CHAPTER 9 Interest Rates One truism of commerce holds that time is money, but how much time is how much money? Interest is a rental rate for money, and an interest rate tells us how much money for how much time. But there are many interest rates, each corresponding to a particular money market. Interest rates state money prices in each of these markets This chapter is the first dealing specifically with interest-bearing assets. As we discussed in Chapter 3, there are two basic types of interest-bearing assets, money market instruments and fixed income securities. For both types of assets, interest rates are a key determinant of asset values. Furthermore, since there are well over $20 trillion of interest-bearing assets outstanding, interest rates play a pivotal role in financial markets and the economy. . Because interest rates are one of the most closely watched financial market indicators, we devote this entire chapter to them. We first discuss the many different interest rates that are commonly reported in the financial press, along with some of the different ways interest rates are calculated and quoted. We then go on to describe the basic determinants and separable components of interest rates. 2 Chapter 9 Figure 9.1 about here. 9.1 Interest Rate History and Money Market Rates Recall from Chapter 3 that money market instruments are debt obligations that have a maturity of less than one year at the time they are originally issued. Each business day, the Wall Street Journal publishes a list of current interest rates for several categories of money market securities in its “MONEY RATES” report. We will discuss each of these interest rates and the securities they represent immediately below. First,, however, we take a quick look at the history of interest rates. Interest Rate History In Chapter 1, we saw how looking back at the history of returns on various types of investments gave us a useful perspective on rates of return. Similar insights are available from interest rate history. For example, at midyear 1997, short-term interest rates were about 5 percent and long- term rates were about 7 percent. We might ask, “Are these rates unusually high or low?” To find out, we examine Figure 9.1 which graphically illustrates almost 200 years of interest rates in the United States. Two interest rates are plotted in Figure 9.1, one for bills and one for bonds. Both rates are based on U.S. Treasury securities, or close substitutes. We discuss bills and bonds in detail in this chapter and the next chapter. For now, it is enough to know that bills are short-term and bonds are long-term, so what is plotted in Figure 9.1 are short- and long-term interest rates. Probably the most striking feature in Figure 9.1 is the fact that the highest interest rates in U.S. history occurred in the not-too-distant past. Rates began rising sharply in the 1970s, and then Interest Rates 3 peaked at extraordinary levels in the early 1980s. They have generally declined since then. The other striking aspect of U.S. interest rate history is the very low short-term interest rates that prevailed from the 1930s to the 1960s. This was the result, in large part, of deliberate actions by the Federal Reserve Board to keep short-term rates low - a policy that ultimately proved unsustainable and even disastrous. Much was learned by the experience, however, and now the Fed is more concerned with controlling inflation. With long-term rates close to 6 percent as this chapter is written, many market observers have commented that these interest rate levels are extraordinarily low. Based on the history of interest rates illustrated in Figure 9.1, however, 6 percent may be low relative to the last 25 years, but it is not at all low compared to rates during the 170-year period from 1800 to 1970. Indeed, long-term rates would have to fall to 4 percent or lower to be considered low by historical standards (but don’t hold your breath). (marg. def. prime rate The basic interest rate on short-term loans that the largest commercial banks charge to their most creditworthy corporate customers.) (marg. def. bellwether One that serves as a leader or as a leading indicator of future trends, e.g., interest rates as a bellwether of inflation.) Money Market Rates Figure 9.2 reproduces a Wall Street Journal “MONEY RATES” report of interest rates for the most important money market instruments. A commonly quoted interest rate is the prime rate. The prime rate is a key short-term interest rate since it is the basic interest rate that large commercial banks charge on short-term loans to their most creditworthy corporate customers. The prime rate is well-known as a bellwether rate of bank lending to business. 4 Chapter 9 Figure 9.2 about here. Loan rates to corporations with less than the highest credit rating are often quoted as the prime rate plus a premium, where the premium depends on the credit quality of the borrower. For example, a medium-sized corporation with a good credit rating might be charged the prime rate plus 1.5 percent for a short-term bank loan. Besides a prime rate for the United States, the “Money Rates” report also lists foreign prime rates for Canada, Germany, Japan, Switzerland, and Great Britain. (marg. def. Federal funds rate Interest rate that banks charge each other for overnight loans of $1 million or more.) The Federal funds rate (or just “Fed funds”) is a fundamental interest rate for commercial bank activity. The Fed funds rate is the interest rate that banks charge each other for overnight loans of $1 million or more. This interbank rate is set by continuous bidding among banks, where banks wishing to lend funds quote “offer rates” (rates