The Structure of Interest Rates - Essay Example

?Introduction Interest rate is the cost of borrowing money. The term structure of interest rates defines the relationship between short and long termrates and the yield curve depicts this relationship graphically. Knowledge of interest rates is important to both, lenders and borrowers. For instance, a corporate treasurer is a borrower and he has to choose between short term and long term debt. Investors can be seen as lenders who lend their money by purchasing bonds (which can be either long term or short term) (Brigham and Ehrhardt, 2010). Interest date data for bonds with different maturities date is published frequently and investors can use it to determine the term structure of interest rates. Some of the most popular interest rate data sources are the Wall Street Journal, Federal Reserve Bulletin and websites like Bloomberg and CNN. The term structure can be verified at any point in time by using published data from renowned sources. Yield curves are drawn using this published data on interest rates. There are short term and long term interest rates. Since long term interest rates have an element of maturity risk premium (MRP), they are usually higher than short term rates. When researching on the term structure of interest rates, it is important to have knowledge of commonly used terms like the Yield to Maturity (YTM), which is defined as the expected rate of return on a bond held till maturity (Brigham and Ehrhardt, 2010). Another concept which is discussed with YTM is that of the zero coupon bonds (or discount bonds). A zero coupon bond is a financial asset which at the date of maturity T, pays its holder a lump sum amount, with no coupon payments before the date of maturity (hence the name zero-coupon). The YTM at time t of a discount bond with maturity T is the constant and continuously compounded rate of rate of return at which the price of the bond accrues from time t to time T and pays one currency unit to the holder at time T. The YTM is also referred to as the spot rate and the notation R (t, T) is used for it. Spot rates are short term interest rates and the term structure of interest rates depicts the relationship between spot rates and their dates of maturity (Gibson, Lhabitant and Talay, 2010). Interest rates are not only used in discounting and pricing for zero-coupon bonds but also other financial derivatives because their prices are sensitive to interest rates. If we go beyond the scope of an individual investor, we can see that interest rates are also important to corporations. This is because when corporations are doing project appraisals, they use interest rate for computing the net present value and the discounted payback period for a project. The cost of capital which is of prime importance to corporations also depends upon interest rates (Benninga and Wiener, 1998). It will be useful to specify the type of interest rate before discussing investment decisions and discounting. There are two main types of interest rates: simple interest rate and compound interest rate. Simple rate of interest is interest on a lump sum principal amount and it does not itself earn interest. Quite contrary to this, is the compound rate of interest which itself earns interest. Investment decisions and discounting are all predominantly based on compound interest rates (Kelly and Tracy, 2010) Long term interest rates are an average of short term interest rates. The relationship between short and long term interest rates involves expectations. For example, if it is expected that short term interest rates will fall then the long term interest rates will fall below the current short term rate. The contrary situation is also valid: if it is expected that short term interest rates will increase then the long term interest rates will rise above the current short term rate. These two situations are possible only because long term rates are derived from short term rates. It is a general perception that long rates are greater than short rates and this is termed as the ‘normal relationship’. Deviations from this relationship occur when short term rates are excessively high and long-term rates are less than short-term rates in this situation (Malkiel, 1962). Effects of a Rise in Risk and Expectations on the Formation of Long Term Rates The term structure of interest rates theory has the expectations hypotheses. Expectations can be applied to future prices or the rate of inflation. As per the expectations hypotheses, long term interest rates are indicative of the mean of future anticipated short term interest rates and risk premium. Price speculation or expectations influence investor decisions greatly (IMF; BIS, 2005). Individual investors and corporations both have to make the critical decision of apportioning their funds between debt and equity. The criteria for this decision are the rate of return on financial assets and the riskiness associated with those assets. The theory of expectations is based on riskiness: the higher the riskiness of an asset, the higher the return demanded by an investor. In finance, it is assumed that an average investor is risk-averse. So this risk-averse investor needs risk premium above the risk free rate of interest for undertaking the risk. Risk premium is used to entice the risk-averse investor, who will not be willing to take the risk otherwise (Friedman, 986). Keynes did not value the importance of expectations but Kalecki discussed the concept of long term expectations and stated that there is a gap between the prospective rate of profit on investment and the rate of interest. The rate of investment decisions is a function of the gap between the prospective rate of profit on investment and the rate of interest, if the degree of risk that an entrepreneur is ready to take exists (Wood, 1994). Risk premium on stocks depends on the degree of risk aversion, variance of stocks and covariance between stocks and bonds. Risk premium on bonds depends on the degree of risk aversion, variance of bonds