Banking notes 3/5/2013

Why do yields change over time
(1) real interest rate changes (supply and demand curve in loanable funds market)
(2) credit risk
*(3) inflation and expected inflation rate
Fisher equation:  real interest rate = nominal interest rate - inflation rate

interest rate changes because people's expected inflation changes all the time

Why different bonds have different yields
(1) credit risks
 concern of default
people would demand a higher interest rate for to compensate the potential loss
risk premium
AAA has the highest safety
government treasures are nominally risk-free
junk bond and traditional bond


Revolving credit cards come branded with two important numbers - the maximum available credit and the interest rate. The credit line tells you how much money that you can borrow at once without paying off the balance. The interest rate is the portion of the balance that gets charged to your account as a financing fee when you have not paid off the balance in full at the end of every month.

Credit cards are unsecured, meaning that there is no collateral for your borrowing.
 The interest rate of credit card is high

Suppose a bank loans you $100, interest rate is 10%, and 4.5% of the loan is never paid back.
Bank needs 110$ next year, but statistically the bank can get back 110*(1-4.5%) = 105.56
So the bank will have to increase the interest rate to get it back.
Suppose the interest rate imposed is A, then 100*(1+A)*(1-4.5%) = 110
a kind of negative externalities

(2) liquidity
Liquidity premium:
A premium that investors will demand when any given security can not be easily converted into cash, and converted at the fair market value. When the liquidity premium is high, then the asset is said to be illiquid, which will cause prices to fall, and interest rates to rise.

For example, assume an investor is looking at purchasing one of two corporate bonds, each with the same coupon payments, and time to maturity. Assuming one of these bonds is traded on a public exchange, while the other is not, the investor will not be willing to pay as much for the non-public bond. The difference in prices, and yields, the investor is willing to pay for each bond is called the liquidity premium.

The measurement of liquidity is difference in asks and bids. 

People are willing to pay a higher price and demand a lower interest rate for liquid bonds and stocks. US treasury securities are one of the most liquid securities on earth, that is the major reason why Fed actually use them to conduct the open market operations.  We don't want interest rate be fluctuated greatly.

(3) taxes
if tax on interest is low, then interest rate is low
The reasons why municipal bond has higher interest rate than US treasury bonds are that (1) municipal bond are more illiquid (2) US treasury bonds are exempt from tax payment

One reason not to tax the rich: some people gain wealth from buying stocks and bonds, and if government tax on securities, it will have to have higher interest rate and these payment will be paid by the poor.

(4) maturity
Why is the yield curve normally upward sloping: expectation and preferred habitat
 lenders are concerned about a potential default (or rising rates of inflation), so they offer long-term loans for higher interest rates than they offer for shorter-term loans.

Expectation theory:  The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Expectations theory postulates that you would earn the same amount of interest by investing in a one-year bond today and rolling that investment into a new one-year bond a year later compared to buying a two-year bond today. This theory is sometimes used to explain the yield curve but has proven inaccurate in practice as interest rates tend to remain flat when the yield curve is normal. In other words, expectations theory often overstates future short-term interest rates. Another term-structure theory, preferred habitat theory, expands on expectations theory to explain why longer-term bonds tend to pay more interest than two shorter-term bonds that add up to the same maturity. It says that investors prefer short-term bonds and are only interested in longer-term bonds if they pay a risk premium. While expectations theory assumes that investors only care about yield, preferred habitat theory assumes they care about maturity as well as yield.

The reasoning behind the expectations theory is that bond investors only care about yield and are willing to buy bonds of any maturity, which in theory would mean a flat term structure unless expectations are for rising rates.

Preferred habitat: A term structure theory suggesting that different bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference if a risk premium for the maturity range is available. The theory also suggests that when all else is equal investors prefer to hold short-term bonds in place of long-term bonds and that the yields on longer term bonds should be higher than shorter term bonds.\

If expected inflation rate is high, then the inverse yield curve will occur, if there is no inflation rate, then the yield curve will be flat. 

(5) currency risk