at which they are willing to lend), and banks wishing to borrow funds quote “bid rates” (rates they are willing to pay). Notice that four different rates are stated: high is the highest rate offered and low is the lowest rate bid during a day's trading; near closing bid is a bid rate to borrow and near closing offered is an offered rate to lend near the end of the day's trading. (marg. def. discount rate The interest rate that the Fed offers to commercial banks for overnight reserve loans.) The Federal Reserve's discount rate is another pivotal interest rate for commercial banks. The discount rate is the interest rate that the Fed offers to commercial banks for overnight reserve loans. You might recall from your Money and Banking class that banks are required to maintain reserves equal to some fraction of their deposit liabilities. When a bank cannot supply sufficient reserves from Interest Rates 5 internal sources, it must borrow reserves from other banks through the Federal funds market. Therefore, the Fed discount rate and the Fed funds rate are closely linked. The Fed funds rate is normally slightly higher than the Federal Reserve's discount rate. The Federal Reserve Bank is the central bank of the United States. It is charged with the responsibility of managing interest rates and the money supply to control inflation and promote stable economic growth. The discount rate is a basic tool of monetary policy for the Federal Reserve Bank. An announced change in the discount rate is often interpreted as a signal of the Federal Reserve's intentions regarding future monetary policy. For example, by increasing the discount rate the Federal Reserve may be signaling that it intends to pursue a tight-money policy, most likely to control budding inflationary pressures. Similarly, by decreasing the discount rate the Federal Reserve may be signaling an intent to pursue a loose-money policy to stimulate economic activity. Of course, many times a discount rate change is simply a case of the Federal Reserve catching up to financial markets’ conditions rather than leading them. Indeed, the Federal Reserve often acts like the lead goose, who upon looking back sees the flock heading in another direction, then quickly flies over to resume its position as “leader” of the flock. (marg. def. call money rate The interest rate brokerage firms pay for call money loans, which are bank loans to brokerage firms. This rate is used as the basis for customer rates on margin loans.) The next interest rate reported is the call money rate, or simply the call rate. “Call money” refers to loans from banks to security brokerage firms, and the call rate is the interest rate that brokerage firms pay on call money loans. As we discussed in Chapter 2, brokers use funds raised through call money loans to make margin loans to customers to finance leveraged stock and bond purchases. The call money rate is the basic rate that brokers use to set interest rates on customer call 6 Chapter 9 money loans. Brokers typically charge their customers the call money rate plus a premium, where the broker and the customer may negotiate the premium. For example, a broker may charge a customer the basic call money rate plus 1 percent for a margin loan to purchase common stock. (marg. def. commercial paper Short-term, unsecured debt issued by the largest corporations.) Commercial paper is short-term, unsecured debt issued by the largest corporations. The commercial paper market is dominated by financial corporations, such as banks and insurance companies, or financial subsidiaries of large corporations. As shown in Figure 9.2, a leading commercial paper rate is the rate that General Electric Capital Corporation (the finance arm of General Electric) pays on short-term debt issues. This commercial paper rate is a benchmark for this market because General Electric Capital is one of the largest single issuers of commercial paper. Most other corporations issuing commercial paper will pay a slightly higher interest rate than this benchmark rate. Commercial paper is a popular investment vehicle for portfolio managers and corporate treasurers with excess funds on hand that they wish to invest on a short-term basis. (marg. def. certificate of deposit (CD) Large denomination deposits of $100,000 or more at commercial banks for a specified term. Certificates of deposit, or CDs, represent large-denomination deposits of $100,000 or more at commercial banks for a specified term. The interest rate paid on CDs usually varies according to the term of the deposit. For example, a one-year certificate of deposit may pay a higher interest rate than a six-month deposit, which in turn may pay a higher interest rate than a three-month deposit. Large-denomination certificates of deposit are generally negotiable instruments, meaning that they can be bought and sold among investors. Consequently, they are often called negotiable certificates of deposits, or negotiable CDs. Negotiable CDs can be bought and sold through a broker. Interest Rates 7 The large-denomination CDs described here should not be confused with the small-denomination CDs that banks offer retail customers. These small-denomination CDs are simply bank time deposits. They normally pay a lower interest rate than large-denomination CDs and are not negotiable instruments. (marg. def. banker’s acceptance A postdated check on which a bank has guaranteed payment; commonly used to finance international trade transactions.) A banker’s acceptance is essentially a postdated check upon which a commercial bank has guaranteed payment. Banker’s acceptances are normally used to finance international trade transactions. For