Finance 301 1st Edition Lecture 5 Outline of Last Lecture I Factors that affect Interest Rates II Forecasting Interest Rates Outline of Current Lecture III Why debt security yields vary IV Yield Curve V Yield Differentials VI Yield Differentials On Money Market Securities VII Yield Differentials On Capital Market Securities VIII Estimating Appropriate Yield Current Lecture I Why debt security yields vary a Credit Default Risk securities with a higher degree of default risk offer higher yields i Rating Agencies Rating agencies charge the issuers of debt securities a fee for assessing default risk ii The risk that someone will default the risk that they cant pay it back iii STP iv Modys v FITCH these 3 companies trying to seize credits on bonds These companies got blamed for these bad ratings vi Oversight of Credit Rating Agencies The Financial Reform Act of 2010 vii b Liquidity How does this affect yield i Liquidity how quickly turn investment into cash without loosing value ii Affects interest rate you pay higher interest rate if less liquid c Tax Status Exhibit 3 2 Are investors more concerned with ATCF or BTCF i People can control their tax status ii Different tax brackets iii Example municipal bond and a corporate bond municipal bonds can pay out less lower interest rate where a corporate is higher municipal bond you don t have to pay taxes on they can give you less for returns Tax effects what interest rates are iv Computing the Equivalent Before Tax Yield 1 at bt 1 T d Term to Maturity Exhibit 3 3 Does term to maturity differ between securities How does this affect the yield i Yes it is different 3 month 10 yr treasury notes 30 yr treasury bonds 30 day treasury bill ii Higher pay outs with longer amount of times II Yield Curve a Return structure of interest rate important model because it shows the expectations of interest rates at any given point in time interest rate on one side time on the other b Several different shapes it can take c Upward sloping expecting a rise in interest rates d Flat investors are uncertain e Downward sloping falling interest rates f Humped investors are uncertain g h i j III Yield Differentials a 90 day treasury bill if you have a lot of money you can get a lot of them and still make a lot of money off of them Its short you arent gonna loose any money b China and japan can still make safe returns using this method c Basis points 1 100 basis points IV Yield Differentials On Money Market Securities a Money market security is an investment that is for 12 months or less b Yields on commercial paper and negotiable CDs are only slightly higher than T bill rates to compensate for lower liquidity and higher default risk i Examples of money market securities c Slightly higher risk put out by corporations or banks V Yield Differentials On Capital Market Securities a Investment that should be held for more than a year b Examples stocks bonds real estate mutual funds c After tax yields higher than treasury bonds because they are tax exempt very few investments you don t have to pay tax on d Municipal bond city bond preferential treatment so people invest in them e Have the lowest yield because they are the safest f VI Stocks expected yields higher than treasuries because there is more risk because something could still happened it is much more likely than the federal government Estimating Appropriate Yield a Yn Rf n DP LP TA i Yn yield of an n day debt security ii Rf n yield of an n day Treasury risk free security iii DP default premium to compensate for credit risk iv LP liquidity premium to compensate for less liquidity v TA adjustment due to difference in tax status