Exhibit 8.2. Call privilege: - Part of bond contract (indenture) giving the issuer permission to retire all or part of a bond issue by buying back the securities in advance of their maturity. - An advantage to the issuer but a disadvantage to the investor. - If interest rates fall, issuer reissues at lower rate, but investor invests in lower-yielding securities. - A high coupon rate means the issuer has to pay high interest costs and has a strong incentive to call in such bonds and replace them. Prepayment risk: - The probability that a loan or security (especially securities that draw their earnings from payment of loans) will be paid off ahead of schedule, (mortgage-backed securities)Tax-exemption privilege: - Granted investors in state and local government (municipal) bonds. - The interest income earned on municipal bonds is exempt from federal income taxes. (a subsidy to induce investors to support local government by financing the construction of schools, highways, etc. - After-tax yield = (1 – t)  Before-tax yield, If their marginal tax bracket is less than t, then they should invest in taxable securities. Convertibility: - The option given to holders of special corporate bonds or preferred stock to exchange those securities for a specific number of the issuing firm’s common stock. - Called hybrid securities because they offer the investor the prospect of both stable incomes from interest or dividends plus capital gains on common stock if the conversion privilege is exercised. - Investors are generally willing to pay a premium for convertibles, resulting in a lower rate of return. o If security prices fall, the investor still earns a fixed rate of return in the form of interest income from a convertible preferred stock. On the other hand, if stock prices rise, the investor can exercise his or her option and share in any capital gains earned on the company’s common stock. o Note investment value comments on page 256. (will graph in class) Overall, forecasting rates is a difficult task. The interest rate on a given security can change for any number of reasons, including a change in any of the risk factors. Forecasting the risk-free rate is also