example, as an importer you wish to purchase computer components from a company in Singapore and to pay for the goods three months after delivery, so you write a postdated check. You and the exporter agree, however, that once the goods are shipped, your bank will guarantee payment on the date specified on the check. After your goods are shipped, the exporter presents the relevant documentation, and, if all is in order, your bank stamps the word ACCEPTED on your check. At this point your bank has created an acceptance, which means it has promised to pay the acceptance's face value (the amount of the check) at maturity (the date on the check). The exporter can then hold on to the acceptance or sell it in the money market. The banker’s acceptance rate published in “Money Rates” is the interest rate for acceptances issued by the largest commercial banks. (marg. def. London Eurodollars Certificates of deposit denominated in U.S. dollars at commercial banks in London.) London Eurodollars are certificates of deposit denominated in U.S. dollars at commercial banks in London. Eurodollar rates are interest rates paid for large-denomination deposits. Eurodollar CDs are negotiable and are traded in a large, very active Eurodollars money market. The “Money 8 Chapter 9 Rates” report lists Eurodollar rates for various maturities obtained from transactions occurring late in the day. (marg. def. London Interbank Offered Rate (LIBOR) Interest rate that international banks pay one another for overnight Eurodollar loans.) The London Interbank Offered Rate (LIBOR) is the interest rate offered by London commercial banks for dollar deposits from other banks. The LIBOR rate is perhaps the most frequently cited rate used to represent the London money market. Bank lending rates are often stated as LIBOR plus a premium, where the premium is negotiated between the bank and its customer. For example, a corporation may be quoted a loan rate from a London bank at LIBOR plus 2 percent. (marg. def. U.S. Treasury bill (T-bill) A short-term U.S. government debt instrument issued by the U.S. Treasury) U.S. Treasury bills, or just T-bills, represent short-term U.S. government debt issued through the U.S. Treasury. The Treasury bill market is the largest market for short-term debt securities in the world. As such, the Treasury bill market leads all other credit markets in determining the general level of short-term interest rates. “Money Rates” reports Treasury bill interest rates set in the most recent weekly Treasury bill auction. Interest rates determined at each Treasury bill auction are closely watched by professional money managers throughout the world. The Federal Home Loan Mortgage Corporation (FHLMC), commonly called “Freddie Mac,” and the Federal National Mortgage Association (FNMA), commonly called “Fannie Mae,” are government-sponsored agencies that purchase large blocks of home mortgages and combine them into mortgage pools, where each pool may represent several tens of millions of dollars of home mortgages. We will discuss mortgage pools in depth in Chapter 13. The interest rates reported in “Money Rates” are an indicator of rates on newly created home mortgages. Since home mortgages Interest Rates 9 Figures 9.3 about here. are long-term obligations, these are not actually money market rates. However, with several trillion dollars of mortgages outstanding, the mortgage market has a considerable influence on money market activity. The Merrill Lynch Ready Assets Trust is a money market fund for customer accounts with the brokerage firm of Merrill Lynch. Recall from Chapter 4 that money market funds are mutual funds that invest in money market instruments. The interest rate reported in the “Money Rates” report is an average of interest rates paid on fund accounts over the previous month. In its daily “CREDIT MARKETS” column, the Wall Street Journal reports the most recent developments in the various markets for interest-bearing assets. A sample “Credit Markets” report is shown later in an Investment Updates box. A recurring feature of this section are charts of information regarding current interest rates and interest rates over the most recent several-month period. Figure 9.3 presents sample chart boxes from the “Credit Markets” column. The “Bond Yields” chart in Figure 9.3A is published each Monday. It graphs recent yields for AA-rated (medium high credit quality) utility company bonds, long-term Treasury bonds, and municipal bonds The “Key Interest Rates” chart in Figure 9.3B is published each Tuesday. This chart lists current interest rates for the major money market instruments along with interest rates for U.S. Treasury notes and bonds (which we discuss in a subsequent section). The “Short-Term Interest Rates” chart in Figure 9.3C is published each Thursday. It displays weekly averages of the Federal funds rate, the three-month commercial paper rate, and the three-month Treasury bill rate over the most recent several month’s period. The “Consumer Savings Rates” box in Figure 9.3D 10 Chapter 9 is also published each Thursday. This box lists prevailing interest rates for money market deposits, bank certificates of deposits, and U.S. savings bonds. CHECK THIS 9.1a Which money market interest rates are most important to commercial banks? 9.1b Which money market interest rates are most important to nonbank corporations? (marg. def. pure discount security An interest-bearing asset that makes a single payment of face value at maturity with no payments before maturity.) 