The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and .. Other RateDetermining Factors.[r]
(1)(2)Chapter 8
The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and
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Money and Capital Markets, 9/e © 2006 The McGrawHill Companies, Inc., All Rights Reserved.
Learning Objectives
(4) Learning Objectives
• To see why it is so difficult to forecast interest rates and
(5)8ư5 McGrawưHill/Irwin MoneyandCapitalMarkets,9/e â2006TheMcGrawưHillCompanies,Inc.,AllRightsReserved. Introduction ãIntheprecedingchapter,weexaminedhowexpected inflation and security maturity affect interest rates •In this chapter, we will look at how some other factors influence interest rates:
marketability, default risk, call privileges,
taxation of security income, prepayment risk,
(6)Marketability
• Marketability – Can an asset be sold quickly?
• Marketability is positively related to the size and reputation of
the institution issuing the securities and to the number of similar securities outstanding.
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MoneyandCapitalMarkets,9/e â2006TheMcGrawưHillCompanies,Inc.,AllRightsReserved.
Liquidity
ã LiquidityAliquidfinancialassetisreadilymarketable. ã Moreover, its price tends to be stable over time and it is
reversible
(8)Default Risk and Interest Rates
• Default risk – The risk that a borrower will not make all the
promised payments at the agreedupon times.
• Promised yield on a risky asset
= riskfree interest rate + default risk premium
• The promised yield on a risky debt security is the yield to
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Money and Capital Markets, 9/e â2006TheMcGrawưHillCompanies,Inc.,AllRightsReserved.
(10)DefaultRiskandInterestRates
ã AmongtheleadingU.S.bankruptcyfilersinmodernhistory
are WorldCom, Enron, Conseco, Texaco, Global Crossing, UAL, Pacific Gas and Electric Company, Kmart, etc.
• Expected yield on a risky asset = piyi
pi = probability that the ith possible yield, y
i, occurs
• Anticipated default loss on a risky asset