and the covariance between stocks and bonds. There are various types of risks in the capital markets such as inflation risk, default risk, market risk etc. An investor requires premium for each kind of risk. If inflation rises, then the investor’s return will fall in real terms so he would require stocks and bonds to be linked to the inflation index. Default risk exists because the seller of bonds and securities might default and the investor will lose all his investment. So for his financial security, default risk premium should also be incorporated into the interest rate. Risk premium depends on factors such as bond volatility. In the USA, during the 1980’s, there was an increase in bond volatility and the correlation between stock and bond returns, due to which risk premiums on long term bonds also rose. The long term interest rates remained high in this decade despite a fall in long-term expected rate of inflation. This data from the 1980’s shows how long term rates depend not only on expected rate of inflation but also on increased risk premiums (Friedman, 986). Nominal Long term rates of interest depend on the following factors: Domestic short-term rates of interest Long term interest rates are related to short term interest rates due to interest rate arbitrage in the absence of market segmentation. Under the term structure of interest rate, an increase in short term interest rates leads to an increase in long term interest rates and a decrease in short term rates will also lead to decrease in long term rates. The theory of the term structure has several versions. Its expectations version states that long term interest rate exclusively depends on the expected evolution of short term rates. Real Economic Activity An increase in economic activity exerts an upward pressure on investment. Firms need debt financing for investment and the demand for loans will increase subsequently. As a result, there will be an increase in the price (interest rates) of long term loans too. Hence long term interest rates are positively related to the level of economic activity. Inflationary Expectations Inflation erodes the value of money and reduces the purchasing power. Fisher suggested that inflation premium should be included in nominal interest rates to make up for the falling purchasing power. Inflationary expectations are directly related to long term interest rates: the higher the expectations for inflation, the higher the long term rate (Johnson and Collignon, 1994). Internal factors such as a large budget deficit (government spending exceeds tax revenue) pulls up domestic interest rates and due to this firms will find it difficult to afford loans at such high interest rates. As the budget deficit is reduced (tax revenue increases and government spending falls), long term interest rates will reduce (Organisation for Economic Co-operation and Development, 1982). Long term interest rates also tend to have relationship with government debt. It is a much debated topic. During the 1990’s when UK and Canada experienced a reduced government debt to GDP ratio, their domestic long term interest rates also fell subsequently (Kinoshita, 2006). Conclusion The term structure of interest rate is an important concept that explains the time value of money since interest rates are used in discounting. Investors and borrowers, both, follow interest rates patterns and speculations as many critical decisions are based on the rate of interest that is expected in the future. Calculations of the net present value of cash flows, cost of capital and discounted payback period all depend on interest rates. The long term interest rates are an average of short term interest rates. Some theories state that there is a normal relationship between short and long term interest rates, under which long term rates are generally higher than short term ones. But this may not be the case always. For instance, if short term rates are excessively high, long term rates tend to be lower. The capital markets are dominated by factors such as risk and expectations. Risk is taken by the investor while he is investing his funds in bond and stocks. The degree of risk influences risk premium which in turn pushes up long term interest rates. Expectations help investors with their decisions. Expectations regarding inflation particularly influence long term rates. Long term rates of interest are sensitive to the degree of risk and expectations. Stock markets operate on speculation and interest rates. Other factors influence long term rates as well such as government budget deficits but the most important are risk and expectations. Top of Form References Benninga, S. and Wiener, Z. (1998) 'Term Structure of Interest Rates', Mathematics in Education and Research, vol. 7, no. 2, pp. 1-9. Brigham, E.F. and Ehrhardt, M.C. (2010) Financial Management Theory and Practice, 13th edition, OH, USA: Joe Sabatino. Friedman, B.M. (986) Financing corporate capital formation National Bureau of Economic Research, Chicago: The University of Chicago Press. Gibson, R., Lhabitant, F.-S. and Talay, D. (2010) Modeling the Term Structure of Interest Rates: A Review of the Literature, Hanover: now Publishers Inc. IMF; BIS (2005) Real Estate Indicators and Financial Stability, 21st edition, Washington DC: Press and Communications, Bank for International Settlement. Johnson, C. and Collignon, S. (1994) The monetary economics of Europe: causes of the EMS crisis, Cranbury: Associated University Press. Kelly, J. and Tracy, J.A. (2010) Accounting Workbook For Dummies, West Sussex: John Wiley & Sons. Kinoshita, N. (2006) Government Debt and Long-Term Interest Rates , IMF. Malkiel, B.G. (1962) 'Expectation, Bond Prices and the Term Structure of Interest Rates', The Quaterly Journal of Economics, vol. 76, no. 2, May, pp. 197-218. Organisation for Economic Co-operation and Development (1982) OECD Economic Surveys: Denmark 1981-1982 (Paris) , Paris: OECD. Wood, J. (1994) John Maynard Keynes: Critical Assessments, Second Series edition, London: Routledge. Read More