9.2 Money Market Prices and Rates Money market securities typically make a single payment of face value at maturity and make no payments before maturity. Such securities are called pure discount securities because they sell at a discount relative to their face value. In this section, we discuss the relationship between the price of a money market instrument and the interest rate quoted on it. One of the things you will notice in this section is that there are several different ways market participants quote interest rates. This presents a problem when we wish to compare rates on different investments. But before we can do this, we must put them on a common footing. After going through the various interest rate conventions and conversions needed to compare them, you might wonder why everybody doesn’t just agree to compute interest rates and prices in some uniform way. Well perhaps they should, but they definitely do not. As a result, we must review some of the various procedures actually used in money markets. We hope you come to recognize that the calculations are neither mysterious nor even especially difficult, although they are rooted in [...]... the current price of the acceptance? 12 Chapter 9 As the following calculation shows, a discount yield of 5 percent and maturity of 90 days gives a current price of $98 7,500: $98 7,500  $1,000,000 × 1  90 × 05 360 The difference between the face value of $1 million and the price of $98 7,500 is $12,500 and is called the “discount.” This discount is the interest earned over the 90 -day period to when... 29 occurs within the next 12 months For example, 2000 will be a leap year So, beginning on March 1, 199 9, we must use 366 days in the formula above Then beginning on March 1, 2000, we must revert back to using 365 days 16 Chapter 9 Example 9. 4: Back to the Future - Leap Year Bond Equivalent Yields Calculate the asked yield (bond equivalent yield) for a T-bill price quoted in December 199 9 with 1 19. .. 0322 360 The discount is $15,205.56 Thus on this 170-day investment, you earn $15,205.56 in interest on an investment of $98 4, 794 .44 On a percentage basis, you earned 1.544%  $15,205.56 / $98 4, 794 .44 In a 365-day year, there are 365/170 = 2.147 periods of 170-day length So if we multiply what you earned over the 170-day period by the number of 170-day periods in a year, we get 3.315%  2.147 × 1.544%... Figure 9. 6 displays real interest rates based on annual rates of return on U.S Treasury bills and inflation rates over the 43-year period 195 0 through 199 2 As shown in Figure 9. 6, following a negative spike at the beginning of the Korean War in 195 0, real interest rates for Treasury bills were generally positive until the Organization of Petroleum-Exporting Countries (OPEC) oil embargo in 197 3 After... rates by looking at fixed-income securities To keep this discussion to a manageable length, we defer the details of how some longer term rates are computed to Chapter 10 Fixed-income securities include long-term debt contracts from a wide variety of issuers The largest single category of fixed-income securities is debt issued by the U.S government The second largest category of fixed-income securities is... asked price of 26:06 As calculated immediately below, its yield to maturity of 6.81 29 percent becomes 6.81 percent after rounding to two decimal places 6.81 29%  2 × 100 26.1875 1 40  1 CHECK THIS 9. 4a What is the yield to maturity (YTM) of a STRIP maturing in five years if its asked price quote is 77:24? 9. 4b What is the YTM of a STRIPS maturing in 15 years if its asked price quote is 38:26? 9. 4c What... $98 ,816.67  1  Days to maturity × Discount rate 360 $100,000 × 1  71 × 06 360 Check for yourself that the price in the second case of a 51-day maturity is $99 ,150. Treasury Bill Quotes The Wall Street Journal reports current interest rates on U.S Treasury bills each business day Figure 9. 4 reproduces a “TREASURY BILLS” interest rate report The maturity of each bill issue is stated in month-day-year... in the late 197 0s The tight-money policy caused the 198 0s to begin with historically high real interest rates Throughout the 198 0s, real Treasury bill rates were falling as inflation subsided During this 43-year period the average real Treasury bill interest rate was slight less than 1 percent 32 Chapter 9 Figure 9. 6 about here (marg def Fisher hypothesis Assertion that the general level of nominal... principles of the expectations theory can be explained with a two-period example Let r1 stand for the current market interest rate on a one-year investment, and let r2 be the current market interest rate on a two-year investment Also, let r1,1 be the market interest rate on a one-year investment that will be available in one year Of course, this rate is not known today 34 Chapter 9 For a two-year investment,... the Treasury yield curve 26 Chapter 9 (marg def U.S Treasury STRIPS Pure discount securities created by stripping coupons and principal payments of Treasury notes and bonds Stands for Separate Trading of Registered Interest and Principal of Securities.) Treasury STRIPS Until about 198 7, the term structure of interest rates was not directly observable simply because default-free, pure discount instruments . $1,000,000 × 1  90 360 × .05 $94 9,305.56  $1,000,000 × 1  365 360 × .05 As the following calculation shows, a discount yield of 5 percent and maturity of 90 days gives a current price of $98 7,500: The. detail in this chapter and the next chapter. For now, it is enough to know that bills are short-term and bonds are long-term, so what is plotted in Figure 9. 1 are short- and long-term interest. quoted in December 199 9 with 1 19 days to maturity and an asked discount of 5.41 percent. Since the 12 month period following the date of the price quote includes February 29, we must use 366 days.